Archive
Sometimes I Just Sits
An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”[1]
The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.
That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)[2]
More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.
The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.
I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.
To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.
Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.
In 2016, if the Fed goes forward with tightening, we will see:
- Lower corporate earnings
- Rising corporate default rates
- Rising inflation
- Lower equity prices; higher commodity prices
- Banks vilified. I am not sure why, but it seems this always happens so there will be something.
All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.
To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.
The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.
[1] This story is attributed variously to A.A. Milne and to Punch magazine, among others.
[2] Cotton is +3% or so versus 1 year ago.
Recession Won’t Be Fun…But Better than Last Time
Yesterday, I mentioned the likelihood that a recession is coming. The indicators for this are mostly from the manufacturing side of the economic ledger, and they are at this point merely suggestive. For example, the ISM Manufacturing Index is at 50.2, below which level we often see deeper downdrafts (see chart, source Bloomberg).
Capacity Utilization, which never got back to the level over 80% that historically worries the Fed about inflation, has been slipping back again (see chart, source Bloomberg).
Now, we have to be a bit careful of these “classic” indicators because of the increased weight of mining and exploration in GDP compared with the last few cycles. A good part of the downturn in Capacity Utilization, I suspect, could be traced to weakness in the oil patch. But at the same time, we cannot blithely dismiss the manufacturing weakness as being “all about oil” in the same way that Clinton supporters once dismissed Oval Office shenanigans as being “all about sex.” Oil matters, in this economy. In fact, I would go so far as to say that while historically a declining oil price was a boon to the nation as a whole (which is why we never suffered much from the Asian Contagion: the plunge in commodity prices tended to support the U.S., which is generally a net consumer of resources), in this cycle low oil prices are probably neutral at best, and may even be contractionary for the country as a whole.
Whether we have a recession in the near term (meaning beginning in the next six months or so) or further in the future, here is one point that is important to make. It will not be a “garden variety” recession, in all likelihood. That is not because we have boomed so much, but because we are levered so much. There are no more “garden variety” recessions.
Financial leverage in an economy, just as in individual businesses, increases economic volatility. So does operational leverage (which means: deploying fixed capital rather than variable inputs such as labor – technology, typically). And our economy has both in spades. The chart below (source: Bloomberg) shows the debt of domestic businesses as a percentage of GDP. Businesses are currently more levered than they were in 2007, both in raw debt figures and as a percentage of GDP.
Investors fearing recession should shift equity allocations (to the extent some equity allocation is retained) to less-levered businesses. But be careful: some investors think of growth companies as being low-leverage but tech companies (for example) in fact have very high operating leverage even if financial leverage is low. Both are bad when earnings decline – and growth firms typically have less of a margin of safety on price. I tried to do a screen on low-debt, low-PE, high-dividend non-tech companies with decent market caps and didn’t find very much. Canon (CAJ), Guess? Inc (GES) to name a couple of examples…and neither of those have low P/E ratios. (I don’t like to invest in individual stocks in any event but I mention these for readers who do – these aren’t recommendations and I neither own them nor plan to, but may be worth some further research if you are looking for names.)
On the plus side, economically-speaking, relatively heavy personal income taxation also acts as an automatic stabilizer. On the minus side, this is less true if the tax system is heavily progressive, since it isn’t the higher-paid employees who tend to be the ones who are laid off (except on Wall Street, where it is currently de rigueur to cut experienced, expensive staff and retain less-experienced, cheaper staff). Back on the plus side, a large welfare system tends to be an automatic stabilizer as well. On the minus side, all of these fiscal stabilizers merely move growth from the future to the present, so the deeper the recession the slower the future growth.
And, of course – there is nothing that central banks can really do about this, unless it is to make policy rates negative to spur additional extension of negative-NPV loans (that is, loans to less-creditworthy borrowers). I am not sure that even our central bank, with its unhealthy fear of the cleansing power of recession, thinks that’s a good idea.
There is some good news, as we brace for this next recession: while overall levels of debt are higher for businesses, financials, and households, the debt burden compared to GDP is lower for households and especially for domestic financial institutions (see chart, source Bloomberg).
Our banks are in relatively good health, compared with their condition headed into the last downturn. So this will not be a calamity, as in 2008. But I don’t expect it to only be a “mild” recession, either – as if any recession ever feels mild to individuals!
Two Types of People?
Investors have learned the same wrong lessons over the last couple of years that they learned in the run-up to 2000, evidently. I remember that in the latter part of 1999, every mild equity market setback was met immediately with buying – the thought was that you had to jump quickly on the train before it left the station again. There was no thought about whether the bounce was real, or whether it “made sense”; for quite a number of them in a row, the bounce was absolutely real and the train really did leave the station.
Then, the train reached the end of the line and rolled backwards down the mountain, gathering speed and making it very difficult to jump off. I remember getting a call from my broker at the time, recommending Lucent at around $45 – quite the discount from the $64 high. I noted that I was a value investor and I didn’t see value in that stock, and to not call me again until he had a decent value idea. He next called with a recommendation later that year, with a stock that had just hit $30…a real bargain! And, as it turned out, that stock was also Lucent. The lesson he had learned was that any stock at a discount from the highs was a “value” stock. (Lucent ended up bottoming at about $0.55 in late 2002 and was eventually acquired by Alcatel in 2006).
