Back From the Moon

January 6, 2016 2 comments

Economics is too important to be left to economists, apparently.

When the FOMC minutes were released this afternoon, I saw the headline “Some FOMC Members Saw ‘Considerable’ Risk to Inflation Outlook” and my jaw dropped. Here, finally, was a sign that the Fed is not completely asleep at the wheel! Here, finally, was a glimmer of concern from policymakers themselves that the central bank may be behind the curve!

Alas…my jaw soon returned to its regular position when I realized that the risk to the inflation outlook which concerned the FOMC was the “considerable” risk that it might fall.

A quick review is in order. I know it is a new year and we are still shaking off the eggnog cobwebs. Inflation is caused (only) when money growth is faster than GDP growth. In the short run, that holds imprecisely because of the influence of money velocity, but we also have a pretty good idea of what causes money velocity to ebb and flow: to wit, interest rates (more precisely, investment opportunities, which can be simply modeled by interest rates but more accurately should include things such a P/E multiples, real estate cap rates, and so on). And in the long run, velocity does not continue to move permanently in one direction unless interest rates also continue to move in that direction.

It is worth pointing out, in this regard, that money growth continues to swell at a 6.2% domestically over the last 12 months, and nothing the Fed is currently contemplating is likely to slow that growth since there are ample excess reserves to support any lending that banks care to do. But it is also worth pointing out that inflation is currently at 7-year highs and rising, as the chart below (source: Bloomberg) shows.

medcpi

Core inflation is also rising in Japan (0.9%, ex-food and energy, up from -0.9% in Feb 2013), the Eurozone (0.9% ex-food and energy, up from 0.6% in January 2015), and recently even in the UK where core is up to 1.2% after bottoming at 0.8% six months ago. In short, everywhere we have seen an acceleration in money growth rates, we are now seeing inflation. The only question is “why has it taken so long,” and the answer to that is “because central banks held interest rates, and hence velocity, down.”

In other words, as we head towards what looks very likely to be a global recession (albeit not as bad as the last one), we are likely to see inflation rates rising rather than falling. The only caveat is that if interest rates remain low, then the uptick in inflation will not be terrible. And interest rates are likely to remain relatively low everywhere, especially if the Fed operates on the basis of its expectations rather than on the basis of its eyeballs and holds off on further “tightenings.”

Because the Fed has really put itself in the position where most of the things it would normally do are either ineffective (such as draining reserves to raise interest rates) or harmful (raising rates without draining reserves, which would raise velocity and not slow money growth) if the purpose is to restrain inflation. It would be best if the Fed simply worked to drain reserves while slack in the economy holds interest rates (and thus velocity) down. But that is the sort of thinking you won’t see from economists but rather from engineers looking to get Apollo 13 safely home.

Want to try and get Apollo 13 safely back home? Go to the MV≡PQ calculator on the Enduring Investments website and come up with your own M (money supply growth), V (velocity change), and Q (real growth) scenarios. The calculator will give you a grid of outcomes for the average inflation rate over the period you have selected. Remember that this is an identity – if you get the inputs right, the output will be right by definition. Some numbers to remember:

  • Current velocity is 1.49 or so; prior to the crisis it was 1.90 and that is also the average over the last 20 years. The all-time low in velocity prior to this episode was in the 1960s, at about 1.60; the high in the 1990s was 2.20.
  • As for money supply growth, the y/y rate plunged to 1.1% or so after the crisis and it got to zero in 1995, but the average since 1980 including those periods is roughly 6% where it is currently. Rolling 3-year money growth has been between 4% and 9% since the late 1990s, but in the early 80s was over 10% and it declined in the mid-1990s to around 1%.
  • Rolling 3-year GDP growth has been between 0% and 5% since the 1980s. In the four recessions, the lows in rolling 3-year GDP were 0.2%, 1.7%, 1.7%, and -0.4%. The average was about 3.9% in the 1980s, about 3.2% in the 1990s, about 2.7% in the 2000s, and 1.8% (so far) in the 2010s.

