Obama started backing off the “absolute default” tactic by today saying “This week, if we don’t start making some real progress both in the House and the Senate, and if Republicans aren’t willing to set aside some of their partisan concerns in order to do what is right for the country [ed. note: our guys are always the patriots and the other guys are always the partisans, right?], then we stand a good chance of defaulting.” So, it’s no longer a sure thing, and the hurdle he has laid out is “good progress” rather than a hard stop.
As I have said before, there should be no default even if there is no agreement reached in our day. There simply is no reason to default unless the Administration decides it is politically opportune to do so. Last week, White House spokesman Jay Carney said “prioritization is default,” meaning that the government would somehow be defaulting by choosing to pay debtholders before others, but that’s simply wrong. Servicing the bonds is most assuredly not a default no matter what else you do. Carney might mean “prioritization is a bad political situation for us,” and he might mean “not paying some vendors would be, if we were a private company, grounds for being forced into bankruptcy,” but the US Govt isn’t a private company and there is no way to force it into default if it services its debt. And it is interesting that the President is now walking back his threats that a default was inevitable if no agreement is in place by the time the debt ceiling is reached.
I am not so sanguine that the current developing deal in the Senate is going to end the impasse. Although Senate Republicans seem willing to give the Administration all that it wants, and probably to apologize as well, the House Republicans already tried their version of a complete surrender and it was roundly rejected by the Administration (and why shouldn’t it be rejected? With the government shut down and the constant threat of default in the air, stocks are +1.7% this month. Toy with us some more, please!). By the time this crisis is over, the Republicans will probably be offering to repeal the 22nd Amendment and let Obama serve another term!
If, in fact, the standoff is resolved, it remains to be seen how quickly all of the economic data releases get back on line once the government is back at work. In any case, some of the data from this month will be suspect because the regular collection procedures will not be followed. For example, even if CPI is released on Thursday (or delayed and released before the end of the month), it will not be based on a full month’s regular survey of prices since for the last week or two no one has been collecting prices. This will be corrected in the next release (since what the price collectors are surveying is the level of prices, not the change in prices), but it may lead to near-term confusion due to the indeterminate effects. Other releases suffer from similar problems of greater or lesser order, but considering how important CPI is right now this is a prime concern.
It is a prime concern right now firstly because the artificial inflation trough induced by the original sequester has passed and inflation will be rising going forward, and secondly (and more importantly) because we will soon have a new Federal Reserve Chairman in Janet Yellen who will have to confront the issue very quickly and either burnish or reject her dovish credentials. So far, it seems clear to most of us that Yellen is a committed dove although a story that circulated in late September tried to argue that since she had been an advocate of a formal inflation target it means she is actually a hawk.
Favoring an annual inflation target has almost no implications for interpreting whether a monetary policy maker is a hawk or a dove. In fact, of the various targeting regimes proposed the non-correcting annual target is the most dovish proposal. That’s because there is no penalty for missing the target. With this sort of target, if you have 2% inflation followed by 20% inflation followed by 2% inflation, you’re back on target and the central bank need do nothing further. But, of course, prices are much higher than if you’d experienced 2%, 2%, and 2%. Other proposals, such as the long-term price-level proposal, force the central bank to steer to a particular compounded inflation level, which means that a big miss to the upside must be “paid back” by a subsequent miss to the downside. Now that is a much more hawkish proposal, because it defends long-term inflation levels rather than declaring a toothless goal. (You can read more about inflation targeting in my article here from 2010). Yellen is among those who thinks it’s important to convince everyone there is a goal, because “grounded inflation expectations” (even if they’re not rationally grounded but rather grounded because you tricked consumers into thinking you really have a target) help to restrain inflation. And on this point there is really not much evidence.
But it also misses the point in the extant environment. If Yellen desires to limit inflation, merely stating that she wants inflation to stay around 2% isn’t a policy action, or even a policy preference. It’s merely an expression of her preference for possible states of the universe. My children do approximately the same thing, with the same effect, when they say “I wish we could have a horse/travel to the Caribbean/build an indoor pool.” Yeah, and I wish I had a Jaguar, too.
Wishing doesn’t make it so. If Bernanke/Yellen want to limit inflation to 2%, merely talking about it is insufficient. What Yellen needs to do is to take action now. (Actually, they needed to take action two years ago, but it’s like James Carville famously said: “the best time to plant a tree was twenty years ago. The second-best time is right now.”) To the extent that Yellen is not urging action to reduce the Fed’s balance sheet and restrain future money growth it means that either she doesn’t really care about 2% inflation, at least in the near-term, or she doesn’t understand what causes inflation. I suppose I hope it is the latter cause, since that would be consistent with Bernanke’s position: he probably cares about limiting inflation but doesn’t understand that letting the balance sheet grow without bound is among the worst things he can do to limit inflation in the medium-term.
I suppose it should not be surprising that there is a great deal of misinformation and misunderstanding about the debt limit and government default. A lot of people and especially folks in the media don’t understand these issues because they have never confronted them, and the warring parties seem to believe they have an incentive to get the media telling their story by whatever means necessary, even if that means spreading disinformation.
Some of this is confusion among non-financial people about what “default” actually means. An individual defaults when he or she fails to pay bills within a reasonable time after they come due. If the default is serious enough, a creditor can force the defaulting party into bankruptcy and attach assets.
This isn’t what it means to default as a sovereign country, however. A sovereign default is when a nation fails to pay interest or principal on its debt when due. And that’s all. If the U.S. fails to pay its soldiers, that is not default. It’s a bad move, perhaps, but it is not default. If the government doesn’t pay you, you can sue…but even if you win, there is no Chapter 7 or Chapter 11 bankruptcy for the U.S. government so you cannot attach assets. So this distinction is key: if the U.S. services the debt, there is no default. This is the case whether or not the debt limit increases or not.