This lesson appears to have been learned as well. On Thursday and Friday a furious rally took stocks up, erasing a week and a half of decline. This happened despite the fact that Friday’s Employment number was just about the worst possible number for equities: weak enough to indicate that the December figure was not just about seasonal adjustment, but represented real weakness, but nowhere near weak enough to influence the Federal Reserve to consider pausing the recent taper. We will confirm this fact tomorrow, before the market open, when new Fed Chairman Janet Yellen delivers the Monetary Policy Report (neé Humphrey-Hawkins) testimony to the House Financial Services Committee (her comments to be released at 8:30ET). While I believe that Yellen will be very reluctant to raise rates any time soon, and likely will seize on signs of recession to stop the taper in its tracks, she will be reluctant to be a dove right out of the gate.
And that might upset the apple cart tomorrow, if I’m right.
I have been fairly clear recently that I see a fairly significant risk of market volatility to come, both on the fixed-income side but especially on the equity side. I think stocks are substantially overvalued and could fall markedly even without any important change in the underlying economic dynamics. But there is actually good news which should be considered along with that fact: when markets were last egregiously overpriced, financial institutions were also substantially more-levered than they are today. The chart below (source: Federal Reserve) shows that as a percentage of GDP, domestic financial institutions are about one third less levered than they were at the 2008 peak.
Now, this exaggerates the deleveraging to some extent – households, for example, appear to have deleveraged by about 20% on this chart, but the actual nominal amount of debt outstanding has only declined from about $14 trillion to about $13.1 trillion. Corporate entities have actually put on more debt (which made sense for a while but probably doesn’t now that equity is so highly valued relative to earnings), but in terms of a percentage of GDP they are at least not any more levered than they were in 2008.
The implication of this fact is some rare good news: since the banking system has led the deleveraging, the systemic risk that could follow on the heels of a significant market decline is likely to be much less, at least among U.S. domestic financial institutions. So, in principal, while it was clear that a decline in equity and real estate prices in 2007-2008 would eventually cause damage to the real economy as the financial damage was amplified through the financial system, this is less true today. We can, in other words, have some reasonable market movements without having that automatically lead to recession. The direct wealth effect of equity price movements is very small, on the order of a couple of percent. It’s the indirect effects that we have to worry about, and the good news is that those indirect effects are smaller now – although I wouldn’t say those risks are absent.
Now for the bad news. The bad news is that significant market volatility – say, a 50% decline in stock prices – would likely be met with “help” from the federal government and monetary authorities. It is that help which likely would hurt the economy by increasing business uncertainty further. It is probably not a coincidence that the last couple of months, which correspond to the implementation of the Affordable Care Act, have led to some weaker growth figures. Whether change is perceived as positive or negative, it’s the constant changing of the rules – and especially now that these rules are increasingly changed by executive fiat without the moderating influence of Congress (I never thought I would write that) – that damages business confidence.
In other words, I wouldn’t be concerned about the direct economic effect of a 50% decline in equity prices; but I would be concerned if such a decline led to meddling from the Fed, the Congress, or the White House.
While investors learned the hard lessons after 2000 and 2008 about the wisdom of automatically buying dips, they eventually forgot those lessons. But that makes them almost infinitely smarter than policymakers, who have refused to learn the obvious lesson of the last few years: your ministrations do little to help, and most likely hurt. So, maybe it really is true that there are two types of people: those who listen to everybody, and those who listen to nobody. The former become investors, and the latter enter government service!
Higher Rates, Higher Credit Growth: Sober Look
I wrote recently about money velocity and reminded readers that theory says higher interest rates tend to increase money velocity because it decreases the demand for real cash balances. This was around the discussion of whether the enormous demand for Verizon bonds could be anecdotal evidence that velocity is increasing.
Yesterday the blog Sober Look – which is one of my favorites because it gives intelligent looks at many different markets – ran an article entitled “Could rising rates fuel credit growth in the US?” in which they in turn cite Deutsche Bank research. It’s a very quick article and worth a read, because it sheds some light on one of the mechanisms by which credit growth may increase with higher rates. Ordinarily, higher rates inhibit money growth at the same time that they increase velocity, partly because the yield curve flattens. But in this case, higher rates may increase both credit growth and money velocity – at least when rates initially rise – since the market is moving ahead of the Fed and steepening the yield curve in a selloff.
It’s just another puzzle piece to rotate in your mind, to try and see how it all fits together!
The Nation’s Balance Sheet and Crowding Out
Recently, I pointed out (in “Kissing Assets Goodbye” from November 1st) that disasters lower a country’s net worth. Therefore, even though they will tend to increase flows-based measures of economic activity, such as today’s New York ISM where the “6-month outlook” subindex jumped from 57.7 to 75.3, it’s not good news. I lamented that, although the numbers are not wrong per se, they are misleading. And they are misleading because there is no economic “asset” and “liability” account for the nation.
I recently saw a paper which attempts to create just such a “balance sheet” for the nation, albeit with a very long lag. It is a project to define “the integrated macroeconomic accounts” of the United States, and it is jointly produced by the Bureau of Economic Analysis and the Fed. You can find a discussion of the effort here, and if you search on “disaster losses” you can find evidence on household, government, and business balance sheets of the impact of Hurricane Ivan in 2004 (about $28bln) and Hurricanes Katrina and Rita in 2005 (about $110bln).
Read through the paper and you can see this is an ongoing project with many current shortcomings, but it’s progress. However, it’s doubtful it will ever be used by economists in anything approximating real time, which means my objection – that economists ignore the fact that a disaster is a net negative even though it is positive in an activity sense – stands. Still, with as much as I bash economists, it’s only fair that sometimes I point out when they’re trying to do things the right way.