Remember, the output is annualized inflation. Start by assuming average GDP, money growth, and ending velocity for some period, and then look at what annualized inflation would work out to be; then, figure out what it would have to be to get stable inflation or deflation. You will find, I think, that you can only get disinflation if money growth slows remarkably (and unexpectedly) and velocity remains unchanged or goes to new record lows. Try putting in some “normal” figures and then ask yourself if the Fed really wants to get back to normal.

And then ask yourself whether you would want Greenspan, Bernanke, and Yellen in charge of getting our boys back from the moon.

Surprising Surprises

December 23, 2015 2 comments

If posting on December 22nd was a bad idea, imagine how stupid it is to post on December 23rd?

But I noticed something unusual and thought to point it out. Yesterday, I observed that the data has generally been weakening, and while some commentators are optimistic on the outlook for 2016 I am not one of them. Actually, it appears that perhaps commentators as a whole are not only too optimistic now, but have been too optimistic all year.

The Citi Economic Surprise Index is an interesting data series that measures how data releases have generally compared to economists’ prior expectations. When data is coming in weaker than expected, it declines; when data is coming in stronger than expected, it rises. This doesn’t necessarily mean that it declines when the economy is weakening, just when the data is surprising on the downside. I’ve always had trouble figuring out just how to use this information, because of that. Is the indicator rising because conditions are getting better, or just because economists are morose? Is it falling because conditions are getting worse, or because economists are too optimistic? Hard to tell.

With that said, here is what the indicator has done over the last three years (source: Bloomberg).

cesiusd

Nothing to see here, right? Well take a look at this! The table below shows the proportion of the time, by year (since the index was created in 2003), that the index was above zero.

2003 57%
2004 49%
2005 68%
2006 43%
2007 57%
2008 36%
2009 67%
2010 56%
2011 54%
2012 63%
2013 61%
2014 54%
2015 8%

Now that, as they would say on Mythbusters, is a result. I have no idea what it means, that economic data has been consistently undershooting expectations all year so that the index has been negative 92% of the time. The second-worst outcome was 2008, but that was clearly a situation in which the economy was getting worse lots faster than economists anticipated.

I am inclined to think that this represents the optimism that economists seem to have that the Fed’s move to tighten policy reflects a response to actual underlying strength. I should add that I believe this is an unfounded, irrational, and borderline psychotic optimism given the historical prognosticative powers of the Federal Reserve…but if that is indeed what is happening then the optimism that these same economists have about the number of rate hikes we will see in 2016 is probably misplaced.

Categories: Federal Reserve, Quick One

Homes for the Holidays

December 22, 2015 Leave a comment

It is not usually a very productive endeavor to write an article on December 22nd. In the past, I have made it more or less a rule not to post anything after about the middle of the month, unless it was a greatest-hits repost series or something. However, today’s Existing Home Sales number was striking enough that it is worth at least a brief comment.

November Existing Home Sales was reported at 4.76mm units (seasonally-adjusted annualized rate), which was considerably below expectations for a nearly-unchanged 5.35mm. The chart (Source: Bloomberg) below makes graphically clear the magnitude of this disappointment.

ehsl

Recently, sales of existing homes had been back to something like normal, around 5.5mm units at an annualized rate. The big selloff will cause consternation in some quarters. It wasn’t the weather: November’s weather was, if anything, warmer than usual and so one wouldn’t have thought foot traffic and closings would have been slower. And it wasn’t payback, like in 2010 when the collapse followed the tax-incentive-expiration-induced spike of 2009. We can’t really even shrug it off as “December economic data;” I am always skeptical of economic figures from December and January because it’s just a mess to seasonally adjust most of them – especially those related to employment and income. But this was a November figure.

It was just a really bad number.

