Tag Archives: fiscal policy

The Fed Continues To Make Policy Mistakes

“During the last year, the Federal Reserve has hinted that the period of ‘ultra-accommodative monetary policy’ was coming to an end. The Fed started that process last October by terminating the latest ‘Quantitative Easing’ program, which induced massive amounts of liquidity into the financial markets. Subsequently, the Fed has turned its focus towards the near ZERO level of the ‘Fed Funds’ rate.” – July 6, 2015

It seems like an eternity ago now, but I warned then the Fed was too late in the cycle to tighten monetary policy due to the impact higher rates have on economic growth.

“While the Federal Reserve hopes that they can effectively raise interest rates without cratering economic growth, the problem is that the bond market may have already beaten them to the punch.

While I do not expect Treasury rates to rise very much, the increase in borrowing costs in an already weak economic environment has an almost immediate impact. The chart below shows the periods in history where Treasury rates have risen and the impact of subsequent rates of economic growth.”

As we suggested, the rise in rates to 3.25% was all the economy could withstand at the time.

I followed up that previous analysis in October 2015 suggesting the Fed had missed its window to hike rates. To wit:

“The problem for the Federal Reserve is that getting caught in a liquidity trap was not an unforeseen outcome of monetary policybut rather an inevitable conclusion. The current low levels of inflation, interest rates, and economic growth are the result of more than 30-years of misguided monetary policies that have led to a continued misallocation of capital.”

“From our cyclical vantage point, we have long been aware of the truism that ‘recessions kill inflation.’ Therefore, when the next recession arrives, it is more likely to push inflation below zero at a time when the Fed has no obvious policy response. The resulting deflation will be the stuff of policy nightmares.”

Why am I reminding you of this?

It is becomingly increasingly clear from a variety of inputs that deflationary pressures are mounting in the economy. Recent declines in manufacturing, and production reports, along with the collapse in commodity prices, all suggest that something is amiss in the production side of the economy.

As shown in the chart below, the Fed should have started lifting rates as the spike in economic growth occurred in 2010-2011 as both the Fed and Government flooded the economy with liquidity. While hiking rates would have slowed the advance in the financial markets, the excess liquidity sloshing around the system would have offset tighter monetary policy.

If they had hiked rates sooner, interest rates on the short-end of would have risen giving the Fed a policy tool to combat economic weakness with in the future. However, assuming a historically normal response to economic recoveries, the yield curve has been negative for quite some time. This explains why “financial conditions” remain at historically low levels despite higher Fed Funds rates.

The chart above also explains the delay in the “yield curve” turning negative earlier in this cycle.

  1. As shown in the chart above, the 2-year Treasury has a very close relationship with the Effective Fed Funds Rate. Historically, the Federal Reserve began to lift rates shortly after economic growth turned higher. Post-2000 the Fed lagged in raising rates which led to the real estate bubble / financial crisis. Since 2009, the Fed has held rates at the lowest level in history artificially suppressing the short-end of the curve.
  2. The artificial suppression of shorter-term rates has skewed the effectiveness of the yield curve as a recession indicator.
  3. Lastly, negative yield spreads have historically occurred well before the onset of a recession. Despite their early warnings, market participants, Wall Street, and even the Fed came up with excuses each time to why “it was different.” Historically, it has never been the case.

However, the Fed is now trapped in a difficult position and is making a “policy mistake” once again.

Given the Fed waiting so long into the economic cycle to hike rates to begin with, they weren’t able to gain much of a spread before the economy was negatively impacted. There have been absolutely ZERO times in history when the Federal Reserve began an interest-rate hiking campaign that did not eventually lead to a negative outcome. To wit:

While the Federal Reserve clearly should not raise rates in the current environment, there is a possibility they will, regardless of the outcome. 

The Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates would likely accelerate a potential slowdown and a significant market correction, from the Fed’s perspective, it might be the ‘lesser of two evils. Being caught at the ‘zero bound’ at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.”

The problem for the Fed is that the bond market was NEVER worried about inflation.

Only the Fed saw an “inflation-monster under the bed.” All the bond market needed was the Fed to come out and indicate a “shift” in their stance to worrying about “deflation” to seal the deal.