Now, one interesting part of the paper is on page 6, where the economists detail the sources of net lending and borrowing in the capital and financial accounts, broken down by sector. For those who think that deficits don’t matter, this is something to chew on. According to the table, in 2007 we were all borrowing: households, businesses, state and local governments, and the federal government. This was financed by our overseas trading partners. Everything changed in 2008, when the government borrowing “crowded out” private borrowing. The table below is a summary of two columns from the paper, and compares net lending or borrowing by sector for 2007 and 2011.
| (billions) | 2007 | 2011 |
| Households & nonprofits | -126 | 476 |
| Nonfinancial noncorporate businesses | -74 | -6 |
| Nonfinancial corporate businesses | -94 | 422 |
| Financial business | -3 | 125 |
| Federal government | -315 | -1357 |
| State & local governments | -93 | -113 |
| Rest of the world provides the difference | 716 | 484 |
| – indicates net borrowing | ||
| + indicates net lending |
The last number in the column is essentially the number needed to make the column sum to zero (although not exactly, due to statistical discrepancies…that is, it isn’t a “plug” number but rather is measured directly), and it clearly is bounded at some level. The rest of the world will not lend us, especially in the current economy, a bazillion dollars. And when so many other countries are running large deficits, there is great competition for those dollars. So the “rest of the world” line cannot simply rise to any level in order to balance out the column. (When our economy was less open, this line was far less flexible even than it is today).
Consequently, when the “Federal government” deficit rises by a trillion dollars, it essentially forces (in a mathematical and accounting sense that the books must balance) the other sectors to become lenders. Or, put another way, if no one buys the bonds then the federal government can’t run that deficit; ergo, the existence of the deficit implies that other sectors have lent.
A more-generous interpretation would be that the other sectors became savers due to the crisis and so, in order to maintain economic growth, the Federal government was forced to borrow. Aside from being a false choice (the government could have chosen to let the economy solve its own problems), that interpretation is less plausible now that we are four years out from the crisis and the deficits still persist.
There are other ways to illustrate this same proposition, such as through the numbers the Fed produces in the Z.1 report, which show that Treasury debt has gone from being 25% of total domestic non-financial sector debt to 40%, in only four years (see chart below, source Federal Reserve Z.1 report).
However, this doesn’t illustrate the “crowding out” causality as well as the table above does. The following chart (Source: Fed Z.1 report) shows it better, but it still begs the question a bit because it shows levels and not flows. For my money, I like that table.
All in all, the paper is worth reading – it’s only 17 pages, and lots of great charts and numbers to go with that.
Zombies Multiplying But At Least We Learned Something
While some elements of the economic and financial landscape seem to be clearing up, others are getting murkier. This is always the case, of course – our knowledge about the true state of the underlying economy and markets is always imperfect, so we are continually moving through shades of murk – but it seems to be more turbulent at the moment. A couple of weeks ago, all that the markets were concerned about was the Greek drama; now, some people believe that drama to be winding down (I myself am not at all sure of that; while Italian Prime Minister Mario Monti can opine with great confidence about the level of sovereign yields, we should take into account the fact that not a single soothing pronouncement of any politician or central banker in Europe has been correct for at least a year. Besides, while Italian yields are back near 5%, Portuguese bonds are over 13% again and headed in the wrong direction).
But at the same time, the economic data are getting less uniformly upbeat. Since December, the Citi Economic Surprise Index (see Chart, source Bloomberg) has been well over 50 most of the time, indicating that the data was routinely surprising on the high side. And yesterday, there was a significant upside surprise in Confidence, continuing the theme of an improving albeit not massively improved labor market. But there was also a horrendous downside surprise in Durable Goods Orders, which clocked an abysmal -3.2% ex-Transportation. Economists tried to soothe investors by saying the downturn was the product of expiring tax incentives, but that doesn’t change the fact that (a) knowing the tax incentives were expiring, they predicted 0.0%, and (b) no matter the reason for the decline, the decline was real and has real economic consequences. Is it encouraging that we obviously moved some growth into 2011, where it can no longer do us any good?
Markets in any event didn’t respond to the weak Durables number. I’m merely pointing out that if the Durables data is a prologue, we’re about to leave the steady-strong data period we’ve just enjoyed for the last three months. We’re overdue for some negative surprises. I am not sure this is necessarily bearish for equity markets being buoyed by ample liquidity, but it doesn’t help.
On Wednesday the ECB announced that it had allotted €529.5bln in the 3y LTRO conducted on Tuesday, bringing the total liquidity it has flushed into the market to about €1trillion. One observer pointed out that the ECB provided enough liquidity through these two LTRO operations to cover 72% of all bank debt that is maturing over the next two years, reducing the roll risk that banks would otherwise have faced.
Now, the roll risk is not to be taken lightly, but we should also not cheer too loudly that this element of market discipline has been removed. For a long time, banks have made the basic error of making long-term funding commitments and receiving only short-term funding commitments from depositors and purchasers of bank commercial paper. This need not create a balance sheet mismatch if the bank hedges with interest rate swaps, but the rollover risk doesn’t go away. Enron failed because they were unable to roll short-term debt. Lehman failed in part because of its inability to fund short-term. Some leverage in banking is inevitable, but locking up the leverage for longer terms is critical to surviving rough periods like this…unless, that is, the central bank is willing to bail you out when you get in that situation, and let you live as a zombie for a while.
Weirdly, the commodities markets ignored the wall of money surging in Europe and precious metals plunged today (-5%), supposedly because Bernanke in his semi-annual Monetary Policy Report and testimony before the House Financial Services Committee did not indicate that QE3 was on tap. I’m not sure why that would be a surprise, since no one has been recently hinting that QE3 in the U.S. was imminent, and with three months of high-side surprises on the data it wouldn’t be my base hypothesis…but it’s very strange in my view that these same markets would ignore that the fact that the ECB is providing more than enough QE for both central banks at the moment. European union may not be true union, but European money is money just the same and LTRO1 and LTRO2 will support inflation globally in the same way that QE1 and QE2 did. I am not a fan of focusing exclusively on gold and silver, but commodities still have a following wind despite the setback today.