It is much more surprising to read James Baker, who among other things has been Treasury Secretary, equating the debt limit increase with solvency. Mr. Baker was interviewed for Peggy Noonan’s column this week in the Wall Street Journal and said, speaking of the President, “He has to get the debt limit raised to avoid default.”
We can walk this through and show why there need not be a default in the case where the debt limit is not raised.
While the government at some point ceases to spend, since it doesn’t have Congressional authorization to do so, it still continues to collect revenue. The U.S. takes in a little less than $3 trillion per year in revenues, and if you think those taxes don’t need to be paid while the government is shut down I invite you to try. Against that revenue, interest payments on Treasury bonds are on the order of $300bln (I don’t have the exact figure). Principal repayments aren’t relevant for this calculation, because as bonds mature the Treasury can re-issue the same nominal amount of bonds. So all the Treasury needs to do in order to avoid default is to pay the interest. They probably also want to pay the $1.6 trillion in Social Security and Medicare payments, and maybe a fair amount of the $700bln in defense and homeland security spending although a lot of that is procurement. But there’s plenty more than is needed to avoid a default.
Incidentally, in theory the Treasury could take in more money by issuing Treasuries with above-market coupons. Perhaps there is a statute that requires the Treasury to always pay the minimum coupon possible, although I am not aware of it. But if there isn’t such a statute, then the Treasury could raise more money by doing the following: when a $10bln TBill issue comes due, the Treasury immediately re-issues a $10bln, 10-year, 10% bond at a price of around 165% of par. Voila, an extra $6.5bln for the coffers. What is limited by statute, as far as I know, is the face amount of bonds that may be issued, not the amount of money that can be taken in.
Now, the Treasury claims that it is unable to pay selected obligations. According to them, it is not operationally possible – the check run is either on, or it is off. All, or nothing. This represents either ridiculous incompetence, or an outright lie. Seriously? The Treasury has no way to cut a single check if it wants to? How about this: take a big stack of blanks and, instead of running them through the printer, fill them out by hand and have the Secretary sign ‘em. Painful? Absolutely. But it is inconceivable that it isn’t possible to run only some checks. The Secretary should speak to his I.T. guys.
We should keep in mind that the Secretary is the President’s former Chief of Staff, and probably knows a lot more about the politics of appearing to be unable to pay than he does the actual capabilities of the machinery.
Does any of this make default impossible? Of course not. There is always the possibility that politics or petulance cause the President to simply refuse to order the Secretary to prioritize interest payments on the debt. It would most likely cause dramatic long-term costs for the government and precipitate a real crisis, and I wonder if it might even be impeachable (the 14th Amendment does not seem to me to give the President the power to raise the debt ceiling and pay anything he wants, but it certainly seems to give him the power to cut checks in order to defend the “validity of the public debt of the United States authorized by law, including debts incurred for payments of pensions.”) But there is no financial reason that failure to raise the debt ceiling should result in an actual default.
Housekeeping note: if you missed my comment on CPI from Friday, you can find it here. And if you missed my Bloomberg Radio interview with Carol Massar on Monday, don’t worry! I will post it when Bloomberg makes it available on their site.
One of the busier sessions in recent memory (although still well short of 1bln shares traded on the NYSE, which was the standard not that long ago) resulted in a sharp rally in the equity market with the S&P +1.2% on the day.
The trigger for this holiday treat was the “progress” in the budget talks and what investors see as the increasing likelihood that the ‘fiscal cliff’ is averted. Be careful, however; whatever progress there was is fairly speculative, and I suspect we will see a bad news wiggle before all is resolved.
It is ironic, perhaps, that what is moving the process closer to resolution is the Republicans’ sudden refusal to be steamrolled, and to instead try and play the game rather than try to negotiate as if both parties were trying to reach a fair resolution. I refer to the fact that Speaker Boehner has begun plans to start a separate legislative track in the House of Representatives by passing a bill that would keep the Bush tax cuts in place for most Americans; the bill would not avert the spending cuts that would take effect as part of the “fiscal cliff,” but would keep the government from reaching more deeply into citizens’ pockets on January 1st. It is, therefore, just exactly what the Republicans would want in these circumstances: spending cuts without tax increases (although fewer spending cuts than they would like).
The fact that this is a good play from the standpoint of the Republicans was immediately apparent from the fact that Democrats wasted no time in accusing Boehner of not negotiating in good faith with the President, and the President himself abruptly began to try and compromise slightly from his heretofore rigid position.
Of course, the Boener plan won’t pass the Senate because it will produce exactly zero Democrat votes, and if it somehow passed by luck it would be vetoed by the President, so it has no chance to become law. However, by putting the Democrats in the position of having to vote against tax cuts, it greatly increases the chances that both parties might negotiate to something that all parties hate, and therefore passes with flying colors.
In the US system, by Constitutional writ all revenue bills have to start in the House of Representatives, so by the very nature of this process the Republicans, who dominate the House, hold the serve in this negotiation. Incredibly, this is the first time they’ve shown any desire to use that advantage to produce a bill that represents something closer to their views.
As noted above, equities reacted very well to the Republicans’ show of spine. I’d noted several weeks back that I thought the Republicans had little incentive to negotiate, since going over the fiscal cliff represents smaller government and this may be the only opportunity that party has to get smaller government in the next few years. If this move persuades the Democrats of this fact, and the President moves to address the spending problem rather than just trying to soak the rich, then the fiscal cliff may be averted. It’s really important in a negotiation, especially if a true compromise is to be reached, that your counterparty knows that you may walk away.
Personally, I think the odds are still against this happening before year-end, but some resolution fairly early in the new year is probably odds-on. However, with the debt ceiling also approaching, 2013 may well see more of these cliffhanger negotiations.
