Today new Fed Chairman Janet Yellen jumped on the bandwagon in blaming the recent growth slowdown on the weather.
Here’s what I have to say about the news and the weather.
First, although it’s becoming quite passé to point this out, the weather should account for a slowdown in economic activity – but, since economists were aware of the weather (presumably), it is less clear that it should account for a surprise in the amount of slowdown we are seeing. The chart below (source: Bloomberg) shows the Citibank economic surprise index, which measures how much recent data have exceeded (positive) or fallen short (negative) of expectations. It is not a measure of growth, per se, but merely of the direction in which economists are missing. I have plotted both the US index and the Eurozone index.
Obviously, economists were far too pessimistic about the numbers in December and January (reflecting data from October to December, and data kept exceeding their estimates. But now they are over-exuberant. So it isn’t that the numbers are falling short; it’s that they’re falling short of where economists (who can presumably recognize snow) thought they would be incorporating the known weather drags. That could simply mean the weather had a worse impact on real people than the bow-tied set thought it would. Or it could mean data is weaker than it ought to be.
Second point: just because the weather was bad should not be taken as carte blanche for the economy to collapse. If the economy was really as strong as equity investors seem to think, should weather be able to derail it so easily? Yes, weather makes it harder to detect the natural rhythm of what is going on, but it wasn’t as if that was easy to begin with. The danger is, as I suggested a week and a half ago, when all news can only be neutral or good. That’s a bad sign for once the weather normalizes again and it gets impossible to shrug off bad news as easily.
Third point: was the weather as bad in Europe? Because, as you can see from the chart above, economists have also been missing on the optimistic side for European figures. To be sure, they’ve been missing by less, and the numbers surprised less on the positive side over the last couple of months, but I don’t know that the Polar Vortex ought to be affecting Italy as seriously as it is affecting Chicago.
All of which is simply to say that the weather isn’t going to be bad forever, so … make hay while the sun doesn’t shine, I guess. Stocks are flat on the year, the hard way (but commodities are +6.5%, measured by the DJ-UBS index; according to our valuation estimates, that should be the normal case over the next few years rather than the rarity it has been over the last few).
It is interesting, too, that as bad as the weather effect has been on the construction industry and sales it hasn’t really impacted the price dynamics at all. The chart below (source: Bloomberg) shows Existing Home Sales in white, and the year/year change in median sales prices of existing single-family homes. Sales are 14% off their highs (seasonally-adjusted, which you should take with a grain of salt due to the unseasonal weather, but notice that the decline started in August when the snow was appreciably lighter), yet prices are still rising at nearly 11% year/year.
Now, a housing bull will say that these are the opposite faces of the same coin. They would say, “because there is so little inventory available – according to the NAR, only 1.9mm homes are for sale, which is higher than last winter but otherwise the lowest since 2002 – prices are rising and fewer are being sold because of the shortage of supply.” This is certainly possible, although I wonder at where all of the ‘shadow supply’ and bank REO property got off to so quickly, especially since the pace of existing home sales (and new home sales) remain at such low fractions of the pace prior to 2007 (existing home sales is currently 64% of the peak rate in 2005; new home sales are at 34% of the 2005 peak). How do you get rid of inventory without selling it?
The housing market continues to be a conundrum, but without a doubt prices are rising. And, also without a doubt, rising home prices are beginning to push rents higher. More economists are raising their forecasts for core inflation looking forward over the next year. Of course, readers of this column know that this is old news here. Speaking of which, Enduring Investments’ Quarterly Inflation Outlook for Q1 has been published. Institutional investors and others interested in our services can register for this private report on our website by filling out the contact form and requesting access to the blog.
Finally, I want to make one observation about the complete impotence of the Republicans to respond to the Democrats’ push for a higher minimum wage. It is terribly distressing to see such bad economics from one party (in this case, the Democrats) and such utter lack of common sense responses to bad economics from the other party (in this case, the Republicans). Here is the only question that needs to be answered: if raising the minimum wage has only salutatory effects on the economy and on the working class, then why not raise it to $1000/hour? Why not $10,000 per hour? Surely, if raising the minimum wage is good, then raising it more can’t be bad. Republicans should be amending the bill to make the minimum wage $10,000/hour.