Why am I so worried about this wall of money, when so few people seem to be? The answer is that I am afraid for the same reason you’re afraid when that huge, mean-looking guy comes sauntering down the street and looking right at you. He might not actually do anything, but you’re well aware that he could do something, and it’s not really in your control. At least I am not the only person worried; for the first time (at least, that I have seen), there is someone actually in the Federal Reserve system who understands and has articulated the argument publicly. In a short “Economic Synopses” publication entitled “Quantitative Easing and Money Growth: Potential for Higher Inflation,” which is located on the research website of the St. Louis Fed, economist Daniel L. Thornton raises the issue that I’ve raised in this column before (for example see here and here). Summing up:
“While discussions of the money supply are nearly nonexistent in modern monetary theory and policy, both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate.”
Dr. Thornton doesn’t say that the expansion of the money supply is automatically going to lead to inflation, only that it is plausible that it may because it has historically done so, and that this is a significant risk that is – as the quote above rather remarkably suggests – essentially not discussed in a serious way within the Fed.
I find it fascinating that more mainstream economists are finally asking these questions. You can also see a version of the argument I made last year via this link to an article by Dr. Steven Cunningham at the American Institute for Economic Research (I must confess that I don’t know anything about the AIER, but they have some interesting articles on the site). The difference is that Dr. Cunningham actually put hypothetical numbers that could result from the dynamic that Dr. Thornton (and I) have mused about.
Maybe I shouldn’t be surprised, but delighted, that this discussion is developing. I’ve said often enough that this crisis was going to serve as a rare opportunity to pit monetarist dogma against Keynesian dogma, at least with respect to inflation. The monetarists have scored a complete knockout, as inflation has risen despite massive output gaps (and prices were rising even in the absolute teeth of the crisis – take out energy, and the housing sector whose bursting helped cause the crisis, and inflation didn’t even decelerate very much). I think the chart in my comment here is the one that Keynesian orthodoxy just has a hard time explaining. In any event, what we are seeing is that thoughtful economists, rather than trying to force models to fit reality, are migrating to models that make more sense and asking the questions those models provoke. That’s encouraging.
Now, whether these ideas are spreading or not, it’s not going to affect central bank actions any time soon. Philadelphia Fed President Plosser can say as often as he likes, as he did today, that the first hikes may come in 2012 (despite the Fed’s promise), but it’s not going to happen unless the economy simply explodes to the upside. While we would all love that outcome, it’s not likely when overburdened debtors are simply being turned into zombie companies, zombie banks and zombie countries. As everyone ought to know by now, the real healing begins…once we kill the zombies.
Disowned
The data today were weaker-than-expected, but I can’t characterize them as weak. ADP missed expectations by 45k when revisions are included, but if we can blame the spike last month and the plunge this month on poor seasonal adjustment, the average was still 231k and that would ordinarily be considered quite acceptable for an expansion (if not for the early stages of an expansion). The average for 2004, 2005, and 2006 was 165k, so this isn’t too shabby in the grand scheme of things.
Similarly, although ISM Manufacturing fell short of expectations at 54.1, as I pointed out yesterday that’s not really falling short of where the actual expectations were. And it represents a jump from 53.1 last month. Again, 54.1 is in the ‘expansion’ zone. It’s below where it was last spring, and in the spring of 2010, but manufacturing isn’t falling apart, at least yet.
Not to be overlooked is that domestic vehicle sales for January were at a seasonally-adjusted 14.13mm units, above expectations and at the highest level (excluding the cash-for-clunkers spike) since May 2008 (see Chart, source Bloomberg).
Considered another way, sales almost reached levels that were typical of mature expansions such as those in the late 1990s and the late 1980s. They are not at levels, and probably won’t reach levels, at the 0%-financing-induced plateau of the early 2000s. It is incredible, when you think about it, that car companies were floundering through the 2000s despite record sales. This is a great example of how excessive private debt can dampen inflation: margins were tight and, rather than push up prices and margins but lose cash flow, heavily-indebted car companies had to spread their interest costs over as many cars as they could in order to make any profit at all. Now, of course, Government Motors has dramatically less debt (in 2008, the old GM had $102bln in long-term liabilities; now it has $55bln) and wiped out $50bln of a $60bln post-retirement medical care liability out when they turned it over to the UAW to run. With essentially $100bln less in debt, GM doesn’t need to sell a trillion cars to make money. (More cynically, the profit motive is somewhat less operative now as well, considering that the overlords have other metrics they are shooting for).
So, while the data are disappointing to those economists and investors who were reaching for the stars but only got the moon, it’s not that bad. I need to add the caveat ‘yet,’ because I think the economy isn’t going to be expanding all year, but we’re still chugging along.
Equities therefore had another swell day, rising 0.9%. Commodities rose, and inflation swaps jumped about 4bps as bond yields rose. Portuguese yields fell sharply as it was able to easily sell its Treasury bills, as I suggested on Monday would happen. By these bill sales Portugal thereby kicks at least some of its funding problem all the way to May and July. Whee! The country is not out of the woods yet, folks.
While we enjoy some good data here, the biggest dangers for investors remain European growth, and global inflation. Regarding the latter, a strongly-worded speech by Bundesbank president Jens Weidmann suggested that the ECB’s provision of liquidity is “too generous” and raises “higher risks for banks and thus also risks to price stability.” The old wisdom held that the ECB had “Bundesbank DNA,” but it sounds to me like it is on the verge of being disowned by Daddy.