The potential significance is this: so far, analysts pointing to weakness in economic data have had to be careful about drawing too-strong conclusions because a lot of the weakness was confined to the oil and gas extraction industries, and spots of weakness in traditional manufacturing where a higher dollar hurt. Housing, however, is wholly domestic. It doesn’t depend on oil and gas extraction, and the strength of the dollar is irrelevant.

Housing data are also notoriously volatile, although that complaint is less true of Existing Home Sales than New Home Sales (which is a much smaller figure, and depends much more on what inventory of homes is being offered). I would simply ignore this figure if it was New Home Sales. It’s harder to shrug off Existing.

I don’t believe a collapse is coming, though. Despite the fact that I have just made several observations that tend to increase the significance of this number, keep in mind that unlike in 2005-2007, there is no apparent bubble in the inventory of existing homes (see chart, source Bloomberg – note it is not seasonally adjusted so there is a distinct annual pattern).

etslhafs

The National Association of Realtors blamed the drop on a new regulation affecting closing documents, which is leading to a longer time-to-close for sales. If that is true – keep in mind that the NAR produces the existing home sales figure, but also keep in mind that they have an incentive to downplay declines – then we should see Existing Home Sales rebound in the months ahead. But even if we do not, the fact that there is no bubble in inventory means that we should not necessarily expect the rate of increase of existing home sales prices (which has been running around 6.5%, as the chart below shows) to decelerate any time soon. And that, of course, helps to drive a big piece of the CPI.

etslmedpriceyoy

All in all, this is a disturbing number and one that bears watching. My intuition is that this is not a sign of broadening weakness in the US economy. While I expect such a broadening, I don’t think we have seen it yet.

Categories: Housing

A Good Time to Remember

December 16, 2015 7 comments

Some days make me feel so old. Actually, most days make me feel old, come to think of it; but some days make me feel old and wise. Yes, that’s it.

It is a good time to remember that there are a whole lot of people in the market today, many of them managing many millions or even billions of dollars, who have never seen a tightening cycle from the Federal Reserve. The last one began in 2004.

There are many more, managing many more dollars, who have only seen that one cycle, but not two; the previous tightening cycle began in 1999.

This is more than passing relevant. The people who have seen no tightening cycle at all might be inclined to believe the hooey that tightening is bullish for stocks because it means a return to normalcy. The people who have seen only one tightening cycle saw the one that coincided with stocks’ 35% rally from 2004-2007. That latter group absolutely believes the hooey. The fact that said equity market rally began with stocks 27% below the prior all-time high, rather than 32% above it as the market currently is, may not have entered into their calculations.

On the other hand, the people who dimly recall the 1999 episode might recall that the market was fine for a little while, but it didn’t end well. And you don’t know too many dinosaurs who remember the abortive tightening in 1997 in front of the Asian Contagion and the 1994 tightening cycle that ended shortly after the Tequila crisis.

Moreover, it is a good time to remember that no one in the market today, or ever, can remember the last time the Fed tightened in an “environment of abundant liquidity,” which is what they call it when there are too many reserves to actually restrain reserves to change interest rates. That’s because it has never happened before. So if anyone tells you they know with absolute certainty what is going to happen, to stocks or bonds or the dollar or commodities or the economy or inflation or anything else – they are relying on astrology.

Many of us have opinions, and some more well-informed than others. My own opinion tends to be focused on inflationary dynamics, and I remain very confident that inflation is going to head higher not despite the Fed’s action today, but because of it. I want to keep this article short because I know you have a lot to read today, but I will show you a very important picture (source: Bloomberg) that you should remember.

coreandfedfunds

The white line is the Federal Funds target rate (although that meant less at certain times in the past, when the rate was either not targeted directly, as in the early 1980s, or the target was represented as a range of values). The yellow line is core inflation. Focus on the tightening cycles: in the early 1970s, in the late 1970s, in 1983-84, in the late 1980s, in the early 1990s, in 1999-2000, and the one beginning in 2004. In every one of those episodes, save the one in 1994, core inflation either began to rise or accelerated, after the Fed began to tighten.