Despite the many arguments to the contrary, we have repeatedly stated that the rise in interest rates was a temporary phenomenon as “rates impact real economic activity.” 

The “real economy,” due to a surge in debt-financed activity, was not nearly strong enough to withstand substantially higher rates. Of course, such has become readily apparent in the recent housing and auto sales data. Consequently, the Fed was unable to gain much clearance between the current level of rates and the “zero-bound.” 

Navarro’s Naivety 

On Tuesday, Peter Navarro, who is the White House trade advisor, called on the Federal Reserve to lower rates.

“The Federal Reserve before the end of the year has to lower interest rates by at least another 75 basis points or 100 basis points to bring interest rates here in America in line with the rest of the world. We have just too big a spread between our rates and that costs us jobs.’

While Peter, and President Trump, both want an “aggressive rate-cutting cycle” to sustain economic growth while he fights an unwinnable “trade war,” the reality is that rate cuts, and even additional measures of quantitative easing, or Q.E., are likely to have a muted effect. As I explained previously, the effectiveness of QE, and zero interest rates, is based upon the point at which you apply the stimulus.

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bailout’ the markets today, is much more limited than it was in 2008. But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to the present.”

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.”

A simple analogy is throwing gasoline on a raging bonfire. The fire will burn for a bit longer, but it won’t burn any hotter. However, throwing gasoline on a pile of dry wood and hitting it with a match provides a better outcome.

Such was the case in 2009. Even without Federal Reserve interventions, it is highly probable the economy would have begun a recovery as the normal economic cycle took hold. No, the recovery would not have been as strong, and asset prices would be about half of where they are today, but an improvement would have happened nonetheless.

The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed has a long history of making policy mistakes which have led to negative outcomes, crisis, bear markets, and recessions.

As I showed, above, the Fed made a mistake not using the flood of liquidity to lift rates. Instead, the Fed opted to create an asset bubble instead. Or, should I say, “again.”

While another $2-4 Trillion in QE, and a return to the “zero bound,” might indeed be successful in further inflating asset prices, there is a finite ability to continue to pull forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. 

Currently, there is evidence the cycle peak has been reached.

If I am correct, and the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be far larger than currently imagined. There is a limit to just how many bonds the Federal Reserve can buy and a deep recession will likely find the Fed powerless to offset much of the negative effects. 

If more “accommodation” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t?

Its The Economy Stupid

In the months leading up to the Presidential election of 1992, Bill Clinton advisor James Carville coined the phrase “It’s The Economy Stupid” as a rallying cry for his candidate. At the time the U.S. economy was mired in weak economic growth despite having recently emerged from a recession. Democratic hopeful Bill Clinton was quick to remind voters of the circumstance and place direct blame on his opponent, George H.W. Bush. The strategy James Carville and Bill Clinton employed focused on the fact that presidential incumbents fare poorly when the economy is suffering.

“Long in the tooth” and “bottom of the ninth inning” are phrases we have recently used to describe the current economic cycle. In just a matter of days, this economic expansion will tie the period spanning 1991-2001 as the longest era of uninterrupted growth since at least 1857.  

Whether the current expansion ends with a recession starting next week, next month or next year is unknown. What is known is that the odds of a recession occurring before the presidential election in a year and a half are reasonably high. As evidenced by public Fed-bashing for raising interest rates, this point is clearly understood by President Trump. 

Boosting Growth Beyond Its Natural Bounds

Donald Trump can certainly win reelection, but his chances are greatly improved if he avoids a recession and keeps the stock market humming along. Accomplishing this is not an easy task for several reasons as we expand on.

Trend Economic Growth

The natural growth rate of the economy is about 2% per annum and declining. The graph below shows the ten-year average growth rate and its trend over the last 60 years.

Data Courtesy: St. Louis Federal Reserve

The slope of the trend line is -0.0336x, meaning that trend growth is expected to decline further by 0.0336% per year or approximately 0.34% per decade.

Fiscal Stimulus

During Trump’s term, economic growth has run 0.50-0.75% above trend in large part due to various forms of fiscal stimulus, including tax reform, hurricane/fire relief, and increased deficit spending. In 2018 for example, Treasury debt outstanding increased by $1.48 trillion as compared to an increase of $515 billion in the prior year. The difference of nearly $1 trillion directly boosted GDP for 2018 by approximately 1.30%.