Another back-page story to keep an eye on as it is a prime candidate for the 2012 “unintended consequences award” was the recommendation, contained in the report released yesterday from the Treasury Borrowing Advisory Committee (TBAC), that the Treasury start to allow T-Bill auctions to clear at negative yields. What happens now is that in periods of crisis, T-bills have been trading with negative yields; however, since the Treasury can’t mechanically auction them at negative yields, the auctions will be extremely well bid at a zero yield (that is, the T-Bill is issued at par and matures at par, with no interest) and then immediately trade at a negative yield in the secondary market. It’s free money to the banks who participate, and the TBAC suggests seemingly-cleverly that the auctions should be allowed to clear at negative yields so that the Treasury isn’t just throwing away money.
The problem is akin to the problem a football team faces when it sells tickets at $80 and watches them immediately be scalped for $150 to fans clamoring for tickets to the sold-out game. Why doesn’t the team just charge the going rate of $150 and cut the scalpers out, taking all the surplus to themselves? There are lots of reasons, most of which boil down to wanting to make sure they keep fans happy,[1] but one reason is that the team wants to make sure the game sells out all the time. If the game isn’t sold out, it can’t be shown in local markets. And if it can’t be shown in local markets, it means the TV revenue is lower. So by sacrificing a few bucks, the team makes sure the game is sold out.
I would suggest the Treasury ought to consider this analogy. A failure to “sell out” a T-Bill auction – for the record, this week the Treasury sold $93billion in 4-week, 3-month, and 6-month bills – would be worth far more in a negative direction than the pennies the Treasury gives up to the “scalpers.”
From a trading perspective, this creates a singular risk every time there is an auction that may clear at negative yields. Maybe everyone will show up and bid 0%, so the auction will just tail back to zero. And, maybe not. It’s a small chance, but it’s one more random thing to have to keep an eye on.
Thursday before Employment would ordinarily be a sedate trading session but we are again on Greek PSI watch. Today a headline ran (on Dow Jones, I think) predicting there would be agreement within 24 hours. Obviously, there will be a knee-jerk positive response when there is a deal announced, even though the details may not be announced right away and we certainly won’t know whether anyone will participate. Greece is not only not out of the woods, it’s tied to the tree.
Initial Claims (Consensus: 371k from 377k) is due tomorrow. Claims the day before Employment doesn’t usually deserve much attention, but in this case it’s worth watching with one eye because the seasonal volatility is diminishing and so the error bars are narrowing as well.
Be aware that both Chicago Fed President Evans (he of the ‘Evans Rule’ suggesting that rates be declared to be immobile until Unemployment falls below some stated threshold) and Chairman Bernanke are speaking tomorrow morning.
[1] By letting fans pay a floating price to a scalper, the scalper can extract the consumer surplus while the football team charges a price that most fans could pay. So a fan who can’t get into the game because the scalper is charging $150 isn’t mad at the team because the team charged $80. He’s mad at the scalper. But I digress.
Yee-Haw News And Ho-Hum Trading
Tuesday was another day of ho-hum trading following yee-haw news.
Anyone expecting a bloodbath following the ratings downgrades clearly has not been paying attention as the market sleepwalks through 2012. Stocks gained 0.4%, 10-year note yields ended virtually unchanged at 1.86%, and TIPS yields fell 2.5bps despite the proximity of a $15bln 10-year auction, now only 2 days away with 10-year TIPS yields at -0.22%.
The dollar slid somewhat, and commodities rallied. Indeed, the only market with a reasonable level of excitement was the Nat Gas market, where prices fell to levels not seen since 2002 (see Chart, Source Bloomberg). It is useful to remember that a significant part of commodities futures returns comes not from movements in the spot price, but from collateral return, normal backwardation, expectational variance, and a couple of other sources.
Natural Gas front contract. Spot gas has gone basically nowhere in a decade as supply responded to price.
Of course, Nat Gas also had the worst fundamentals of any commodity. Coming into the month, the mild winter and the added supply from frackers had combined to make NG the fourth-most-contango commodity (a commodity in contango is one which has deferred contracts at higher prices than nearby contracts, implying a negative roll return), with the worst momentum, among the universe of normal commodities. That combination means that it was not selected this month to be one of the commodities in the USCI basket. And that, in turn, means that USCI has appreciated by 3.79% this month while DJP, an ETN that tracks the DJ-UBS Commodity Index, is up only 0.02%.
European bonds closed mixed, with small gains in Greece, Portugal, Ireland, and Italy on the back of successful sales of short bills in Spain, Hungary, Belgium, and by the EFSF. But it isn’t very surprising that these sales of 3-month to 18-month bills were well-received, considering that the ECB has made hundreds of billions of Euros available virtually free to banks, which can earn an easy spread in this way. Let me know when Spain sells a 5-year note. Portugal also bounced a little today because the huge move yesterday was caused by Citi removing the country from its European Bond Index after its downgrade. Some investors who systematically wait for these “forced” moves to take the opposite side of figured to be getting a mild bargain. For a little while, anyway!
Fitch tried to grab the headlines back from S&P by saying that Greece is insolvent and will default. Really, though, at this point it’s about the over/under on when, not if, Greece defaults. Markets did not react to this news, nor to S&P’s statement that it will take ratings actions on European banks and insurers within the next month, some as early as the next week. This is potentially a bigger deal than the original downgrade itself. While a sovereign rating is a strange beast – since many investors will treat the sovereign as the closest thing there is to a risk-free investment in a particular country, no matter what its rating – ratings of financial companies affect actual contracts, collateral covenants under a CSA (collateral support annex to an ISDA), and credit lines. It was a downgrade to AIG that triggered one of the big failures in 2008, when the additional margin demanded by CSA agreements could not be met by the firm. And the problem for investors is that unless you’re the guy holding the CSA that has the rating trigger in it, you won’t know about the problem until it’s too late. Not that investors need any more reason to avoid financials than that their business model is irremediably destroyed and ROE will be permanently lower in the future, but the silent-but-violent nature of the blowup events means the only person holding the credit that is about to go under will be the person who is the last to hear about margin calls.
