Tag Archives: QE4

Why “Not-QE” is QE: Deciphering Gibberish

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”  – Alan Greenspan

Imagine if Federal Reserve (Fed) Chairman Jerome Powell told the American people they must pay more for the goods and services they consume.

How long would it take for mobs with pitchforks to surround the Mariner Eccles building?  However, Jerome Powell and every other member of the Fed routinely and consistently convey pro-inflationary ideals, and there is nary a protest, which seems odd. The reason for the American public’s complacency is that the Fed is not that direct and relies on carefully crafted language and euphemisms to describe the desire for higher inflation.

To wit, the following statements from past and present Fed officials make it all but clear they want more inflation:  

  • That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation,” – Jerome Powell November 2019
  • In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” -Jerome Powell December 2019
  • Been very challenging to get inflation back to 2% target” -Jerome Powell December 2019
  • Ms. Yellen also said that continuing low inflation, regarded as a boon by many, could be “dangerous” – FT – November 2017
  • One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent.” –Ben Bernanke October 2017
  • Further weakness in inflation could prompt the U.S. Federal Reserve to cut interest rates, even if economic growth maintains its momentum”  -James Bullard, President of the Federal Reserve Bank of St. Louis  May 2019
  • Fed Evans Says Low Inflation Readings Elevating His Concerns” -Bloomberg May 2019
  • “I believe an aggressive policy action such as this is required to re-anchor inflation expectations at our target.”  Neel Kashkari, President Minneapolis Fed June 2019

As an aside, it cannot be overemphasized the policies touted in the quotes above actually result in deflation, an outcome the Fed desperately fears.

The Fed, and all central banks for that matter, have a long history of using confusing economic terminology. Economics is not as complicated as the Fed makes it seem. What does make economics hard to grasp is the technical language and numerous contradictions the Fed uses to explain economics and justify unorthodox monetary policy. It is made even more difficult when the Fed’s supporting cast – the media, Wall Street and other Fed apologists – regurgitate the Fed’s gibberish.   

The Fed’s fourth installment of quantitative easing (“QE4”, also known as “Not-QE QE”) is vehemently denied as QE by the Fed and Fed apologists. These denials, specifically a recent article in the Financial Times (FT), provide us yet another opportunity to show how the Fed and its minions so blatantly deceive the public.

What is QE?

QE is a transaction in which the Fed purchases assets, mainly U.S. Treasury securities and mortgage-backed-securities, via their network of primary dealers. In exchange for the assets, the Fed credits the participating dealers’ reserve account at the Fed, which is a fancy word for a place for dormant money. In this transaction, each dealer receives payment for the assets sold to the Fed in an account that is essentially the equivalent of a depository account with the Fed. Via QE, the Fed has created reserves that sit in accounts maintained by it.

Reserves are the amount of funds required by the Fed to be held by banks (which we are using interchangeably with “primary dealer” for the remainder of this discussion) in their Fed account or in vault cash to back up a percentage of specified deposit liabilities. While QE is not directly money printing, it enables banks to create loans at a multiple of approximately ten times the reserves available, if they so choose.

Notice that “Quantitative Easing” is the preferred terminology for the operations that create additional reserves, not something easier to understand and more direct like money/reserve printing, Fed bond buying program, or liquidity injections. Consider the two words used to describe this policy – Quantitative and Easing. Easing is an accurate descriptor of the Fed’s actions as it refers to an action that makes financial conditions easier, e.g., lower interest rates and more money/liquidity. However, what does quantitative mean? From the Oxford Dictionary, “quantitative” is “relating to, measuring, or measured by the quantity of something rather than its quality.”   

So, QE is a measure of the amount of easing in the economy. Does that make sense to you? Would the public be so complacent if QE were called BBMPO (bond buying and money printing operations)? Of course not. The public’s acceptance of QE without much thought is a victory for the Fed marketing and public relations departments.

Is “Not-QE” QE?

The Fed and media are vehemently defending the latest round of repurchase market (“repo”) operations and T-bill purchases as “not QE.” Before the Fed even implemented these new measures, Jerome Powell was quick to qualify their actions accordingly: “My colleagues and I will soon announce measures to add to the supply of reserves over time,” “This is not QE.”

This new round of easing is QE, QE4, to be specific. We dissect a recent article from the FT to debunk the nonsense commonly used to differentiate these recent actions from QE.  

On February 5th, 2020, Dominic White, an economist with a research firm in London, wrote an article published by the FT entitled The Fed is not doing QE. Here’s why that matters.