Bonds, interestingly, sold off. You would think that the prospect for a smaller deficit, even marginally, would help the Treasury market but in this case I think investors are reacting to the fact that if the fiscal cliff is averted, it lessens the chance of near-term recession and brings forward the day of reckoning for the Fed. Today, 10-year Treasury yields rose to 1.82%, which is near the highest level since early May, and 10-year real yields rose to -0.73%. Over the last five days, nominal yields have risen 16bps, and all of that has come from real yields. That is, inflation expectations have barely moved and 10-year breakevens remain at 2.50%. Ten-year inflation swaps are at 2.77%, and the important 1-year inflation, 1 year forward has risen to 2.23%.
So, whether the ‘day of reckoning’ for the Fed is near, or far…what do they do, when they’ve hit that point? And, more importantly, what does it do to the market?
Let’s assume that we are at some point in the future and either the Unemployment Rate has dipped below 6.5%, the forward PCE inflation rate has risen above 2.5%, or inflation expectations have become “unanchored.” The first thing that the Fed will do is to stop unlimited QE: the statement does not imply that they will immediately start trying to get out of the hole they are in, only that they will stop digging the hole. But suppose that inflation continues to tick up – since the evidence is that inflation is a process with momentum. What does the Fed do next? This is the real question. How quickly can the Fed react to adverse inflation outcomes?
The traditional option is that the Fed raises the overnight rate. The Fed announces this move, but the important part is what happens next: the Open Market Desk (aka ‘the Desk’) conducts reverse repos to decrease the supply of reserves, or sells securities outright if it wishes to make a more-permanent adjustment. This causes the price of reserves (also known as the overnight rate) to rise, and the Desk adjusts its activity so that the overnight rate floats near the target rate.
The problem is that this won’t work right now. There are far too many reserves in circulation for the overnight interest rate to be increased by reverse repos or small securities sales. In fact, if it wasn’t for the interest being paid on excess reserves, the overnight rate would certainly be zero, and might even be negative because the supply of reserves greatly outweighs the demand for reserves. They are called “excess” reserves for a reason – the bank doesn’t need them, and will lend them overnight for pretty much any available rate.
So in order for the Fed to push the overnight rate higher, it must first soak up all of the excess reserves in the system – about $1.5 trillion at the moment – by selling bonds. Obviously, this is not something that can be done in the short-term.
But this misses the point a little bit anyway, because it isn’t the rate that matters to monetary policy but the amount of transactional money (such as M2). The Fed can set the overnight rate at 1% by simply agreeing to pay 1% as interest on excess reserves (IOER). But that won’t do anything at all to M2, because it won’t change the amount of reserves in the system and doesn’t change the money multiplier that relates the quantity of those reserves to M2.
So the short rate is dead. It isn’t going to move for a very long time, unless the FOMC decides to help the banks out by paying a higher IOER. And if they do that, it’s not going to affect inflation so it would just be a sweet present to the banks.
Okay, so perhaps the Fed can sell those long-dated securities and push long-term interest rates higher, slowing the housing market and the economy and squelching inflation, right? That’s partly right: the Fed can sell those securities, and it can push long rates higher (although the Fed has oddly claimed that if it sold those bonds, interest rates wouldn’t rise very much, which makes one wonder why they did it in the first place since presumably the opposite would also be true and buying them wouldn’t push rates down), and that would slow growth. However, it wouldn’t affect inflation, because inflation is not meaningfully affected by growth (I’ve discussed this ad nauseum in these articles; see partial arguments here, here, here, and here). But you don’t have to believe all of the evidence on that point; just play it in reverse: if driving long rates down didn’t cause a sudden jump in inflation, why would driving long rates up cause a sudden dampening in inflation?
Fama, in that article I quoted last week, had a very good point which I thought it was worth developing in more detail. The Fed has its hands off the wheel with respect to inflation…which isn’t a problem, except that they’re sitting in the back seat. The back seat of a very, very long bus.
In any event the issue isn’t when the Fed starts its tightening, but when inflation stops going up. These are not the same things. If core inflation were to start ticking higher today, at a mere 1% per year, I think it would take 6-9 months for the Fed to stop QE (core PCE is at 1.6%), probably another 3 months at a minimum before they started to tighten, and then at least 1-2 years before they could have any meaningful impact on the money supply and cause inflation to slow. Maybe I’m being pessimistic, or maybe I’m being a bit generous by assuming that after a year the FOMC would start doing something very dramatic to sop up reserves, like issuing a trillion dollars in Fed Bills, but even assuming that everything works out just about as well as it conceivably can, if inflation started heading higher in that way then you’re looking at a core CPI figure of 4-5% before it stops rising. Like I said, it’s quite a long bus, and that translates to long “tails” of inflation outcomes.
How would markets react to this? Obviously, bond rates would be much higher, but would this be good or bad for equities? The conventional wisdom holds that equities are good hedges for inflation, because over a long period of time corporate earnings should broadly keep pace with inflation. While that is true, it is also the case that earnings tend to be translated into prices at lower multiples when inflation is high (a fact that has been known for a long time; in 1979 Franco Modigliani and Richard Cohn described this as an error but there isn’t consensus on that issue) so that stocks tend to do relatively poorly when inflation is rising and better when inflation is falling from a high level. Moreover, stocks do especially poorly in the early stages of inflation when short-term inflation is surprising to the upside, as the chart below (Source: Enduring Investments) illustrates.
This chart highlights headline inflation, rather than core, but the point should be clear: nominal bonds and equities produce good real returns when inflation is surprising to the low side (even if that means that inflation is just going up slower than expected), and very poorly when inflation surprises to the high side (even when the overall level is low).
In my mind, this means that every investor needs to have some inflation protection, but especially now when the chances for an ugly inflation surprise are significant. For the record, the best asset class when inflation is surprising to the high side as measured here? Even inflation-linked bonds have produced negative real returns in such circumstances, because the real yield increase outweighs the higher inflation accruals in the short run. But commodities indices historically produced a 4% real return over that time period when inflation surprised at least 2.5% to the upside.