Even if the Treasury’s net spending were to increase by another $1.48 trillion this year, the incremental contribution to GDP growth for 2019 would be zero. Any decline in Treasury spending from prior year levels will reduce economic growth.  It is a story for another day, but most economic measures are centered on percentage growth rates and not absolute dollars, meaning what matters most is the rate and direction of change.  

Given that control of the House of Representatives is in Democratic control we find it unlikely that deficits can increase markedly from current levels. Simply, the Democrats will not do anything to boost the economy and help Trump’s election chances.

Monetary Stimulus

Without the help of fiscal stimulus and a low rate of natural economic growth, Trump’s best hope to sustain 3-4% economic growth and avoid a recession by 2020 is for the Fed to lower interest rates and quite possibly re-introduce QE. Trump and his economic team have been publically insistent that the Fed does just that. Consider the following clips from the media:

3/29/2019 – White House economic advisor Larry Kudlow says he wants the Fed to cut its overnight lending rate by 50 basis points “immediately.”

4/5/2019 – (Reuters) – “I think they should drop rates,” Trump told reporters. “I think they really slowed us down. There’s no inflation.”  The U.S. president also suggested that the central bank pursue an unconventional monetary policy called “quantitative easing” that was used to nurse the economy back after the global financial crisis. “It should actually now be quantitative easing,” Trump said.

3/26/2019 – Stephen Moore, Donald Trump’s nominee for a seat on the Federal Reserve Board, told the New York Times that the central bank should immediately reverse course and lower interest rates by half a percentage point.

4/14/2019

The Fed has partially acquiesced to Trump’s public demands. Over the last three months, the Fed has gone from a steadfast policy of further rate hikes and QT on “autopilot,” to ending the prospect of interest rate increases this year and halting QT by the end of the third quarter.

As far as the next step, reducing rates and possibly reengaging in QE, the Fed does not seem willing to do anything further. Consider the following clips from the media:

3/27/2019 – “I doubt we’re accommodative, but I also doubt we’re restrictive,” said Dallas Fed President Robert Kaplan. “If we’re restrictive, it is very modest.”

4/12/2019 – Minneapolis Fed President Neel Kashkari says it isn’t time to cut rates.

3/20/2019 – Per the FOMC statement from the most recent meeting- The Fed expects the benchmark rate to stay near 2.4 percent by the end of 2019.

4/11/2019 – “We’re strictly nonpartisan” “We check our political identification at the door” -Jerome Powell

4/12/2019 – Per Bond Buyer: Powell said to tell Democrats Fed won’t bend to pressure.

Based on the statements above and others, the Fed appears comfortable that their current policy is appropriate. It does not seem likely at this time that they will “bend to pressure” to get Trump and his team off their backs. 

Summary

Given that fiscal stimulus and the anemic growth trend will do little to help Donald Trump win reelection, all eyes should focus on the Fed. Pressure on the Fed to lower rates and start back up QE will become much stronger if the economy slows further and/or the stock market declines.

We believe the Fed will try to protect its perceived independence and keep policy tighter than the President and his team prefers. This dynamic between the President wanting a stronger economy to help his election chances and a Fed focused on maintaining their independence is likely to fuel fireworks on a scale rarely if ever seen in public. The market implications of such a publically waged battle should not be ignored.

This article is a prelude to another following soon which discusses the investment implications and consequences if Donald Trump were to fire or replace Chairman Powell.

Just in case you are wondering we believe the President can fire the Chairman despite no historical precedence for such an action. The paragraph below is from the Federal Reserve Act.

Bears Getting Bullish On Boxing Day

On the day after Christmas when investors were sad with the coal they found in their stockings, Santa provided some Boxing Day cheer. The S&P 500 posted a 5% gain, in a rally that was widely expected. We along, with many market technicians, had been highlighting the extremely oversold conditions and thought a relief rally was inevitable. The question was just a matter of when.