The generous interpretation of this fact would be that the Fed peered into the future and divined that inflation was about to rise, and so moved in spectacularly-accurate anticipation of that fact. But we know that the Fed’s forecasting abilities are pretty poor. Even the Fed admits their forecasting abilities are pretty poor. And, as it turns out, this phenomenon has a name. Economists call it the “price puzzle.”

If you have been reading my columns, you know this is no puzzle at all for a monetarist. Inflation rises when the Fed begins to tighten because higher interest rates bring about higher monetary velocity, because velocity is the inverse of the demand for real cash balances. That is, when interest rates rise you are less likely to leave money sitting idle; therefore, investors and savers play a game of monetary ‘hot potato’ which gets more intense the higher interest rates go – and that means higher monetary velocity. This effect happens almost instantly. After a time, if the Fed has raised rates in the traditional fashion by reducing the growth rate of money and reserves, the slower monetary growth rate comes to dominate the velocity effect and inflation ebbs. But this takes time.

And, moreover, as I have pointed out before and will keep pointing out as the Fed tightens: in this case, the Fed is not doing anything to slow the growth rate of money, because to do that they would have to drain reserves and they don’t know how to do that. I expect money growth to remain at its current level, or perhaps even to rise as higher interest rates provoke more bank lending without and offsetting restraint coming from bank reserve scarcity. By moving interest rates by diktat, the Fed is increasing monetary velocity and doing nothing (at least, nothing predictable) with the growth rate of money itself. This is a bad idea.

No one knows how it will turn out, least of all the Fed. But if market multiples have anything to do with certainty and low volatility – then we might expect lower market multiples to come.

 

Summary of My Post-CPI Tweets

December 15, 2015 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…sign up to receive notice when my book is published! The title of the book is What’s Wrong with Money?: The Biggest Bubble of All, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. You can also pre-order online.

  • #CPI +0.0%/+0.2%. Y/y on headline goes to +0.5%, highest since December. Welcome to base effects!
  • Core was actually +0.18% m/m, a bit higher than expected. y/y on core goes to 2.02% from 1.91% as we dropped off a weak mo.
  • Next month, core #CPI will go to 2.1% or 2.2% y/y, simply because we drop off last December’s +0.06% aberration.
  • The rise in core seems dramatic (highest since 2012 now), but it’s just catching up with Median. Expected.

coremed

  • Primary Rents actually decelerated to 3.64% from 3.74%, and OER roughly unch at 3.08% from 3.09%. So core was held DOWN somewhat.
  • Even with that, overall Housing subindex was 2.14% y/y from 2.12% y/y. Big jump in Lodging Away from Home helped that.
  • Medical Care 2.95% from 2.98%. Boost to core came from “Other” (2.08% from 1.86%) and Education/Communication (1.32% from 0.97%).
  • Core #CPI, ex-housing, 1.18% from 1.00%. That’s the story here. Highest since mid-2014.
  • Core services 2.9%, highest since Nov 2008; core goods -0.6%, partial retrace from last month but still very weak.
  • The internals here not pleasant. We know housing will continue to accelerate. Core goods will not deflate forever.
  • Love this picture of core goods and core services. Note services is usually the stickier piece.

coregoodsserv

  • Early guess at Median CPI: 0.18%, keeping y/y at 2.47%. But median component looks like South Urban housing; hard to seasonally adj.
  • The categories that are mainly non-core: Food & Beverages 1.2% from 1.6% y/y; Transportation -6% from -7.9%.
  • Transport improvement notjust fuel (-24.2% from -27.9%), but also insurance (5.5% v 4.7%) and new/used vehicles (-0.1% v -0.4%)
  • …and airline fares (-3.8% v -5.2%), which is astonishing given the decline in jet fuel prices: down 67% v mid-2014.
  • Nothing in the #CPI today is soothing. But nothing here could change the Fed outcome tomorrow anyway.
  • FOMC has done nothing to dissuade the market from assuming a tightening. But important to remember the surprise risk is asymmetrical.
  • That is, the FOMC is much more likely to be willing to surprise the market dovishly than hawkishly. I do think they will tighten tho.
  • Last fun chart of the day. Weight of #CPI components rising faster than 3% per annum.