The article presents three factors that must be present for an action to qualify as QE, and then it rationalizes why recent Fed operations are something else. Here are the requirements, per the article:

  1. “increasing the volume of reserves in the banking system”
  2. “altering the mix of assets held by investors”
  3. “influence investors’ expectations about monetary policy”

Simply:

  1.  providing banks the ability to make more money
  2.  forcing investors to take more risk and thereby push asset prices higher
  3.  steer expectations about future Fed policy. 

Point 1

In the article, White argues “that the US banking system has not multiplied up the Fed’s injection of reserves.”

That is an objectively false statement. Since September 2019, when repo and Treasury bill purchase operations started, the assets on the Fed’s balance sheet have increased by approximately $397 billion. Since they didn’t pay for those assets with cash, wampum, bitcoin, or physical currency, we know that $397 billion in additional reserves have been created. We also know that excess reserves, those reserves held above the minimum and therefore not required to backstop specified deposit liabilities, have increased by only $124 billion since September 2019. That means $273 billion (397-124) in reserves were employed (“multiplied up”) by banks to support loan growth.

Regardless of whether these reserves were used to back loans to individuals, corporations, hedge funds, or the U.S. government, banks increased the amount of debt outstanding and therefore the supply of money. In the first half of 2019, the M2 money supply rose at a 4.0% to 4.5% annualized rate. Since September, M2 has grown at a 7% annualized rate.  

Point 2

White’s second argument against the recent Fed action’s qualifying as QE is that, because the Fed is buying Treasury Bills and offering short term repo for this round of operations, they are not removing riskier assets like longer term Treasury notes and mortgage-backed securities from the market. As such, they are not causing investors to replace safe investments with riskier ones.  Ergo, not QE.

This too is false. Although by purchasing T-bills and offering repo the Fed has focused on the part of the bond market with little to no price risk, the Fed has removed a vast amount of assets in a short period. Out of necessity, investors need to replace those assets with other assets. There are now fewer non-risky assets available due to the Fed’s actions, thus replacement assets in aggregate must be riskier than those they replace.

Additionally, the Fed is offering repo funding to the market.  Repo is largely used by banks, hedge funds, and other investors to deploy leverage when buying financial assets. By cheapening the cost of this funding source and making it more readily available, institutional investors are incented to expand their use of leverage. As we know, this alters the pricing of all assets, be they stocks, bonds, or commodities.

By way of example, we know that two large mortgage REITs, AGNC and NLY, have dramatically increased the leverage they utilize to acquire mortgage related assets over the last few months. They fund and lever their portfolios in part with repo.

Point 3

White’s third point states, “the Fed is not using its balance sheet to guide expectations for interest rates.”

Again, patently false. One would have to be dangerously naïve to subscribe to White’s logic. As described below, recent measures by the Fed are gargantuan relative to steps they had taken over the prior 50 years. Are we to believe that more money, more leverage, and fewer assets in the fixed income universe is anything other than a signal that the Fed wants lower interest rates? Is the Fed taking these steps for more altruistic reasons?

Bad Advice

After pulling the wool over his reader’s eyes, the author of the FT article ends with a little advice to investors: Rather than obsessing about fluctuations in the size of the Fed’s balance sheet, then, investors might be better off focusing on those things that have changed more fundamentally in recent months.”

After a riddled and generally incoherent explanation about why QE is not QE, White has the chutzpah to follow up with advice to disregard the actions of the world’s largest central bank and the crisis-type operations they are conducting. QE 4 and repo operations were a sudden and major reversal of policy. On a relative basis using a 6-month rate of change, it was the third largest liquidity injection to the U.S. financial system, exceeded only by actions taken following the 9/11 terror attacks and the 2008 financial crisis. As shown below, using a 12-month rate of change, recent Fed actions constitute the single biggest liquidity injection in 50 years of data.

Are we to believe that the latest round of Fed policy is not worth following? In what is the biggest “tell” that White is not qualified on this topic, every investment manager knows that money moves the markets and changes in liquidity, especially those driven by the central banks, are critically important to follow.

The graph below compares prior balance sheet actions to the latest round.

Data Courtesy St. Louis Federal Reserve

This next graph is a not so subtle reminder that the current use of repo is simply unprecedented.

Data Courtesy St. Louis Federal Reserve

Summary

This is a rebuttal to the FT article and comments from the Fed, others on Wall Street and those employed by the financial media. The wrong-headed views in the FT article largely parrot those of Ben Bernanke. This past January he stated the following:

“Quantitative easing works through two principal channels: by reducing the net supply of longer-term assets, which increases their prices and lower their yields; and by signaling policymakers’ intention to keep short rates low for an extended period. Both channels helped ease financial conditions in the post-crisis era.”   -LINK

Bourbon, tequila, and beer offer drinkers’ very different flavors of alcohol, but they all have the same effect. This round of QE may be a slightly different cocktail of policy action, but it is just as potent as QE 1, 2, and 3 and will equally intoxicate the market as much, if not more.