Of note, the most vocal about the potential for a short term rally appeared to be those with longer term bearish outlooks. In particular, John Hussman who over the past few years, has repeatedly made a strong and compelling case for the market dropping 50% or more. On Wednesday morning with the market barely green, he posted the following bullish statement on his Twitter account:

ICYMI: “While we don’t observe conditions to indicate a ‘bottom’ from a full-cycle standpoint, we do observe conditions permissive of a scorching market rebound. Yes, that means one or more daily moves of ~100-150 points on SPX and 900-1300 on the Dow. You think I’m kidding.”

Make no mistake, Mr. Hussman makes it clear that the 100-150 point “scorching market rebound” rally which he correctly called is a temporary surge within a bear market. Providing support for his Tweet is the graph below which shows that market surges of Wednesday’s magnitude occur during bear markets, not bull markets.

The important question we are grappling with is whether Wednesday was the peak before another leg lower or will the market continue higher over the next week or two.

Technically we think a run higher of 5% or even 10% to firm resistance levels is possible. However, we are very cautious to try to take advantage of the situation because everyone, bulls and bears, seem to be on the same page. There is an old Wall Street saying that states the market will do that which inflicts the most pain. Said differently, the boat tips over when everyone is standing on one side.

Our concern here is that a rally seems so obvious from a technical viewpoint and seasonal perspective that the market will do the opposite of what everyone is expecting. Our advice as we have said on numerous occasions, short term traders should stay disciplined with stop loss orders and longer term investors should use market relief rallies to bring your stock exposure to levels that are commensurate with the amount of risk you are willing and able to endure.

Greetings From Stiltsville : Deficit Spending is not a Free Lunch

A special thank you to Peter Cook, CFA for co-authoring this article with us.

Imagine an island called Stiltsville, where a person’s value is based solely on their height. In order to increase their value, people living on the island used to wear platform shoes. A person wearing six-inch platform shoes would suddenly be more valuable than a person of similar height who wore normal footwear. Eventually, platform shoes were replaced by stilts, three-foot stilts were be replaced by six-foot stilts, and so on. People eventually rose to be the height of giraffes. The main point is that, on an island where height is valued above all else, people will try to game the situation to their advantage by increasing their height by any means available.

People from other lands would look at the people of Stiltsville and recognize their obsession with height greatly distorts their perception of value.  They would also likely conclude that distorted perceptions result in actual distortions in productivity, because:

  • People waste time and money thinking about how to increase their height, and
  • Walking around in platform shoes or stilts does not necessarily increase a person’s productivity, and instead most likely impairs it

Now imagine a world in which the health of an economy is perceived to be based on one metric; Gross Domestic Product (GDP). GDP is simply the total amount of spending in an economy. GDP, as currently measured, does not distinguish between “good” spending and “bad” spending. GDP does not distinguish between consumption spending and investment spending. GDP also does not distinguish whether spending is generated by existing wealth, by going into debt temporarily, or by going into debt permanently. In this world, every dollar spent on education or new means of production, is counted the same as every dollar spent on epic bachelor parties and video games. 

This world, the world of GDP accounting, is the world we live in. More spending today than occurred yesterday is considered economic growth. Growth, regardless of how it happened or at what cost, is highly sought after by politicians, economists and central bankers.

Gaming the System

Like the island where height is valued above all else, the world in which GDP is valued above all else can easily be gamed, making an economy appear healthier and larger than it really is. Instead of wearing platform shoes or stilts, politicians game GDP by increasing the amount of government spending without necessarily increasing the productivity of the economy. Politicians also tinker with the tax code and provide incentives for the private sector to increase consumption and/or to favor one type of spending over another. Central bankers, who should know better, sit idly by adjusting interest rates, which allows the government’s poor fiscal habits to persist and grow. Neither politicians, economists, nor central bankers have any regard for the quality of spending.

When such irresponsible behavior continues unabated over time, the divergence between the reported GDP and the actual health of an economy grow larger and larger.

Exploring Fiscal Spending

A book could easily be written, and probably has been, on the flaws of GDP and the errors of using GDP as an economic benchmark. To keep this short and get our point across, we will focus solely on the fiscal spending component of GDP. However, make no mistake, a rash of consumer materialism toward bigger houses, more expensive cars and a host of other non-productive spending has led to hollow GDP growth as well.