wgtover3

The CPI report today was mainly interesting because while core rose as expected – actually, a little bit more than expected – that was not due to primary rents and Owners’ Equivalent Rent, which have been the driving force for some time. Indeed, Primary Rents actually decelerated, so the rise in core CPI came despite sluggishness in one of the formerly-leading components.

So what happened? Well, other elements of core services took the reins. Un-sexy elements like Information and Information Processing (-0.8% from -1.5%, and compared to a 2-year compounded rate of -1.3%), Personal Care Services (3.1% vs 2.7%), Medical Care – Professional Services (2.0% vs 1.8%), and Health Insurance (3.6% vs 3.0% – see chart below, source Bloomberg).

healthins

It is worth pointing out that health insurance is only 0.75% of the CPI because the BLS measures the costs of medical provision more directly. This is a residual. But still very interesting given what we know anecdotally is happening in the ACA marketplace.

Here is the chart of core inflation, ex-shelter (Source: Enduring Investments).

corexshelt

This doesn’t look alarming, but the story of the low core inflation over the last few years can be thought of this way: shelter prices going up; core services ex-shelter decelerating somewhat; core goods deflating. We can’t count on core goods deflating forever (although our models have them deflating at roughly this pace for a little while yet), and they tend to move around more than core goods. But the core services ex-shelter piece, filled with things like medical care, has played a major role. Those pieces are now re-accelerating.

Nothing that happened today, as I note in the tweet-feed, will change what the Fed does tomorrow. While I was long skeptical that the Committee would tighten in December, the market priced it in and no Fed speaker (with any weight) tried to signal otherwise. That tacit agreement with market pricing has historically meant that the FOMC was prepared to do what the market had priced in. But there are four caveats worth noting.

First, as I said in the tweet-stream the Fed is always more likely to surprise on the dovish side than on the hawkish side. Thus, if the market was pricing in no action but the Committee wanted to tighten, they would be much more aggressive about speaking out so as not to surprise the markets. They never seem to care about surprising them in the dovish direction. So there’s that.

Second, this would be the first tightening of the Yellen regime. We don’t know that she operates in the same way that prior Fed Chairmen have operated; perhaps she is less worried (or aware) about surprising the markets. It is worth keeping in mind although I doubt very much she wants to be a rebel in this way, especially with high yield markets in what can generously be called “disarray.”

Third, whatever happens tomorrow the second tightening is very much up in the air. We are starting to see failures of high yield funds and we will see failures of high yield companies. If this gets particularly ugly, it is possible the Fed will take a pass in the first or possibly the first couple of meetings in 2016. If that happens, it will be harder to get started again. So I’d be careful to price a long string of tightening actions here.

Fourth, and finally: I have been calling it “tightening” but the Fed of course is not tightening policy. They are only raising interest rates. There will still be plenty of money in the system, and rates will be going up not because demand for money outstrips its supply, but because the Fed says so. The result of this will be very different from the results that followed prior Fed tightenings. Inflation will rise, because velocity rises when interest rates rise and that leads to higher inflation – and this generally happens when the Fed starts to tighten – but since the Fed will not be reining in money growth inflation will continue to rise. That’s unusual, but it will happen because the deviation from the script is important: ordinarily, it is the slowing of money growth rather than the increasing of interest rates that restrains inflation; the increase of interest rates actually accelerates inflation. The Fed has no plans to slow money growth, nor any way to really do it – so inflation will continue to rise.