 It isn’t clear to me why you would want to wait until they were unanchored, if anchoring matters, since presumably it isn’t easy to anchor them again. After all, the whole reason the Fed wants anchored inflation expectations is because a regime change is thought to be hard – so if they are unanchored, you’ve just made it really hard to get inflation back down. In any event there’s not much evidence that “anchored” inflation expectations matter to actual inflation outcomes, but it’s just weird to me that the Fed would imply that they’d wait until expectations get loose from the anchor.
The latest fiscal cliff follies are redolent of that old proverb:
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the message was lost.
For want of a message the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
On Wednesday, Treasury Secretary Geithner – one of the worst, if not the worst, Treasury Secretaries in history, I am pretty sure – said in an interview on CNBC that the Administration would “absolutely” send the country off the fiscal cliff if the rates on the top 2% of Americans don’t go up.
Now, I’ve heard lots of numbers bandied about, and decided I wanted to get the source data directly. The latest information i can find from the IRS is from tax year 2009, but it is instructive. According to the IRS, in 2009 there were 104,164,970 tax returns filed. The number with adjusted gross income above $200,000 was 3,912,980, or about 3.8% of all returns. They don’t break it down any more than that, so let’s call those successful people “the rich” and work from there.
Those 4 million returns covered $1.626 trillion in modified taxable income (32% of the total taxable income) and produced $429bln in tax (45% of the total tax generated). Now, let’s suppose that the top tax rate rose from 35% to 39.6% in tax, and for grins we’ll pretend that taxpayers are completely indifferent about this and so they do nothing to try and reduce taxable income (by, say, buying municipal bonds rather than corporate bonds). You might think that the tax take will rise by $74.8bln (4.6% * 1.626 trillion). But you’d be wrong, because the increase wouldn’t affect all of the taxable income paid by high-earners, but only that income that is taxed at the top marginal rate. In 2009, only $485bln in income was taxed at that rate, so a 4.6% increase in the marginal rate would only raise $22.3bln per year, or around $250-300bln over the next 10 years.
Now, over the last year the deficit has been about $1.1 trillion, so if I understand Geithner correctly, the Administration is willing to push the country over the cliff about an issue that amounts to 2% of the deficit, and would increase aggregate revenues by only 1%.
It’s one thing to argue for the philosophical point, but to say that you’re willing to put a hole in the bottom of the boat because you don’t like the seat you were offered…it seems a bit irrational.
What might be even more irrational is the sudden optimism that is breaking out all over Capitol Hill, about how great the economy will be if the fiscal cliff can just be averted. Today a Republican Senator being interviewed on CNBC said “The economy is ready to explode. There’s no doubt about that,” echoing what President Obama had said just a couple of days ago.
Do they mean implode, perhaps?
There is certainly no sign whatsoever that “the economy is ready to explode” ecstatically if the fiscal cliff is averted. Indeed, I think part of the reason we’re likely to go over the cliff is that the President wants to be able to blame the poor growth for the next few years on the Republicans in the same way he spent the last four years blaming the previous President. And the Republicans, since the Administration has offered no spending cuts and has dismissed entitlement reform altogether, don’t really have a choice unless they want to completely capitulate – at least with the fiscal cliff, some spending will be cut. Since, if austerity is enforced, there will be no way to test the counterfactual, it makes sense to build up how great it would have been. But the point I want to make is that to proffer such a claim only makes tactical sense if no deal is in the offing…because if a deal is struck, then we’ll quickly find out that the economy isn’t going to explode higher at all, and those statements will be exposed as completely moronic.
We will on Friday find out how much the economy is not exploding – surely, because of the impending cliff – when Payrolls (Consensus: 85k vs 171k) and Unemployment (Consensus: 7.9%) are announced. These figures will be impacted by Hurricane Sandy, so it will be difficult to interpret them. Or, perhaps I should add cynically that this uncertainty will make it even easier for politicians to claim whatever the heck they want!
With 10-year yields already at four-month lows (1.59%) and the bullish seasonal pattern having run its course, I think the risk is for higher bond yields both tomorrow and going forward. Now, the 1.82% level has mostly contained any selloff since April, but I think we will be headed in that direction. Equities have downside risk in my view after this recent rally (an even more impressive rally when you consider that Apple was dragging on the index!); I think there is far too much optimism about an imminent resolution to the fiscal cliff, and I don’t think we’ll see any resolution until after the new year.
Unless today’s unseasonably-warm temperatures in the New York area (through some metaphysical conservation-of-energy mechanism) means that Hell is freezing over, we are a long way from resolution on the fiscal cliff discussions.
The Republicans countered President Obama’s proposal for a $1.6 trillion tax hike with their own plan that would cut the cumulative deficit (according to static scoring, as all of these proposals are) by $2.2 trillion through a combination of closing special interest loopholes, introducing deduction caps on high earners, increasing the Medicare eligibility age, cutting some discretionary spending, and using chained CPI as the Social Security escalator in order to slow the growth of benefits. After having previously lambasted the Republicans for not offering specifics, the White House today labeled the proposal “nothing new,” apparently without irony.
To be fair, the Republicans had called the President’s proposal a “la-la land offer.” So you can see, we are obviously very close to a deal and a smiling, hand-shaking, giddy signing ceremony in the Rose Garden.
All of this is sheer madness. These hikes and cuts are measured over the projection horizon, so we’re arguing about cutting perhaps 20% per year from the current trillion-dollar deficits. Good heavens, it’s a good thing we’re not trying to do something radical, like balance the budget. The combination of the national debt and the Social Security and Medicare liabilities add up to over $1.1million per taxpayer (Source: www.usdebtclock.org), and the debate is over cutting around $20,000 per taxpayer over the next decade. Don’t strain yourselves, fellows.