Keep in mind that QE 1, 2, and 3 were described as emergency policy actions designed to foster recovery from an economic crisis. Might that fact be the rationale for claiming this round of liquidity is far different from prior ones? Altering words to describe clear emergency policy actions is a calculated effort to normalize those actions. Normalizing them gives the Fed greater latitude to use them at will, which appears to be the true objective. Pathetic though it may be, it is the only rationale that helps us understand their obfuscation.

Warning! No Lifeguards On Duty

In a poll administered by the CFA Institute of America {Link}, readers, many of whom are professional investors, were asked which behavioral biases most affect investment decisions. The results are shown in the chart below.

We are not surprised by the results, but we believe a rational investor would put these in reverse order.

Compounding wealth, which should be the primary objective of every investor, depends first and foremost on avoiding large losses. Based on the poll, loss aversion was the lowest ranked bias. Warren Buffett has commented frequently on the importance of limiting losses. His two most important rules are: “Rule #1 of investing is don’t lose money. Rule #2 is never forget rule #1.”

At Real Investment Advice, we have covered a lot of ground on investor behavioral biases. In 5 Mental Traps Investors are Falling In To Right Now, Lance Roberts lucidly points out, “Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.”

Lance’s quote nicely sums up the chart above. These same biases driving markets higher today also drove irrational conduct in the late 1920s and the late 1990s. Currently, valuations are at or near levels reached during those two historical market peaks. Current valuations have long since surpassed all other prior valuation peaks.

One major difference between the late 1920s, the late 1990s, and today is the extent to which the Federal Reserve (Fed) is fostering current market conditions and imprudent investor behavior. To what extent have investors fallen into the overconfidence trap as the herd marches onward?

This “ignorance is bliss” type of behavior raises some serious questions, especially in light of the recent changes in Fed policy.

Not QE

As predicted in QE By Any Other Name, the Fed recently surprised investors with a resumption of quantitative easing (QE). The announcement of $60 billion in monthly Treasury bill purchases to replenish depleted excess reserves and another $20 billion to sustain existing balances was made late in the afternoon on Friday October 11. With a formal FOMC meeting scheduled in less than three weeks, the timing and substance of this announcement occurred under unusual circumstances.

The stated purpose of this new round of QE is to address recent liquidity issues in the short-term funding markets. Up to this point, the Fed added additional liquidity through its repo facility. These are actions not taken since the financial crisis a decade ago. The liquidity problems, though not resolved, certainly have largely subsided.

So why the strange off-cycle announcement? In other words, why did the Fed seemingly scramble over the prior few days to announce a resumption of QE now? Why not wait to make this announcement through the normal FOMC meeting statement and press conference process? The answer to those questions tells us more about current circumstances than the actual policy change itself.

The Drowning Man

As is always the case with human beings, actions speak louder than words. If you observe the physical behavior of someone in distress and know what to look for, you learn far more about their circumstance than you would by listening to their words. As an example, the signs of drowning are typically not what we would expect.  A person who is drowning can often appear to be playing in the water. When a person in the water is in distress, their body understands the threat and directs all energy toward staying alive.

People who drown seldom flail and scream for help as is often portrayed on television. If you ask a drowning person if they are okay, you might not receive a response. They are often incapable of producing the energy to speak or scream as all bodily functions are focused on staying afloat.

Since the Financial Crisis, investors, market analysts, and observers are helplessly watching the Fed, a guardian that does not realize the market is drowning. The Fed, the lifeguard of the market, is unaware of the signs of distress and unable to diagnose the problem (see also The Voice of the Market – The Millennial Perspective).

In this case, it is the global banking system that has become so dependent on excess reserves and dollar liquidity that any shortfall, however temporary, causes acute problems. Investor confidence and Fed hubris are blinding many to the source of the turbulence.

Lifeguards

Fortunately, there are a few other “lifeguards” who have not fallen into the behavioral traps that prevent so many investors from properly assessing the situation and potential consequences.

One of the most articulate “lifeguards” on this matter is Jeff Snyder of Alhambra Investments. For years, he has flatly stated that the Fed and their army of PhDs do not understand the global money marketplace. They set domestic policy and expect global participants to adjust to their actions. What is becoming clear is that central bankers, who more than anyone else should understand the nature of money, do not. Therefore, they repeatedly make critical policy errors as a result of hubris and ignorance.