Subtle Clues: Not Everyone Thinks the Fed Will Win

December 8, 2015 Leave a comment

The illiquid trading of December is already well in evidence – and we haven’t even reached the bad part yet. One we are past the CPI report and the Fed meeting, there will be a few days where serious traders are squaring up based on what they now believe after those data points. After that, it will get truly quiet for the last couple of weeks.

A little quiet is what the energy market needs. On Monday front Crude broke to new six-year lows. Not since oil bottomed at $32.40 in December 2008 have prices been this low. Prior to that, the last time we saw sub-$40 oil was in July 2004. Ditto with gasoline prices, which are averaging just a touch above $2/gallon nationwide. This is truly amazing, and is causing all sorts of carnage in energy and energy service companies as has been widely reported.

What is interesting, though, and has been widely unreported has been the impact these recent price declines have had on inflation expectations as impounded in the price of inflation derivatives and TIPS breakevens. In short: not very much.

In prior episodes, such as last year at about this time, plunging energy quotations affected not only near-term inflation expectations but also long-term inflation expectations. The reason that near-term breakevens, or say 1-year inflation swaps, respond to energy prices is very simple: these contracts are pegged to headline inflation, which includes energy; while the market tends to overreact to the energy effect it tends to price fairly efficiency the near-term effect of movements in gasoline on actual inflation outturns.

But it makes very little sense that even very large moves in gasoline prices should be reflected in long-term­ inflation expectations. This is for two reasons: first, energy prices are mean-reverting, so declining prices in one year are more likely to see appreciating prices the following year (or, at least, big declines tend not to be followed by big declines). Second, even a significant change in energy prices, amortized over ten years for example, ends up not being a very big movement per year when you then also take into account how low the pass-through is from energy prices to inflation swap prices.

A bunch of this is sort of “inside baseball” talk to inflation traders, which I know isn’t my audience for the most part. But you can readily understand, I think, that if gasoline prices drop 50% in one year – and if we don’t expect them to continue to drop 50% in every year – then that’s only around a 5% movement per year in energy prices, averaged over ten years. That’s like saying gasoline prices rise a dime per year for ten years. Do you think that would have, or should have, a big effect on your overall inflation expectations?

In practice, it turns out to affect the market. The chart below (source: Bloomberg) shows the national average gasoline price (in white) from the American Automobile Association versus the 10-year breakeven (that is, the difference in the 10-year Treasury yield minus the 10-year TIPS yield, a number that approximates the inflation required to break even between these two investments). You can see that this is a fairly tight relationship in the grand scheme of things. When gasoline prices fell from $3.60 to $2.00 in 2014-15, breakevens plunged from 2.20% to 1.60%. As I have just pointed out, that’s larger than makes sense but the direction makes sense.

bei and gasoline

This phenomenon, incidentally, is why we (meaning me, and my company when we are doing analysis) strip out the implied energy effect by using futures quotes, so as to come up with an implied core inflation curve. (And you can actually hedge, so you can create something that looks very much like core inflation rather than headline inflation). By doing this, we can often see when the inflation market is overpricing the energy effect or underpricing it, and indeed this can be traded as part of an institutional investment strategy.

But recently, we haven’t really needed to be so fine with the calculation. Notice on the right side of the chart above that over the last couple of months inflation expectations (breakevens) have risen even as crude and gasoline prices have continued to slide. The chart illustrates how unusual this is. What this means is that expectations for long-term core inflation have been rising – investors are actually looking past the near-term energy washout and saying “we don’t believe this will be sustained, and even if it is we don’t believe that core inflation will average 1.25% for five years.” That’s what was being priced in late October; now that figure is a still low but much more-sensible 1.5%.

Will investors be right? I must say that we have been aggressive in saying that being long at these breakeven levels leaves few ways to lose, at least for investors who can hold through the bumps. And inflation has long upper tails, so that even if you think 1.50% for five years is fair, you should be willing to pay a bit more simply because a miss on the high side is likely to be a worse miss than a miss on the low side.