.
By now, I suppose we all recognize that one of the precipitating factors for this crisis, if not the precipitating factor, was the rise in leverage and in particular private leverage. There has been a lot of ink spent about the ‘deleveraging’ that is going on; as I have written several times before (most recently in “Scrooge Businesses”) the data say this is largely a myth. Domestic financials are deleveraging; Households are deleveraging slightly; Businesses are now re-leveraging. And of course, this is all occurring with the backdrop of the great increase of leverage that the federal government is generously taking on our behalf. I think that many of us feel that society must be deleveraged broadly in order to build the foundation for robust future growth. I want to take a quick moment here to talk about the difficulty of actually reducing overall leverage.
John Mauldin recently wrote (and he has written many times before on this topic, as have others):
“…a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time…ultimately, there must be a trade surplus if leverage and debt are to be reduced.”
The statement is true from any given country’s perspective; Mauldin’s argument is that we can’t all run trade surpluses. That’s not quite true: emerging market countries are in general drastically less-leveraged than are the developed countries, so if we could just persuade them all to run large trade deficits to the developed world, we could shift our indebtedness to them. Let’s assume for the sake of argument that isn’t a serious alternative. What, if anything, do we need to do to reduce ALL debt and leverage?
It may seem easy. Each of us needs to save, pay down credit cards, and so on. We all know people who are doing this. And yet, the numbers say that in aggregate, it’s not happening. That’s because when Person A sells his house to person B, one is delevering but the other one is levering. When Person A defaults, he delevers but the bank who lent him the money increases its leverage. If Person A defaults and the government injects capital into the bank, then the government is taking on Person A’s leverage.
What the numbers tell us (see the charts in ‘Scrooge Businesses’ referred to above) is that the government’s increase in leverage is simply balancing out the decrease in the banks’ leverage, and households and businesses are just trading around leverage and not doing much. Is there anything we can do, absent borrowing lots of money from EM?
It turns out that there is one thing we can do, and you may be able to guess what it is by the fact that it has been the last refuge of heavily-indebted governments for many generations. Leverage is, notionally, the dollar value of debt divided by the dollar value of assets. Back in the 1970s and 1980s, one reason that overall leverage wasn’t growing too fast is that the real value of debt evaporated pretty quickly. That is, you paid off your mortgage with dollars that were worth a lot less than when you took out the mortgage, and the house was worth a lot more. This happened because the value of a mortgage is a fixed number of dollars. Inflation helped keep leverage in check by eroding those claims. As a society, we became used to this effect, and when inflation went away in the 1990s and 2000s, we continued to draw as much debt as we had been (and more) but when we went to pay it back, it was still a lot of money! Much more debt got rolled and refinanced, and the debt numbers climbed.
The solution to the debt/assets ratio is inflation, unfortunately. While many assets will not keep pace with inflation, some will. Below is a chart (Source: Enduring Investments) that I use in presentations in a different context – illustrating how a corporation’s capital structure drifts (to non-optimal levels) over time if debt is nominal. But the chart has meaning in the context of this discussion. The curves show how rapidly your leverage decreases under different inflation assumptions, assuming that you start at 100% leveraged, your assets keep pace with inflation and your debt is nominal. So for example, if inflation is 1%, after 10 years your leverage is down to 78% or so; if inflation is 7%, then your leverage is down to 45%.
Inflation isn't all bad. If you're a debtor. And aren't we all?
Note that this has nothing to do with amortizing the loan. We are assuming no amortization here. So all you do is pay the interest, and in 10 years your leverage drops 150% more (55% instead of 22%, roughly) with 7% inflation.
So, do you still think the Fed is neutral on inflation? Do you still think the Committee really wants inflation pegged at 2%? At the very least, the FOMC wants inflation to be at the upper end of the band that allows it to retain its credibility. And, if push came to shove, I suspect they might allow an “oops” to happen if they thought a little more inflation might help delever society.
And it might. It just might.
.
Speaking of inflation, the next two days see PPI (Consensus: +0.1%/+0.1% ex-food-and-energy), which isn’t important, and CPI (Consensus: +0.1%/+0.1%), which is. I’ll have more to say on CPI tomorrow.
Scrooge Businesses
Stocks rallied today, as did commodities, in thin year-end trading (I am very tired of this latter phrase, which it seems we could have accurately used since October). The putative reason for the rally was that Initial Claims remained low (364k) rather than bouncing to 380k as the consensus estimate had predicted. The quality of the Initial Claims data will deteriorate rather sharply over the next couple of weeks and for the first few weeks of January, but it does seem likely that we have moved out of the old range of 400k-425k and into a new lower range. This is consonant with a general improvement in the overall data (and in the mood in the country!).
M2 money supply leapt $32bln last week. So much for the possibility I mentioned a few weeks ago that the pace of money growth might be slowing. The 52-week rise in M2 is back up to 9.8%. One of the restraints on inflation, despite this money growth, has been the slower rise in transactional money in Europe, where the year-on-year rate of rise in M2 as of the end of October was only 2.1%. This is soon to change, however, thanks to the ECB’s new operation. As a blog post from The Economist pointed out yesterday, ECB President Mario Draghi has stopped the stern denials about the ECB engaging in quantitative easing.