Snyder claims that without an in-depth understanding of the dollar-based global lending market, one cannot grasp the extent to which problems exist and monetary policy is doomed to fail. Like the issues that surfaced around the sub-prime mortgage market in 2007, the funding turmoil that emerged in September was a symptom of that fact. Every “solution” the Fed implements creates another larger problem.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

We added the emphasis in the quote because we believe that to be a critically important point of consideration. Inflation is the one thing no one is looking for or even considering a possibility.

Summary

Today, similar to the months leading up to the Financial Crisis, irrational behavioral biases are the mindset of the market. As such, there are very few “lifeguards” that know what to look for in terms of distress. Those who do however, are sounding the alarm. Thus far warnings go largely unheeded because blind confidence in the Fed and profits from yesteryear are blinding investors. Similar to the analogy James Grant uses, where he refers to the Fed as an arsonist not a firefighter, here the Fed is not the lifeguard on duty but the invisible undertow.

Investors should frequently evaluate a list of cognitive biases and be aware of their weaknesses. Humility will be an enormous asset as this economic and market expansion ends and the inevitable correction takes shape.  We have attached links to our other behavioral investing articles as they may be helpful in that difficult task of self-evaluation.

Finally, we must ask what asset can be a life preserver that is neither being chased higher by the herd nor providing any confirmation bias.

Gold is currently one of the most hated investments by the media and social media influencers. The only herd following gold are thought to be relics of ancient history and doomsday preppers. Maybe, as we saw in the aftermath of the prior valuation peaks, those who were ridiculed for their rigor and discipline will once again come out on top.

Gold provides ballast to a portfolio during troubling times and should definitely be considered today as the distress becomes more pronounced and obvious.

Please find below links to some of our favorite behavioral investing articles:  

Dalbar 2017: Investors Suck at Investing and Tips for Advisors

8 Reasons to Hold Some Extra Cash

The 5-Laws Of Human Stupidity & How To Be A “Non-Stupid” Investor

The Money Game & the Human Brain

The Definitive Guide to Investing for the Long Run

Navigating With The R Star

“It’s difficult to make predictions, especially about the future.” – Niels Bohr

On November 28, 2018, Federal Reserve (Fed) Chairman Jerome Powell gave a speech at the Economics Club of New York that sent the stock market soaring by over 2%. The reason cited by market pundits was the reversal of language he used a few weeks earlier suggesting that the Fed still had several more rate hikes ahead. In other words, he softened that tone and seemed to imply that the Fed was close to pausing.

By most accounts, Fed policy remains very accommodative but the “Powell Pivot”, which began in late November and continues to this day, hinges on an obscure metric called R-Star (r*).  Even though interest rates have been held low and vast amounts of liquidity force fed into markets through quantitative easing, the idea that interest rates should not rise much further presents a unique dilemma for the Fed. Rationalizations for their guidance hinges on r*. Before going in to details about this important measure, let us reflect on history.

Doomed To Repeat It

“Well, we currently see the economy as continuing to grow, but growing at a relatively slow pace, particularly in the first half of this year. As the housing contraction begins to wane, as it should sometime during this fiscal year, the economy should pick up a bit later in the year. –Federal Reserve Chairman Ben Bernanke on January 17, 2008 in response to Congressman John Spratt ranking member of the House Budget Committee

The table below was a document used on an unscheduled Fed conference call on January 9, 2008 to discuss deteriorating credit conditions in the U.S. economy. At that time and unbeknownst to the Fed, the economy slipped into recession the prior month, yet the Fed’s commentary and one- and two-year outlook for growth remained positive. The point is not to deride Bernanke and the Fed, but show that even the most well-informed PhD economists struggle to forecast economic activity or assess current economic conditions properly.

The challenge in assessing the outlook for a highly complex system like the U.S. economy cannot be overstated. Yet, what we saw in the past and still see currently, is a small group of people with enormous influence over the economy failing to grasp the natural mechanisms of a market economy. To put it another way, the Fed continues to believe that they know things they simply cannot know, and most concerningly, they set monetary policy on the basis of that fallacy.

An Abstract Barometer

Over the past several years, Fed economists invented a concept that purportedly identifies the point at which monetary policy is “neutral” or in equilibrium with economic activity. This number, called r* (r-star), is abstract and imprecise as it requires a variety of assumptions about the level of interest rates and economic activity. R* is formally defined as the “inflation-adjusted, short-term interest rate that is consistent with the full use of economic resources and steady inflation at or near the Fed’s target level.

As discussed in Clues from the Fed II – A Review of Jerome Powell’s Speech 11/27/18, his exact language was the following:

“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.”