The obvious answer is that if the minimum wage was $10,000/hour, no one would hire anybody – and we all know that, and even Democrats know that, and we all know why: because there is almost no one in the country who can produce enough goods or services to be worth $10,000/hour. If you are hiring people, you have to decide whether you will get enough out of them to afford their labor and still stay in business. The answer is obvious at $10,000. But it’s the same question at $10: can this group of workers produce enough so that I can afford to pay them all $10? If not, they will not be earning $10/hour but $0/hour (or at least some of them will be). We know exactly what would happen with a $10,000/hour minimum wage, and it’s easy to demonstrate it. But the Republicans are absolutely inarticulate on this point, and on most points, and that is why they keep losing arguments where they have the stronger position.
Housekeeping Note: earlier this week I published an article on the Mt. Gox/bitcoin fiasco. If you didn’t see the note (it didn’t get out on all of the syndication channels), you can find it here.
Since I wrote a blog post in early December on “The Effect of the Affordable Care Act on Medical Care Inflation,” in which I lamented that “I haven’t seen anything of note written about the probable effect of the implementation of the Affordable Care Act on Medical Care CPI,” several things have come to my attention. This is a great example of one reason that I write these articles: to scare up other viewpoints to compare and contrast with my own views.
In this case, the question is not a trivial one. Personally, I approach the issue from the perspective of an inflation wonk, but the ham-handed rollout of the ACA has recently spawned greater introspection on the question for purely political reasons. This is awkward territory, because articles like that by Administration hack Jason Furman in Monday’s Wall Street Journal do not further the search for actual truth about the topic. And this is a topic on which we should really care about a number of questions: how the ACA is affecting prices, how it is affecting health care utilization and availability, how it is affecting long-term economic growth, and so on. I will point out that none of these are questions that can be answered definitively today. My piece mentioned above speculated on possible effects, but we simply will not know for sure for a long time.
So, when Furman makes statements like “The 7.9 million private jobs added since the ACA became law are themselves enough to disprove claims that the ACA would cause the sky to fall,” we should immediately be skeptical. It should be considered laughably implausible to suggest that Obamacare had a huge and distinguishable effect before it was even implemented. Not to mention that it is very bad science to take a few near-term data points, stretching only for a couple of years in a huge and ponderous part of the economy, to extrapolate trends (this is the error that Greenspan made in the 1990s when he heralded the rise in productivity growth that was eventually all revised away when the real data was in). Furman also conflates declines in the rate of increase of spending with decelerating inflation – but changes in health care spending include price changes (inflation) as well as changes in utilization. I will talk more about that in a minute, but suffice to say that the Furman piece is pure politics. (A good analysis of similar logical fallacies made by a well-known health care economist that Furman cites is available here by Forbes.)
I want to point you to another piece (which also has flaws and biases but is much more subtle about it), but before I do let’s look at a long-term chart of medical care inflation and the spread of medical care inflation to headline inflation. One year is far too short a period to compare these two things, not least because one-time effects like pharmaceuticals losing patent protection or sequester-induced spending restraints can muddy the waters in the short run. The chart below (source: Enduring Investments) shows the rolling ten-year rise in medical care inflation and, in red, the difference between that and rolling ten-year headline inflation.
You can see from this picture that the decline in medical care inflation, and the tightening of the spread between medical care inflation and headline inflation, is nothing particularly new. Averaging through all of the year-to-year wiggles, the spread of medical care has been pretty stable since the turn of the century (which, since this is a 10-year average, means it has been pretty stable for a couple of decades). Maybe what we are seeing is actually the anticipation of HillaryCare? (Note: that is sarcasm.)
Now, the tightening relative to overall inflation is a little exaggerated in that picture, because for the last decade or so headline inflation has been somewhat above core inflation due to the persistent rise in energy prices throughout the ‘00s. So the chart below (source: Enduring Investments) shows the spread of medical care inflation over core inflation, which demonstrates even more stability and even less reason to think that something big and long-term has really changed. At least, not that we would already know about.