It’s incredible that some of these things are even subject to argument. The Medicare eligibility age will eventually be effectively infinity, because the program is not viable on this planet with health care such as we have come to expect, and since the liability is in real terms (units of healthcare, not of dollars) we can’t inflate our way out of it. So gradually moving the eligibility age a whole lot higher is something that we simply will have to do. Why not now?
People who say that cutting the deficit by $2.2 trillion over 7-10 years is hard to do have not actually tried it. It is actually pretty easy to get the budget back to some semblance of balance, as long as you don’t have to run for re-election or if you consider the future of the country to be more important than winning another term (and you know, there’s even a chance your constituents may reward that bold sacrifice!). All that you have to do is to reverse most of the things we’ve done to the budget over the last decade and you’re close – of course, the interest costs now are a lot higher, and will only climb in the future. But if you put entitlement reform on the table, it gets downright easy…again, if you don’t have to run for re-election.
Now, that interest portion of the deficit is somewhat scary. The chart below comes from Bloomberg, and it’s one of my favorite Bloomberg functions (DDIS). It shows the debt maturity distribution of U.S. Treasuries, and shows the interest and principal amounts currently scheduled.
It appears as if the interest costs (right column) max out at $196bln in 2013 and then decline, but keep in mind that these numbers ignore the fact that debt will be rolled when it matures. The $196bln is something closer to the baseline expectation, in the event that the Fed keeps interest rates anchored pretty near zero. It may be disturbing to note that the Treasury next year needs to roll $1.26 trillion in maturing securities, in addition to the $1 trillion of new money they need to raise due to the deficit; in 2014 the problem will start to grow even scarier as all of the 5-year issuance from 2009 starts to come due, along with all of the debt that has been rolled in the last couple of years. If you want to point to a come-to-Jesus moment in the bond market, it is likely to be in 2014 when this fact intersects with the expectation of the end of QE. It’s one thing to sell $2.26 trillion in Treasury securities if the Fed is committed to buying $1 trillion of them. It’s a little harder when they’re not, or if they are (as they claim they can) actually trying to sell some Treasuries from their own vaults. Good luck.
That’s why I don’t think we ought to be arguing over $200bln per year in the fiscal cliff. The problem is already much larger than that.
Now, that presumes that QE actually ends sometime in 2013. Some Fed officials have recently made noises to suggest that there is no reason that QE needs to end any time soon, and that the Fed is “nowhere near” the limit of what it can do. The problem is that 2014 will force a very serious choice on the Fed, because I think inflation is going to continue to rise throughout next year (our point forecast for core inflation is about 2.8% for 2013, but with all the tails to the upside), while I seriously doubt that Unemployment will get below 7%. And, as just noted, the market reality is that without Fed buying, the Treasury is going to have a devil of a time placing its debt in 2014 without higher yields (as an aside, I also suspect all dollar swap spreads will be negative in the next few years).
I’m not the only one who thinks that inflation is likely to be rising. While the nominal interest rate debacle is, in my opinion, not likely to hit us until 2014, rising inflation is happening today and the expectation of a continuation of that trend is being reflected in inflation swap rates. The chart below (Source: Bloomberg) shows that 10-year inflation swap rates are again up around 2.75%.
Now, if inflation expectations are rising but the Fed is going to fix nominal 10-year rates at 1.60%-1.80% where they are now, then the scary result is that TIPS yields, already ridiculously low, could go further. I am not bullish on TIPS, because as a rule I won’t buy something that is rich on the expectation that it might get richer. That way lies madness, since when the thing you bought goes down you have no plausible excuse. Moreover, speaking for myself, I know that I would be unable to maintain a position that I knew to be fundamentally mispriced the wrong way. But if 10-year inflation expectations went to, say, 3.6% and 10-year nominal yields were fixed at 1.6%, real yields would be forced to -2.00%. This is the reason I won’t short TIPS in the current environment, although I view them as overvalued.
What article would be complete without news from Europe? Today Greece offered to pay up to €10bln to buy back their own bonds, with bids due Friday. Completion of this buyback is a precondition to Greece’s receiving the next tranche of the bailout, but it will be challenging if they refuse to pay market prices (as the Euro finance minister communiqué released last week suggested, since it limited the prices paid to those prevailing on November 23rd). It still is a philosophical step forward, since at least it serves to recognize the unrealized gains that Greece effectively has when its liabilities are priced where they are now. This is, after all, essentially the same thing that happens in a default: in that case, Greece would offer to pay 35 cents on the dollar for all of its debt. In this case, they’re trying to “default” on just enough of the private debt so that the public debt can be carried at par for a while and maybe, someday, be paid off at par.
I just wonder if they can make it to “someday.”
Whether it is that the passage of the U.S. election released Europe to begin fighting amongst themselves again about Greece, or instead that they’ve been fighting the whole time and we just didn’t notice because we were so introspective, it’s certainly happening and heating up again. The Eurozone finance ministers are bickering, publicly, over whether Greece should be given two more years to hit its financial targets. (See articles here and here.) Also, and more importantly, the IMF wants the government owners of Greek bonds to write off some of their losses and lessen the Greek burden while some of the finance ministers (e.g., German Finance Minister Schauble) insist “that’s not legally possible.” Guess what? It’s going to happen whether it’s legally possible or not – but not this month. Greece will probably eventually get its tranche/lifeline this month, but the battle will be engaged with increasing intensity as time goes on.
That, however, is not the reason why stocks keep sliding (S&P -1.4% today) and bonds keep rallying (albeit gently today, with the 10y note yield down to 1.59%). I think that is happening because one week post-election, there is no sign that either Democrats or Republicans are budging on their positions vis a vis the fiscal cliff. The Democrats are winning on messaging, as they usually do these days, with the “Papa John’s Pizza approach” in which they have seized on the part of Romney’s budget proposal that they liked (reducing deductions for high-income taxpayers) while ignoring the connection of that element with the intention to keep tax rates down. I call it the Papa John’s Pizza approach because it reminds me of the commercial with Peyton Manning.