The current “target level” for the Fed Funds rate, the primary interest rate lever used to impact the economy by altering interest rates, is currently in a range of 2.25-2.50%. What Powell seems to have implied, or what the market gleaned from the comment above, is that the Fed may only increase the target rate by another 0.25-0.50% as opposed to the 1.00-1.50% forecast by the very same Fed just two months prior. The extent to which the Fed is willing to tighten monetary policy by raising interest rates has a dramatic impact on the amount of risk investors are willing to take. Thus, with the dovish change in Powell’s language, the stock market took off.

Just The Facts

The data on the economy remains robust. Annualized GDP growth through the 3rd quarter of 2018 was 3.3% and the unemployment rate sat near a historic low at 3.9%. The regional surveys from the Fed consistently reflect that companies are having difficulty finding qualified workers, which implies that demand is good and wage growth, a key determinant of inflation, is likely to move higher. The index of Leading Economic Indicators remains solidly positive and consumer and business sentiment surveys nationally, while weakening, continue to point towards expansion.  

Data Courtesy: St. Louis Federal Reserve

Examining charts of various measures of inflation also offers insight into current circumstances. The traditional measures of inflation, Consumer Price Inflation (CPI) and Core (ex-food & Energy) CPI seem benign with core levels at roughly 2.2% although those indicators have declined modestly in recent months.

Data Courtesy: St. Louis Federal Reserve

Alternative inflation indicators like the Employment Cost Index (ECI) wages and average hourly earnings reflect a steady trend of rising wage pressures as shown in the chart below.

Data Courtesy: St. Louis Federal Reserve

The chart below uses the ECI Wages and Salaries data from above and compares it with two components of compensation from the NFIB small business survey. As shown, both metrics demonstrate mounting wage pressures. The NFIB survey shows that companies planning to raise worker compensation is trending higher. Additionally, the survey shows that the single biggest problem for small business is availability of quality labor (correlation using 9-month lead is over 76%) and that measure is also trending higher.

Data Courtesy: St. Louis Federal Reserve

Manufacturing activity captured via the Purchasing Managers Index (PMI) appears to lead CPI with some durability. The correlation is 52% since 2000 and 76% since 2006. Given the current level of manufacturing activity, it suggests that Core CPI should remain above 2.0% over the next several months.

Data Courtesy: St. Louis Federal Reserve

Economies Are Hard To Forecast

Economic systems are complex with many hidden, unobservable and non-linear relationships making economic activity very difficult to forecast. However, by applying simple logic about possible outcomes, we can better frame the risks of higher inflation due to wage pressures. If, as is currently forecast, GDP growth begins to gradually decline as the effects of tax reform and fiscal stimulus diminish, then we should expect gains in employment to moderate. That scenario does not necessarily argue for unemployment to rise which leaves the current labor market situation tight. The effects described above would remain well in place and higher labor costs could reasonably push inflation higher. Higher inflation would put upward pressure on long-term interest rates while creating a headwind for corporate profits, margins and stock prices. That would not be good for most investors.

Another scenario, again given the difficulties associated with forecasting GDP, is that economic growth does not moderate as much as expected and remains somewhat above the post-crisis trend. Labor costs, in that case, would accelerate and could cause wage inflation to move meaningfully higher. Clearly, the risks emanating from that scenario would be very bad for both stocks and bonds and thus a world enamored with passive investing and awash in 60/40 portfolios.

Other Info

A cursory review of other economic data provides even more evidence that the level of interest rates is well below what it should be. Household net worth, industrial production and retail sales are all more than fully recovered from the crisis and have been for some time. Furthermore, the U.S. never experienced deflation, and thus the common point of comparison and rationalization for gradual policy adjustments – that the U.S. could end up in a situation akin to what Japan has been experiencing and combatting for decades – rings hollow. The counter-factual argument is that Fed actions prevented a “Japan-like” outcome, but there is no evidence to support that claim. All this strongly argues that the Fed Funds target rate remains not just slightly accommodative as Powell acknowledges but extremely accommodative.

The following graph, from our article Why Fed’s Monetary Policy Is Still Very Accommodative, shows that the current level of monetary policy is accommodative and unprecedented over the last four decades.

Fortunetellers

Since the financial crisis, the Fed has exerted ever more influence over the economy through extraordinary policy measures. Importantly, their financial crisis and post-crisis involvement came partially as a result of their prior involvement in stoking a housing and stock market bubble that in part led to the crisis.