The other piece I mentioned, which is more worth reading (hat tip Dr. L) is “Health Care Spending – A Giant Slain or Sleeping?” in the New England Journal of Medicine. The authors here include David Cutler, whom Forbes suspected was tainting his views with politics (see link above), so we need to be somewhat cautious about the conclusions but in any event they are much more nuanced than in the Furman article and the article makes a number of good points. And, at the least, the authors distinguish between spending on health care and inflation in health care. A few snippets, and my remarks:
- “Estimates suggest that about half the annual increase in U.S. health care spending has resulted from new technology. The role of technology itself partly reflects other underlying forces, including income and insurance. Richer countries can afford to devote more money to expensive innovations.” This is an interesting observation that we ought to think carefully about when professing a desire to “bend the cost curve.” If we are reining in inflation, that’s a good thing. But is it a good thing to rein in innovation in health care? I don’t think so.
- The authors, though, clearly question the value of technological innovation. “The future of technological innovation is, of course, unknown. But most forecasts do not call for a large increase in the number of costly new treatments… some observers are concerned that a wave of costly new biologic agents (for which generic substitutes are scarce) will soon flood the market.” Heaven forbid that we get new treatments! “The use of cardiac procedures has slowed as well.” This is a good thing?
- “Health spending has clearly been associated with health improvements, but analysts differ on whether the benefits justify the cost.” Personally, it makes me uncomfortable to leave this question in the hands of the analysts. If the benefits don’t justify the cost, and the market was free, then no one will pay for those improvements. It’s only with a highly regulated market – replete with “analysts” doing their cost/benefit analysis on health care improvements – that this even comes up.
- Some of the statistical argument is a little weak. “The recent reduction in health care spending appears to have been correlated with slower employment growth in the health care field; this suggests that such changes may continue.” I’m not sure that the causality runs that way. Surely tighter limits on what health care workers can earn might cause slower employment growth? That’s at least as plausible as the direction they are arguing.
That sounds very critical, but I point these things out mainly to make them obvious. Overall, the paper does a very good job of discussing the possible causes of the recent slowdown in health care inflation (although they focus inordinately on “the first 9 months of 2013”, a period during which we know the sequester impacted health care prices), give plenty of credit to reforms instituted far before ACA implementation, correctly distinguish between utilization and prices, and highlight some of the promising trends in health care costs – and yes, there are some! The authors are clearly supportive of the ACA, which I am not, but by and large they raise the salient questions.
It matters less if we instantly agree on the solution than that we agree on the questions.
Note: The following blog post originally appeared on March 13, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
I had not planned to write tonight, but there was too much that happened today, and too much that is likely to be misunderstood and misinterpreted. Not, necessarily, that what follows will help that situation, but I felt a need to add my two cents (which, don’t forget, is two cents more than you paid for it, so you’re two cents ahead no matter what).
And this takes us to the final, and most interesting, event of the day. It began when JP Morgan trumpeted a nickel increase in its dividend and a $15bln stock buyback. My first reaction was that this is not a phenomenon you tend to see in bear markets or early in bull markets, but rather in mature bull markets. Firms have a marked tendency to buy stock back when it’s expensive, not when it’s cheap, and an even more marked tendency to announce a buyback when they want a stock price supported. An announcement of a buyback program is not a promise to buy, and often no stock is actually bought. It is only an announcement of an intention to buy, which the firm need not honor. And this is a bank. Anyone with even a passing knowledge of Basel III knows that banks are going to be raising Tier 1 capital – especially in Europe, but in the U.S. as well – for a while. There is no way that banks, whether or not they feel overcapitalized by 2000s standards or not, are actually going to be buying back large chunks of stock. So my second thought was “wow, are they actually going to scare up the stock so that they can sell more? That can’t be legal.”
Moments later, we found out what the real point was. It seems the Fed had completed the stress tests and informed all of the banks a couple of days ago (it’s unclear when), and were going to make a public announcement on Thursday.