Republicans: So how are we going to do this?
Democrats: We loved Romney’s idea, and we agree with you. We’ll cut deductions.
Republicans: No, no, no, no, no…you mean we’ll cut deductions and keep income tax rates from rising.
Democrats: Right. We’ll cut deductions.
Republicans: …you mean we’ll cut deductions and keep rates from rising.
Democrats: I’m glad we agree. We’ll cut deductions. See how open minded we are? We’re using Romney’s plan!
Say what you want about the class warfare approach, the Democrats run rings around the Republicans when it comes to communication.
One place where better communication is actually destructive, but ironically one of the only places where we’re actually moving towards better communication, is at the Federal Reserve. A Wall Street Journal article today was entitled “Fed Leans Toward Clearer Guidance,” and indicated that “the Fed would state how high inflation would have to rise or how low unemployment would have to fall before it would begin moving rates, which have been near zero since late 2008.” This was the main newsworthy point that Fed Vice-Chair Janet Yellen made yesterday, and it was driven home today in the release of the minutes from the October Fed Meeting:
“A number of participants questioned the effectiveness of continuing to use a calendar date to provide forward guidance….Many participants thought that more-effective forward guidance could be provided by specifying numerical thresholds for labor market and inflation indicators.”
Since June, a “soft” Evans Rule based on this idea has been in place, as I pointed out at the time. It is not terribly surprising that the Fed would move towards a more explicit formulation of the rule, because Fed economists have never figured out why ambiguity is a good thing when it comes to policy-making. If they really do manage to reduce the Fed’s deliberations to a series of simple and public rules, then they should just finish the job and replace the Fed with a computer, as Milton Friedman proposed many years ago.
As I’ve written frequently (and borderline obsessively), clarifying the exact path that the Federal Reserve will take in the future reduces the uncertainty that investors face. This is good in the absence of leverage, but if the opportunity to leverage exists then the decrease of apparent uncertainty causes an increase in the leverage desired by investors. The problem is that a margin of safety doesn’t only protect an investor from known uncertainties, which would decrease in this instance, but also from unknown uncertainties, which would not be affected and for which a margin of safety is absolutely crucial if we desire to avoid another financial market meltdown. But no one is listening to me.
Commodities rose today, despite the continued decline in equities. This is not unreasonable. I think that commodities and stocks are telling two different stories. If there’s a recession, it should hurt stocks and commodities (but more directly should hurt stocks) while further QE3 ought to help them (but more directly help commodities). Right now stocks are going up on QE3 while commodities are going down on the recession … exactly the opposite of what ought to be happening. To my mind that just means the ‘value gulf’ is getting wider and wider. The chart below (Source: Bloomberg) shows the ratio of the S&P total return index to the DJ-UBS index.
Right now there is an enormous loathing for commodities that I don’t really understand – it seems to me to be the bipolar nature of commodities investors that they either love or hate the stuff. It probably comes from the fact that there are no “value” investors in commodities since the theory on what constitutes “value” is so light. Right now it looks to me like stocks are relatively expensive, although they’ve been that way for a while.
For tomorrow’s CPI figures, the consensus forecast calls for an 0.1% rise month/month for both the headline and core indices (seasonally adjusted), maintaining the y/y core increase at 2.0%. Last month, core rose to 1.98%, and we’re ‘dropping off’ a +0.17% on the y/y comparison. If economists are right, and 0.1% is the rounded change in core inflation on the month, then the y/y rise in core inflation will more likely decline to +1.9% than stay at +2.0% (of the possible prints that would lead to +0.1% on the monthly, from +0.05% to +0.149%, anything from +0.05% to +0.129% would cause a downtick in the y/y figure while only monthly changes in the range of +0.130% to +0.149% would keep the number stable.
However, I don’t see what will cause core to droop like that. I think economists are paying too much attention to the last several monthly changes and ignoring the fact that the weak prints were caused by outlier points (as evidenced by the fact that the Median CPI of the Cleveland Fed and the Sticky CPI of the Atlanta Fed, both different measures of central tendency, remain at +2.3% and +2.2% respectively). Moreover, housing CPI – the main driver of core inflation – is accelerating with both primary rents and owner’s equivalent rent rising last month, and all indicators of housing tightness from housing inventories to apartment tightness continue to suggest that higher price increases are more likely than lower price increases ahead. Moreover, we’re seeing upside surprises in other countries, such as in Greece that I mentioned yesterday, the in the UK where core inflation rose to +2.6% y/y versus 2.2% expected (see Chart, Source Bloomberg), befuddling most economists there.
That doesn’t mean the y/y core figure in the U.S. will definitely rise back to +2.1% this month; to do that, core would need to print +0.23% for the month, meaning the main body of the economist profession was off by half. Come to think of it, that’s not so far-fetched. If the last three months of core prints (+0.090%, +0.052%, and +0.146%) are quirky-low, then there should be a payback at some point. It’s hard to call for that in any given month, though.
Wow, where do we begin after a hurricane-induced hiatus? So much has happened. Since I last wrote, the U.S. elections have fallen into the rear-view mirror, the Bank of Japan has increased its asset purchases again, Greek inflation has accelerated to 0.9% from 0.3% (while Greek Industrial Production contracted for the 49th of the last 53 months, illustrating again how helpful it is to look at the growth rate of a country as a guide to deflationary pressures), and the stock market has moved to 3-month lows (and 10y note yields to 2-month lows) while the dollar has strengthened.