Now, as they seek to reverse out of those policies, their job is proving more difficult than anticipated and contrary to what Bernanke, Yellen and Dudley told us as they were enacting said policy. That circumstance does not appear to have imposed much humility on the Fed. Despite all their innovations, such as r*, complex labor market indicators, data dependency and forward guidance, Jerome Powell is flying just as blind as Bernanke was in the early innings of the financial crisis. He confirmed this by reasserting and then reversing prior language around his assessment of the economy four times since October 3, 2018. This is not the most confidence-inspiring tactic for a Fed Chairman.

A more reliable approach to monetary policy would be to allow markets to dictate prices. Billions of buyers and sellers, borrowers and lenders, who transact every day are collectively better informed than the small group of unelected and unaccountable figureheads at the Fed. Should the Fed find the urge to become engaged, and it would be a rare occasion indeed, they should respond to market forces and stay out of the way of the robust pricing mechanisms of markets.

Summary

The analogy for the Fed and its approach to monetary policy is one of a driver on a curvy country road. A licensed driver obeying the law who pays attention to the speed limit and other important road signs indicating warnings should be able to successfully navigate to a destination. If, however, the driver decides to navigate by anticipating the contours of the road and confidently driving above the speed limit, he will eventually end up off the road, through a fence or over a cliff. Unfortunately, we are all passengers along for the Fed’s ride currently.

Most of us are willing passengers, having been convinced that the Fed knows what they are doing. That is understandable given the influence on markets from the trillions in liquidity they supplied, but it is not true. The consequences of years of excessive policy will eventually begin to reveal themselves, and we posit they already are. The intersection of manipulated economic forces and societal outrage are exhibit A. What is so confounding, is the misplaced trust in the entities and leaders that are causing the problems described.

R* and all the other economic terms that supposedly guide policy-makers are conjured from the realm of scientific economic analysis but human beings and their behavior cannot be modeled in a spreadsheet. The problem is the failure to apply proper humility or even common sense when crafting the formulas on which policies rest and livelihoods depend.

Normal Is In The Eye Of The Beholder – RIA PRO

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester, and discussed HERE, it turns out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence:

Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.”

The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

This article was made exclusive to RIA Pro subscribers on February 25th. We share it with you to demonstrate one of the many benefits of subscribing to RIA Pro. If you would like to take us for a test ride, use the coupon code PRO30 for a 30-day free trial. To learn more please click here.

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

Normal is in the Eye of the Beholder

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester and discussed HERE, it turs out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence: “Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.” The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

3 Things: Bear Rallies, Dividends, Empathy

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Biggest Rallies Occur In Bear Markets

As expected, the market was oversold enough going into last Friday to elicit a short-term reflexive bounce. Not surprisingly, it wasn’t long before the “bulls” jumped back in proclaiming the correction was over.

If it were only that simple.

First, as I have discussed in the past, market prices remain in a “trend” until something causes that trend to change. This can be most easily seen by looking at a chart of the S&P 500 as compared to its 400-day moving average.

SP500-MarketUpdate-021716

As you will notice in the main body of the chart, during bull markets, prices tend to remain ABOVE the 400-dma (orange-dashed line). Conversely, during bear markets, prices tend to remain BELOW the 400-dma.

The one event in 2011, where all indicators suggested the market was transitioning back into a bear market, was offset by the Federal Reserve’s intervention of “Operation Twist” and eventually QE-3.

During cyclical bear markets, bounces from short-term oversold conditions tend to be extreme. Just recently Price Action Lab blog posted a very good piece on the commonality of short-term rebounds during market downtrends:

“The S&P 500 gained 3.63% in the last two trading sessions. About 75% of back-to-back gains of more than 3.62% have occurred along downtrends. Therefore, a case for a bottom cannot be based solely on performance.”

SP500-Downtrends-Rallies-021716

It may be seen that 73.85% back-to-back gains of more than 3.62% have occurred along downtrends, i.e., this performance is common when markets are falling. The sample size consists of 195 back-to-back returns greater than 3.62%.

Therefore, strong rebounds along a downtrend cannot be used to support a potential bottom formation.”

After a rough start to the new year, it is not surprising that many are hoping the selling is over.

Maybe it is.

But history suggests that one should not get too excited over bounces as long as the downtrend remains intact.

I Bought It For The Dividend

One of the arguments for “buy and hold” investing has long been “dividends.” The argument goes this way:

“It really doesn’t matter to me what the price of the company is, I just collect the dividend.”

While this certainly sounds logical, in reality, it has often turned into a very poor strategy, particularly during recessionary contractions.

A recent example was Kinder Morgan (KMI). In late-2014, as I was recommending that individuals begin to exit the energy sector, Kinder Morgan was trading around $40/share. The argument then was even if the share price of the company fell, the owner of the shares still got paid a great dividend.