Because GDP measures all spending in an economy, government spending financed by budget deficits increases the level of GDP. Since much of government spending is not productive as it does not produce a return as large as the initial expenditure, this spending is a shell game which only shifts the timing of spending to ostensibly “produce growth.” Debt-financed spending today pulls consumption forward from tomorrow, but in doing so creates less spending in the future as the obligations to service existing debt grow. If new debt does not provide a revenue stream sufficient to cover the interest cost, then it is non-productive and results in a drag on economic growth. This does not mean all government spending needs to be productive, but non-productive expenses should be paid for with current tax revenue and not debt.

Rational observers understand that politicians elected today seek to deliver benefits to their constituents today.  Due to the current nature of politics and the strong motivations to be re-elected, very few politicians seem to care about anything beyond the next election. Since 1960, as shown below, fiscal spending inflated the GDP calculation in all but five years.

Data Courtesy St. Louis Federal Reserve

The era of consistent deficits began in the 1960’s during President Lyndon Johnson’s “guns and butter” policies. Johnson’s spending habits, while large at the time, pale in comparison to deficit spending since. Politicians have seemingly become addicted to making GDP appear larger than it is by spending more than is received in taxes each year, and by an increasing amount. The result is a charade which values the optics of economic growth over economic prosperity.

The cumulative effect of the obsession to increase GDP with deficit spending is shown below.  As a percentage of GDP, federal debt has tripled over the past 40 years.  More recently, deficit spending exploded higher in the wake of the Great Recession of 2008-09. Today, total federal debt outstanding is over $21.5 trillion, exceeding annual GDP of roughly $20.6 trillion. The ratio of debt-to-GDP is currently 104%. Before the 2008/09 recession federal debt was only 60% of GDP.

Data Courtesy St. Louis Federal Reserve

Summary

In our make-believe island of Stiltsville, where height matters above all else, it will eventually be obvious that 17-foot tall people who cannot easily navigate stairs and doorways are not as valuable as those on bare feet. In time, our world will face the harsh reality that an economy artificially boosted on non-productive spending and over-materialism may temporarily portray greatness in a warped sense, but will be increasingly beset with inevitable economic hardship.

Is deficit spending consequence-free as politicians and central bankers would have us believe?  Not if you believe the conclusions of Reinhart and Rogoff, who published “This Time is Different: Eight Centuries of Financial Folly” in 2009. Their exhaustive study of the history of government spending demonstrates that when the ratio of government debt-to-GDP exceeds 90%, economic growth slows and economic problems multiply eventually leading to a financial crisis. Having rejected all forms of fiscal and monetary prudence, U.S. debt-to-GDP far exceeds that level. Either an economic problem lies ahead, or this time really is different.

Finally, consider the following scenario:

Imagine the “GDP” of your family is equal to your family’s spending. Would your financial situation be “better” if:

  1. It maximizes spending every year, even if it must borrow to do so, or
  2. It limits spending, and tries to save and invest, subject to what it earns?

Most people would pick #2 understanding the dire consequences that would eventually emerge with option #1.  But using the consensus definition of GDP and a “growth at all costs” mentality, economists and politicians have chosen #1. Despite that unpleasant reality, we will all eventually deal with the consequences and share in the responsibility for putting our economic house back in order.

Election Night Cheat Sheet

Historically, the last two years of a president’s term have been great for stock investors as shown below. We can blindly follow history and hope that this is once again the case, or we can examine the facts in front of us and decide if there is reason to be suspect.

Public policy matters to markets and the economy and as a result a significant determinant of the next two years depends on what happens tonight. While the pollsters from both sides of the aisle are claiming victory, the fact of the matter is no one knows what this election may bring. Trump proved the pollsters wrong two years ago and we have little reason to believe they have it right this time. The results depend heavily on the much anticipated “Blue Wave” and whether Democratic turnout can offset the successes, economic and otherwise, of the Trump administration’s first two years.

The question of whether or not the Republicans can keep control of the House and Senate has vast implications for the economy and markets. The following Cheat Sheet provides our latest thoughts on three election result scenarios and what each might mean for the stock and bond markets as well as Federal Reserve policy, the U.S. dollar and economic activity. Please click on the picture to enlarge it.