Sadly, the only way for retail investors to position explicitly for this is through the ETF RINF, which is the Proshares 30y breakeven spread, and the bid/offer is intimidating as is the expense ratio. But it’s something.

What I find fascinating is that this is happening at all. Everyone professes to believe that the Fed is ahead of the curve and will surely squash inflation. But that isn’t how they’re positioning.

Categories: Federal Reserve, Theory, TIPS

Swimming Naked

December 3, 2015 2 comments

I almost never do this, but I am posting here some remarks from another writer. My friend Andy Fately writes a daily commentary on the FX markets as part of his role at RBC as head of US corporate FX sales. In his remarks this morning, he summed up Yellen’s speech from yesterday more adroitly than I ever could. I am including a couple of his paragraphs here, with his permission.

Yesterday, Janet Yellen helped cement the view that the Fed is going to raise rates at the next FOMC meeting with her speech to the Washington Economic Club.  Here was the key paragraph:

“However, we must also take into account the well-documented lags in the effects of monetary policy. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.” (Emphasis added).

So after nearly seven years of zero interest rates and massive inflation in the size of the Fed balance sheet, the last five of which were in place after the end of the Financial Crisis induced recession, the Fed is now concerned about encouraging excessive risk-taking?  Really?  REALLY?  That may be the most disingenuous statement ever made by a Fed Chair.  Remember, the entire thesis of QE was that it would help encourage economic growth through the ‘portfolio rebalancing channel’, which was a fancy way of saying that if the Fed bought up all the available Treasuries and drove yields to historic lows, then other investors would be forced to buy either equities or lower rated debt thus enhancing capital flow toward business, and theoretically impelling growth higher.  Of course, what we observed was a massive rally in the equity market that was based largely, if not entirely, on the financial engineering by companies issuing cheap debt and buying back their own shares.  Capex and R&D spending have both lagged, and top-line growth at many companies remains hugely constrained.  And the Fed has been the driver of this entire outcome.  And now, suddenly, Yellen is concerned that there might be excessive risk-taking.  Sheesh!

Like Andy, I have been skeptical that uber-dove Yellen would be willing to raise rates unless dragged kicking and screaming to that action. And, like Andy, I think the Chairman has let the market assume for too long that rates will rise this month to be able to postpone the action further. Unless something dramatic happens between now and the FOMC meeting this month, we should assume the Fed will raise rates. And then the dramatic stuff will happen afterwards. Actually I wouldn’t normally expect much drama from a well-telegraphed move, but in an illiquid market made more illiquid by the calendar in the latter half of December, I would be cutting risk no matter which direction I was trading the market. I expect others will too, which itself might lead to some volatility.

There is also the problem of an initial move of any kind after a long period of monetary policy quiescence. In February 1994, the Fed tightened to 3.25% after what was to that point a record period of inaction: nearly one and a half years of rates at 3%. In April 1994, Procter & Gamble reported a $102 million charge on a swap done with Bankers Trust – what some at the time said “may be the largest ever” swaps charge at a US industrial company. And later in 1994, in the largest municipal bankruptcy to that point, Orange County reported large losses on reverse repurchase agreements done with the Street. Robert Citron had seen easy money betting that rates wouldn’t rise, and for a while they did not. Until they did. (It is sweetly sentimental to think of how the media called reverse repos “derivatives” and were up in arms about the leverage that this manager was allowed to deploy. Cute.)

The point of that trip down memory lane is just this: telegraphed or not (it wasn’t like the tightening in 1994 was a complete shocker), there will be some firms that are over-levered to the wrong outcome, or are betting on the tightening path being more gradual or less gradual than it will actually turn out to be. Once the Fed starts to raise rates, the tide will be going out and we will find out who has been swimming naked.

And the lesson of history is that some risk-taker is always swimming naked.

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