Fast forward today and the price of the company has fallen to recent lows of $15/share (equating to a 62.5% loss in value) and the dividend was cut by 80%.

Two things happened to the investor’s original thesis. The first, was that after he had lost 50% of his capital, the dividend was no longer nearly as important. Confidence in the company eroded and the individual panic sold his ownership into the decline. Secondly, when a company gets into financial trouble, the first thing they will do is cut the dividend. Now you have lost your money and the dividend.

But it is not just KMI that has cut dividends as of late. Many companies have been doing the same to shore up internal cash flows. As pointed out recently by Political Calculations:

“Speaking of which, the pace of dividend cuts in the first quarter of 2016 has continued to escalate. Through Friday, 12 February 2016, the number of dividend cuts has risen into the “red zone” of our cumulative count of dividend cuts by day of quarter chart.”

Dividend-Cuts-021716

Importantly, while the media keeps rambling on that we are “nowhere” close to a recession, it is worth noting the following via NYT:

“The only year in recent history with more dividend cuts was 2009, when the world was staggering through a great financial crisis. A total of 527 companies trimmed dividends that year, Mr. Silverblatt’s data shows. Coca-Cola and other dividend-paying blue chips like IBM and McDonald’s were under severe stress in those days, too, but their financial resources were deep enough to allow them to keep the dividend stream fully flowing.”

Buying “dividend yielding” stocks is a great way to reduce portfolio volatility and create higher total returns over time. However, buying something just for the dividend, generally leads to disappointment when you lose your money AND the dividend. It happens…a lot.

Preservation of capital is first, everything else comes second.

Empathy For The Devil

Danielle DiMartino Booth, former Federal Reserve advisor and President of Money Strong, recently penned an excellent piece that has supported my long-held view on the fallacy of “consumer spending.” To wit:

“As for the strongest component of retail sales, it’s not only subprime loans that are behind the 6.9-percent growth in car sales over 2015. Super prime auto loan borrowers’ share of the pie is now on par with that of subprime borrowers – each now accounts for a fifth of car loan originations. What’s that, you say? Can’t afford that new set of wheels? Not to worry. Just lease. You’ll be in ample company — some 28 percent of last year’s car sales were made courtesy of leases, an all-time high. ”

Retail-Sales-021716

What has been missed by the vast majority of mainstream economists is that in a country driven 68% by consumer spending, there are limits to that consumption. A consumer must produce (work) first to be paid a wage with which to consume with. Each dollar is finite in its ability to create economic growth via consumption. A dollar spent on a manufactured good has a greater multiplier effect on the economy than the same dollar spent on a service. Likewise, a dollar spent on a manufactured good or service has a greater economic impact than a dollar spent on paying taxes, higher healthcare insurance costs, or interest payments.

The only way to increase the level of spending above the rate of income is through leverage. However, rising debt levels also suggests more of the income generated by households is diverted to debt service and away from further consumption. The chart below shows the problem.

Debt-GDP-021816

Over the 30-year period to 1982, households accumulated a total of $2 trillion in debt in an economy that was growing at an average rate of 8%. Wages grew as stronger consumption continued to push growth rates higher. Over the next 25-year period, households abandoned all fiscal responsibility and added over $10 trillion in debt as the struggle to create a higher living standard outpaced wage and economic growth.  Since the turn of the century, average economic growth has been closer to 2%. See the problem here.

The bailouts following the financial crisis kept households from going through a much needed deleveraging. Likewise, since banks were taught they would be bailed out repeatedly for bad behavior, no lessons were learned there either. Not surprisingly, as shown by the recent Fed Reserve 2016 Loan Officer Opinion Survey, lending standards are now back to levels seen just prior to the financial crisis.

Loan-Officer-Mortage-Survey-021816-2

Loan-Officer-Mortage-Survey-021816

What could possibly going wrong? The problem is the consumer is all spent out and all leveraged up. While you shouldn’t count the consumer out, just don’t count on them too much.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Billions Lost, Tax Withholding, Yield Curve

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Companies Lose Billions On Stock Buybacks

I recently wrote an article about why “Benchmarking Your Portfolio Is A Losing Bet.” In that missive, I discussed all the things that benefit a mathematically calculated index versus what happens in an actual portfolio of securities. One of those issues was the impact of share buybacks:

“The reality is that stock buybacks are a tool used to artificially inflate bottom line earnings per share which, ultimately, drives share prices higher. As John Hussman recently noted:

The preferred object of debt-financed speculation, this time around, is the equity market. The recent level of stock margin debt is equivalent to 25% of all commercial and industrial loans in the U.S. banking system. Meanwhile, hundreds of billions more in low-quality covenant-lite debt have been issued in recent years.”