“Each jurisdiction has not only its own rules, but also its own vocabulary. We call them non-standard measures. They are certainly unprecedented. But the reliance on the banking channel falls squarely in our mandate.” (The source of the quote is an interview with the Financial Times here, but the Economist article makes for better reading.)
The ‘news’ of the day being thus dispensed with, I can proceed directly into a belated observation or two about the Fed’s Z.1 “Flow of Funds” release that was posted in early December. The Z.1 is a rich source of bauxite with just a little alumina within it, but one does occasionally find something valuable and/or interesting. I like to plot the debt numbers in various ways, because the Fed helpfully slices up the debtors into convenient categories (although they seem to still include Fannie Mae and Freddie Mac debt in “private” domestic financial institutions, which is a ridiculous fiction. More on the impact of that fiction in a moment).
I have published charts with roughly quarterly regularity simply to provide a concrete reminder that the popular story about household deleveraging is largely a myth. The chart below shows it very clearly: most of the deleveraging has come from domestic financial institutions. This will continue, as the Fed moves to implement substantially all of the Basel III recommendations and demands an extra layer of “protection” in the form of capital from systemically important institutions. Households have de-levered somewhat as well, but not really very much in the grand scheme of things. It just feelslike deleveraging compared to the wild leveraging behavior seen prior to 2008. Relative to income, consumers are carrying less debt, and it is the first decline in a generation, true. But it isn’t very much.
Businesses are adding debt!
But here’s the interesting thing in the chart above. Businesses are re-levering. Okay, technically they are not re-levering, but they are adding debt. This also spears a popular story, that of the cash-hoarding trolls that run businesses in America today. We are told that if businesspeople would only have confidence (those lousy one percenters!) the economy would be healed. Well, it’s a wonderful story, except for the fact that ‘taint so. Business owners are behaving like Scrooge, all right, but it’s Scrooge after the visitation by Marley’s ghost.
It is true that there is more cash on corporate balance sheets than there was five years ago. In some cases, it looks as if companies are issuing debt to hold cash! But that may not be far from the truth. After credit lines evaporated in 2008 and 2009, a prudent business will need to keep lots more cash on hand as an insurance measure. It is a good sign that business debt is growing, and it means this measure confirms the recent expansion in commercial bank credit that I mentioned and illustrated in a comment last week.
The second interesting chart is shown below. It computes the total federal, state, and local government debt as a proportion of GDP. The ratio currently stands at 86.6%.
U.S. public debt is approaching 100% of GDP.
That would not be a big story in itself, but the red line is. The red line is the ratio if you simply recognize that Fannie Mae and Freddie Mac debt are de facto obligations of the Federal government. And that ratio is at 96.1%, and will almost certainly exceed the magical 100% level by the middle of next year.
[Of course, you could plausibly argue that if you include Social Security and Medicare obligations, the obligation ratio is wayyyyy over 100%. But there are two differences with those obligations. One is that the government can decide to stop paying those benefits and it would not constitute a default. An abrogation of the social contract, yes; a default, no. The other difference is that Social Security and Medicare are inflation-linked, so the government can’t inflate out of them. Therefore, the existence of those obligations shouldn’t influence whether or not a calculated decision is made to spur inflation to reduce the real burden of the debt.]
Have a very Merry Christmas, a Happy Hanukkah, or be otherwise jolly no matter what your religious or secular persuasion. There will be one more article before the new year – but not this week!
The Devil Is In The Double-Entry
Strong Durable Goods Orders, ex-Transportation, of +1.7% will help end Q3 on a strong note (the first look at Q3 GDP is due tomorrow, and the consensus expects 2.5% growth and a 2.2% rise in the Core PCE price index). It does look like September was generally better than was feared in August; the question from here is whether Q4 data will follow the lead of the miserable October Consumer Confidence figure reported on Tuesday. As ever these days, though, the drama in Europe was the driving force behind market action. Bonds fell, with the 10y yield up 9 bps to 2.20%, and stocks rose 1.1% as investors seemed to see the balance of the news as favoring a brokered peace between EU nations fighting to put Humpty Dumpty back together again.
I confess that I don’t see what they are seeing. There may be a solution, but if there is then it will be force-fed on banks following the old maxim “If a piece doesn’t fit, then you’re not using a big enough hammer.” The ‘plan’ being promoted as such discusses fairly serious haircuts on holdings of Greek debt, required recapitalization of banks (although in some reports the recapitalization would have to come from raising money in the market, which has next to no chance of happening in these circumstances), bolstering or levering the EFSF, and various other bells and whistles. The only little problem is that the folks who hold most of the Greek debt, who must be party to any controlled restructuring, don’t like it.
This afternoon’s Bloomberg headline was “Impasse on Greek Debt Relief With Bankers Threatens EU Crisis Summit Deal.” The Institute of International Finance, which speaks for a consortium of banks, said there is no current agreement “on any element of a deal.” I find the headline chilling because it makes “bankers” the bad guys. It would not surprise me in the least if the politicians are calculating that by framing this as ‘reasonable people vs the bankers’ (why not pile on the bankers?) the politicians will bring them to heel without force because banks won’t want the bad publicity on top of what they already have as the villains of the world today. And, if they don’t comply, then the politicians can frame the bankers as the road block.