By far the largest event of the last couple of weeks, besides the restoration of power to my home, has been the U.S. elections. The immediate weakness in equity markets is completely understandable, but for the most part doesn’t reflect a vote against the President. Real equity market returns will be weaker over the next couple of years, but that’s because current valuation levels are high and future earnings will be lower than they would be under a more capitalist government. I don’t think investors are putting prices lower on that theory; indeed, as I wrote just before Sandy I thought that stocks are more likely to go higher than lower in the short-term with an Obama victory.
But let me define short-term, because in that post I completely neglected the very short-term effect of the days just after an Obama victory. I think an important part of the selling of equities now is reflecting investor realization of tax gains now, versus in the future when capital gains and income tax rates are likely to be at least somewhat, and potentially significantly, higher. That’s not a long-term effect, because those investors will also buy companies they perceive to be relative bargains in the case of a profligate spending policy (which is what everyone agrees we are likely to get – although some people think that’s a good thing; I suppose your own feeling on that matter likely defines how you voted). So this is mostly a cycling of positions, a re-setting of tax basis at a higher level, and shouldn’t amount to a major selloff by itself.
There still may be some net selling while the twin risks of the “fiscal cliff” and the Greek exit from the Euro remain uncertain and near-term. And here is where I am getting somewhat uneasy with my bullish argument (which hinged on the notion that typically myopic investors would prefer a 2013 recession that is shallower, due to heavy government spending, than a deeper one due to a Republican shrinking of government aka “austerity”). I think there are some bigger issues that are hard to look past right now, and they are related to those twin risks I just mentioned.
One of those issues concerns the “fiscal cliff.” Perhaps I am cynical, but I have long expected the issue to be averted at the eleventh hour (as usual – for example, see the annual ‘doc fix’ for Medicare). But it now occurs to me that the Republicans have absolutely no reason to compromise on their demand for no increase in taxes. Under a President Romney, the Republicans would have been able to leverage their control, make a few key concessions, and avert much of the damage. Under a President Obama, forcing the cliff to take effect is now the only way that the minority party of smaller government can force any austerity over the next few years. Especially if you believe – and I think it’s worth considering – that the failure of the Republicans to unseat a President with sub-50% approval ratings and an ~8% Unemployment Rate indicates that the argument is lost that we should take short-term pain in order to restore fiscal sanity, this represents the best remaining hope for fiscal sanity. The only way I can see the Republicans giving in on the ‘fiscal cliff’ is if (a) they sell their principles, which is always a possibility, or (b) the Democrats promise considerable compensation in terms of future legislation. I can’t imagine what that would be. So, in short, I think the odds that there will be a resolution of the ‘fiscal cliff’ have dropped considerably.
The second issue is the one of Greek exit from the Euro. I think I have been very consistent on this issue: I do not believe there is a viable future path in which Greece remains in the Euro. Whether the exit is clean and negotiated or sudden and traumatic or painful and drawn-out is the issue. This has been clear for months, even years, now. Yet, for a couple of months there has been relative quiet on this front, until the last week or two as the Eurogroup considers the distribution of the next aid tranche to Greece. We’ve also stopped hearing much about Spain, Italy, and Portugal although the Spanish 10-year bond yield is creeping back to 6% again (5.88% today). I don’t think this silence heading into the U.S. elections was accidental. The relationship between the U.S. President and the citizens of the world ex-U.S. is a very strong one, and I have no doubt that the politicians in Europe recognized that their chances of getting help from U.S. taxpayers would be much better after November 6th if Obama won re-election. Now that he has, the European issue must be confronted as world growth is weakening again. I have no idea whether the U.S. will try and contribute to a solution (which would ensure a painful and drawn-out resolution in which Greece would still, at the end, leave the Euro), but in any event this set of events is back in motion, and is not positive in the short-term for world growth or equity markets.
So in short, while I still think we can trust the myopia of equity investors to push markets higher over the next couple of months, I am less sure of that than I was. The election was a trigger for a lot of potentially bad outcomes, and with equity markets remaining rich I would certainly be maintaining a conservative risk posture here.
At least something can be conservative.
Since the financial markets are almost shut today due to “Frankenstorm,” and will in fact close early today, I am writing this article early on the notion that (a) it will be difficult to write later and (b) there will be little additional news worth writing about.
Not much paradigm-changing economic data has come out recently. Thursday’s Durable Good numbers were approximately on-target (ex-transportation +2.0% versus +0.9% expected, but with a revision to August’s figures of -0.5%), as were Initial Claims (369k, right in the middle of the range) and Friday’s initial release of the Q3 GDP report (2.0% vs 1.8% expected, with Personal Consumption +2.0% vs +2.1% expected). Today’s Personal Consumption and Spending reports were as-expected, as were all of the price deflators. The Dallas Fed Manufacturing Report was a bit stronger-than-expected but is merely back in the middle of the 3-year range.
There is, though, some positive economic news although it will take some time to be realized in the official figures. Gasoline futures recently approached the lows for the year (although in the last few days the approach of Hurricane Sandy and the general tightness in the delivery markets has caused a not-negligible rally), and retail gasoline prices which were recently threatening $3.90 are back to $3.54 (I wait with bated breath to see whether the people who shriek about the inflationary impact of gasoline rising will shriek with joy now that it’s falling – this volatility, folks, is why the Fed focuses on core inflation…not because they don’t drive). This is an unmitigated positive, if a small one, for the economy. While gasoline prices are still a multiple of where they were at the 2008 lows, they are only 18% above where they were to end 2007 (see chart, source Bloomberg).
Set against that, however, is the unmitigated negative of the election and the fiscal cliff. A Wall Street Journal story from late last week identified something we have seen in our business and which has been reported anecdotally by a number of our contacts.
Here is why dozens of chief executives have inserted themselves into the debate over reducing the federal budget deficit: Some say uncertainty over the looming “fiscal cliff” of tax increases and spending cuts already is hurting their business. “It’s a pause button,” Robert Swanson, executive chairman of Linear Technology Corp., told investors Oct. 17, after the semiconductor maker reported a 3% drop in fiscal first-quarter profit. Chief Financial Officer Paul Coghlan said companies that use Linear’s chips are growing more cautious before the election and the Dec. 31 deadline.