Sidebar: This is why people think that Wall Street is run by a bunch of crooks. The moment that banks had this information, they were in possession of material nonpublic information that should have been immediately released if the banks were going to prepare any offering in their own securities. Whether the Fed says they can or can’t, the information must be released. And here is one positive checkmark for JPM: they announced that the Fed had approved their buyback and dividend plans in the context of passing the stress test. But thanks a lot, Fed, for putting banks in the awkward position of having to choose between ticking off the Fed, or ticking off the SEC. And great job, bank managements, for mostly choosing to keep a secret that makes you look like a member of an elite club/secret cabal, rather than choosing to release the information. Good job, JPM. (But I’m not done with you yet).
So, the Fed decided that they needed to immediately release the stress tests results, early. Well, not immediately; they decided to wait until 4:30ET, after the markets closed to retail investors, because golly it would be too much to ask to let people get the information when the markets were open. Sidebar: this is why people think the Fed is run by a bunch of crooks who are in bed with the Wall Street crooks. Who is running the PR at the Fed?
Bank of America bravely followed JP Morgan through the breach to announce that they, too, had passed the stress tests. US Bank announced a share buyback, dividend hike, and a passing stress test grade. (Quick quiz, with the answer to be given later: are the banks announcing share buybacks likely to be the strong banks or the weak banks with respect to the stress test? Write down your answer and we’ll come back to it.) Volume on the exchange spiked, with better than 50% of the day’s volume coming in the last hour of trading, and almost 30% in the last 7 minutes before the bell.
The stress test results were released, and four financials failed: Ally Financial, SunTrust, MetLife, and Citigroup. Well, good luck raising capital now, Citi. (Important Disclosure: I am expressing no opinion on any of these individual equities or any of the other securities of these companies. I neither own, nor intend to buy, nor sell, any of their securities in the near future. My negative opinion on banks generally is well-known, but I do not have any position, positive or negative, on the banking sector, nor do I plan to make such a sector bet in the near future).
Now, initially the press coverage listed three of the four firms that failed, but not MetLife, so I was forced to go skimming through the “CCAR” report to find the fourth one. If I hadn’t done that, I almost certainly would not have noticed Figure 7, which is reproduced below for your easy reference.
You can see the four banks which failed are the shortest bars on this chart, so you can easily pick out Ally, Sun Trust, Citi, and with a straightedge you can conclude that MetLife is the fourth. But then it’s a really close race for fifth-worst with KeyCorp, US Bank, Morgan Stanley, and… JP Morgan. It must be great to be JP Morgan. When you wonder why they drew the line where they did, you might imagine the counterfactual situation where JP Morgan came out on the other side of the line. JP Morgan, which was the Fed before there was a Fed, and will probably be the Fed after the Fed is gone. JP Morgan, which the Fed called on multiple times during the crisis to save the world (for example, by serving as a lending conduit to entities which the Fed could not directly lend to). I wonder what the odds are that JP Morgan would be allowed to fail? I’m going to speculate: zero. And that’s why the line is where it is.
Now, it is interesting to see which banks scored very highly. They’re banks that don’t have exposure to as many of the blow-up areas that were tested by the Fed (which is not to say they aren’t exposed to blow-ups: just that they’re not the ones that the Fed tested).
By the way, don’t let anyone tell you “well, this was a really severe test, and so these banks are actually in really good shape.” Yes, this test is much more stringent than the cotton-candy version the European regulators put their banks through last year, but it only measures expected reactions to broad macroeconomic events, and not the interaction of the entire system under such a stressful scenario. That reaction is non-linear, and it is very difficult to model. Moreover, we can’t model the unknown: a rogue trader, a $65billion Ponzi scheme, a tsunami and nuclear meltdown in Japan, a terrorist attack in New York. As Roseanne Roseannadanna used to say, “It’s always something.”
When all is said and done, are we better off that the Fed did these stress tests? I suppose the answer is yes, if only because it means the regulators actually took some interest in looking at these businesses and their risks. But if it creates a false sense of comfort, or reverses the trend towards greater capital cushions, then probably not. Time will tell.
I am about ranted out for today, and there are no important economic releases tomorrow. It will be interesting to see how the spin machines work on Citigroup and JP Morgan, which are after all separated by only a thin line on Figure 7, but by a huge gulf in reputation.
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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.