Now, unlike for politicians, publicity isn’t everything to banks. What we need to keep in mind is that this argument from the banks’ perspective is about accounting. The economic value has been lost already. What is salient to the bankers at the moment is the question of how much of an accounting write-down they can avoid, so that they don’t have to take any more of a bailout than is necessary. A second salient point, probably, is that whatever haircut they give Greece will be the starting point for negotiations with Italy, Ireland, Portugal, Spain, and some others. The negotiations over Greece are akin, although of course not planned as such, to the ‘targeted negotiations’ that the United Auto Workers historically have applied in contract discussions with the auto industry. The first deal becomes the model for the next deal. This negotiation is about far more than just Greece.
Again, the money is already gone. Nothing can change the fact that Greece will never pay 100% of its current obligations. Nor 80%. Nor 60%, in all likelihood. This is about accounting for the losses. (Do not, in other words, be surprised if any ‘solution’ includes continued regulatory generosity about the counting of losses, just as every ‘stress test’ has).
Since this is not just about Greece, banks are not going to concede easily. Since it is not just about Greece, any political agreement is going to be hard to get past vigilant legislatures. That is to say that even if they get Humpty back together again, the trick is going to be keeping him together.
And all of this happens as we motor into conditions of declining market liquidity as the end of the year approaches. Perhaps the recent odd decoupling of some markets (for example, TIPS were strong today, and equities were strong, and inflation swaps widened 5-6bps even though commodities fell 1%) is an early consequence of the declining liquidity. I don’t know; it seems early for that but I am keeping an eye on this decoupling.
.
I noted yesterday that commercial bank credit has finally joined the land of the living and has expanded by more than 1% over the last year (and at a considerably faster pace quarter-on-quarter). This I cited as a small ray of sunshine in the overall gloomy murk that is the financial/credit/sovereign crisis. It is a sign that some of the bank reserves, heretofore sequestered due to the attractiveness of riskless interest-on-excess-reserves (IOER) relative to risky lending at low rates, are making their way into the real economy. This does have a dark side, and that’s the fact that – since we have never had excess reserves like this – we have no idea how quickly excess reserves will move into the transactional money supply and put upward pressure on prices. It is foolhardy to rely on a model here, because we’ve never seen anything like this. It could be gradual, and controllable, or it could be a dam bursting. We simply don’t know, no matter what the august Chairman tells you.
But in an attempt to remain cheerful, let me review why QE1 made some sense when it was implemented (it’s hard to argue that QE2 made any sense at all while IOER was in place). At the time, a key worry of policymakers was that the economy may have entered into a major deleveraging cycle, which would be associated with a sharp decline in the velocity of money. Since it isn’t the quantity of money M, but the quantity times the velocity V, that affects nominal output (mainly through prices unless money illusion is epidemic), policymakers are rational to try and offset a decline in velocity with an increase in money. In full disclosure, I was one of those who at the time thought the plunge in velocity would be far more than could be compensated for by conventional monetary policy, and I doubted that the Fed could prevent deflation although I also said that the deleveraging would provide ideal conditions for an inflationary period thereafter.
So what happened, in the event? Money velocity did in fact decline, but the decline was not particularly severe compared to the severity of the event. The chart below (source: Bloomberg) shows M2 velocity since the 1960s.
Money velocity back to the old standard of normal.
Note that the decline in velocity was no more than was seen in the early-2000s recession. What is more, the level of velocity is not particularly low on a historic basis. The last two decades are the outliers. To me, this suggests that the decline in velocity has very probably run its course, absent a more gut-wrenching financial debacle, and so the current growth in M2 is more worrisome if it lacks that offsetting effect.
Also, the deleveraging that you hear so much about is simply overhyped. The chart below (source: Federal Reserve) shows the debt outstanding, in billions, of domestic financial institutions, households, and businesses.
Deleveraging? Hmmm.
You can see from this chart that whatever deleveraging there has been has been predominantly done by domestic financial institutions – and much of that, by the way, is because banks were flush with reserves and didn’t need to roll as much debt. The terrible household deleveraging you have heard about is mostly mythical. It feels like there has been deleveraging, because we’re so used to increasing debt every quarter, but there hasn’t been much. And businesses have essentially the same amount of debt now as they did when the crisis began. Almost all of the leverage, that is, is on the bank side. And neither that, nor household indebtedness, is even back to trend.
So I am skeptical that we are in a grand deleveraging cycle. Yes, we are deleveraging, but no, it isn’t dramatic. The gross level of debt from these three groups is still up 283% since 1990 (although that should fairly be adjusted for the rise in nominal GDP). There are two sides to that observation. It may be that we have only just begun to deleverage, and so we have much further to go and money velocity will continue to fall while we do so. But it may also be that most of the deleveraging cycle, for now at least, is complete. If that is the case, it is bullish for the economy (although please note this is not a call for Thursday, but something that would be felt in 2012 and 2013), but it also means that the Fed has overstayed its welcome and the uncomfortable rise in inflation over the last year is likely to continue.
.
As I send this ‘to print,’ headlines are flashing across the tape that Euro leaders have either reached a deal on a 50% writedown of Greek debt, or that they have reached a deal with banks on that haircut, or that they are ‘close’ to reaching such a deal. The stock market so far is justifiably hesitant, since only a couple of hours ago – indeed, when I started writing this article – there was ‘no element’ of a deal in place. I am pretty sure they are close to a dramatic announcement. I would be surprised if they were close to an actual substantive deal, given my observations above. This is not about just Greece, and any ‘deal’ that trades nothing to the banks that they don’t already have (they already have the economic losses) in exchange for an order to go raise more money in the market for themselves isn’t much of a deal in my mind! My suspicion is that the banks may have agreed to the idea of 50% but not to any details of structure. Since as my friend Peter Tchir has pointed out the 21% haircut wasn’t really a haircut at all, the structure does matter. So the drama continues, the breathtaking headlines and ethereal details continue. It is all getting quite exhausting.