It isn’t merely the fiscal cliff itself. I’ve heard from a number of potential clients (in the financial industry and elsewhere) that there is great uncertainty associated with the results of the election itself. While the ‘fiscal cliff,’ a collection of tax increases and spending cuts that automatically kick in at year-end if Congress and the President do not agree to an alternative budget, could cause great short-term damage to growth in 2013, business-owners also believe that for the first time in the last half-dozen or so elections the results of the Presidential contest will have a significant effect on the business climate going forward. From a taxation perspective, on the basis of the future of Obamacare, on the degree of regulatory intrusiveness, the candidates seem to differ much more significantly than were McCain v. Obama, Bush v. Kerry, Bush v. Gore, Clinton v. Dole, or Clinton v. GHW Bush. Arguably Dukakis vs. GHW Bush showed a meaningful difference, and certainly Reagan v. Mondale, but it has been a generation since the election was thought to matter very much to business. This year, it certainly does. A storm is coming on November 6th, but like Frankenstorm it will pass.
But that doesn’t mean the election frees the stock market. I believe that a Romney victory (which is the current odds-on bet since undecideds typically break heavily for the challenger and he already has a lead overall and is tied or ahead in every important battleground state) would send stocks lower, while an Obama victory would send them higher – in the short term. The reason I believe this is that I think investors will interpret a Romney victory as producing a greater chance of fiscal austerity (relatively, that is – we’re not getting any important austerity in this country for a while) and a greater chance of a less-accommodative Fed over the next couple of years especially when a President Romney would replace Bernanke (whose term is up in January 2014) with a hawkish Chairman. These things would be more likely to produce a deeper recession in 2013 than we are already likely to get under Obama.
However, let me be clear: I think the Romney policies are closer to the correct policies, and I am highly confident that the stock market in five years would be significantly higher under Romney’s stated policies than under Obama’s. But the stock market is full of short-term-focused investors these days, and the more immediate focus would be on the near-term implications of a change from a relatively profligate fiscal and monetary policy (that anaesthetizes near-term pain even as our limbs are sawed off) to one that aggressively moves to address the nation’s financial future sanely, at a somewhat higher short-term cost.
The data seems to support this. Below is a chart combining the Intrade market for the probability of President Obama’s re-election (in white) and the S&P 500 (Source: Bloomberg), showing that this phenomenon has existed for a while. There is some argument that the causality runs the other way – that a lower stock market indicates a slower economic outlook and therefore a lower likelihood of Obama’s re-election, and I agree there is some circularity there. But I suspect the current consensus view, that a Romney victory is a big win for “risk-on” assets, is wrong in the short-term.
Now, I should say that I think Intrade investors are far off on the actual probabilities, but the point is the direction of movement. Also note that because the Intrade market is a binary option that either ends up at 100 or 0, it will naturally gain volatility as the market gets closer to election day. A similar effect will happen in the equity market, but it will not of course be as pronounced. (See my note on the subject of option-like market behavior here.)
I expect to get some partisan vitriol on this article. Save it – the power is going to be out, and so your anger will go unrequited! (Do you think it was an accident that I wrote this article today?!) Good luck to all in the hurricane’s path. It’s going to be a bumpy ride.
Here is a summary of my post-Employment tweets (@inflation_guy on Twitter):
- Before any comments about unemployment, a note: it isn’t the NUMBERS that affect the political race, it’s the reality of unemployment.
- Unemployment rate 7.796% from 8.111% and vs expectations of 8.2%. 114k new jobs, tho weak in private payrolls, +86k net revisions though.
- According to household survey, 873k more people are employed this month. Uh huh. can you say ‘seasonal adjustment problem?’
- I doubt there is manipulation in these numbers, but they’re the kind of numbers that make people suspect manipulation.
- avg hourly earnings and avg weekly hours both a tick higher than expected.
- In sum, this isn’t a robust report by any stretch (114k new jobs), but it’s better than expected. I expect the unemp drop will retrace.
- Series I like, “Not in Labor Force, Want a Job Now,” fell to 6.727mm people: still 2nd highest since series started in 1994.
- As a reminder: people don’t vote the numbers they see on TV. They vote the numbers they see and feel.
The Employment report was good, but not terrific. Any way you slice it, 114k new jobs isn’t going to get anyone dancing in the streets, even with revisions. A quick word to the conspiracy theorists out there: if I was going to manipulate this number, I would do a better job. By monkeying with seasonal adjustments and secondary assumptions, you could produce a much better “new jobs” number. It would require a whole lot of people to be “in on it,” so you might as well get some value out of it, if you’re that kind of sleazebag. So I don’t think there’s any manipulation here, just bad seasonal adjustment.
But more importantly, it isn’t the number that affects the election. People think that because the unemployment rate and the re-election success of the incumbent are related, the former causes the latter. It’s not so. It’s that both are related to a third factor, the actual condition of the labor market. Remember that these are experiments, imperfect estimates of real world conditions. As it turns out, individuals are really good at assessing the state of the job market without any help from the statisticians – they just look at how many of their pals are out of work. So even if this was a completely made up number (or, more likely, just a fortuitous wiggle in the Obama direction), it wouldn’t affect the polls. Thought experiment: if the BLS today had reported 4% unemployment, what would the effect on the election be? The correct answer is zero, because everyone would know that’s not the real unemployment rate.
It’s the same thing here. If the unemployment rate really dropped 0.3% in one month, then it will affect the polls. If it didn’t, it won’t.
Judging from the total of the various employment and activity series we have, I think we have an economy that is still growing slowly, but decelerating and risking a relapse into recession. But we’re not there yet.