Note the surge in debt to fund those buybacks.

Hussman-StockBuyBacks-Debt-113015

“The importance of buybacks cannot be overlooked. The dollar amount of sales, or top-line revenue, is extremely difficult to fudge or manipulate. However, bottom line earnings are regularly manipulated by accounting gimmickry, cost cutting, and share buybacks to enhance results in order to boost share prices and meet expectations. Stock buybacks DO NOT show faith in the company by the executives but rather a LACK of better ideas for which to use capital for.”

The entire article is worth a read to understand how indices and your portfolio are two very different things.

I bring this up because surges in stock buybacks are late bull market stage events. This is something I have repeatedly warned about in the past it is a false premise that companies repurchase stock at high prices because they have faith in their company. Such actions eventually lead to rather negative outcomes as capital is misallocated to non-productive resources.

Bernard Condon via AP picked up on this issue:

“When a company shells out money to buy its own shares, Wall Street usually cheers. The move makes the company’s profit per share look better, and many think buybacks have played a key role pushing stocks higher in the seven-year bull market.

But buybacks can also sap companies of cash that they could be using to grow for the future, no matter if the price of those shares rises or falls.

Defenders of buybacks say they are a smart use of cash when there are few other uses for it in a shaky global economy that makes it risky to expand. Unlike dividends, they don’t leave shareholders with a tax bill. Critics say they divert funds from research and development, training and hiring, and doing the kinds of things that grow the businesses in the long term.

Companies often buy at the wrong time, experts say, because it’s only after several years into an economic recovery that they have enough cash to feel comfortable spending big on buybacks. That is also when companies have made all the obvious moves to improve their business — slashing costs, using technology to become more efficient, expanding abroad — and are not sure what to do next to keep their stocks rising.

‘For the average company, it gets harder to increase earnings per share,’ says Fortuna’s Milano. ‘It leads them to do buybacks precisely when they should not be doing it.’

And, sure enough, buybacks approached record levels recently even as earnings for the S&P 500 dropped and stocks got more expensive. Companies spent $559 billion on their own shares in the 12 months through September, according to the latest report from S&P Dow Jones Indices, just below the peak in 2007 — the year before stocks began their deepest plunge since the Great Depression.”

While buybacks work great during bull market advances, as individuals willfully overlook the fundamentals in hopes of further price gains, the eventual collision of reality with fantasy has been a nasty event. This is shown in the chart below of the S&P 500 Buyback Index versus the S&P 500 Total Return.

Buyback-Index-021016

If this was the Dr. Phil Show, I am sure he would ask these companies;

“Well, how is that working out for you ?”

Tax Withholding Paints Real Employment Picture

I always find the mainstream media and blogosphere quite humorous around employment reporting day. The arm waving and cheering, as the employment report is released, reaches the point of hilarity over some of the possibly most skewed and manipulated economic data released by any government agency.

Think about it this way. How can you have the greatest level of employment growth since the 1990’s and the lowest labor force participation rate since the 1970’s? Or, how can you have 4.9% unemployment but not wage growth? Or, 95.1% of the population employed but 1/3rd of employable Americans no longer counted?

The importance of employment, of course, is that individuals must produce first in order to consume. Since the economy is nearly 70% based on consumption, people need to be working to create economic growth. Of course, there is another problem with the data. How can you have 4.9% unemployment and an economic growth rate of sub-2%?

A recession is coming and a look at real employment data, the kind you can’t fudge, tells us so. David Stockman recently dug into the data.

“If we need aggregated data on employment trends, the US government itself already publishes a far more timely and representative measure of Americans at work. It’s called the treasury’s daily tax withholding report, and it has this central virtue: No employer sends Uncle Sam cash for model imputed employees, as does the BLS in its trend cycle projections and birth/death model; nor do real businesses forward withholding taxes in behalf of the guesstimated number of seasonally adjusted payroll records for phantom employees who did not actually report for work.

My colleague Lee Adler…now reports that tax collections are swooning just as they always do when the US economy enters a recession.

The annual rate of change in withholding taxes has shifted from positive to negative. It has grown increasingly negative in inflation adjusted terms for more than a month and it is the most negative growth rate since the recession.”

Tax-Withholding-021016

“Needless to say, the starting point for overcoming the casino’s blind spot with respect to the oncoming recession is to recognize that payroll jobs as reported by the BLS are a severely lagging indicator. Here is what happened to the headline jobs count in just the 12 months after May 2008. The resulting 4.6% plunge would amount to a nearly a 7 million job loss from current levels.”

Employment-Post-2008

Good point.

Is The Yield Curve Indicator Broken?

As one indicator after another is signaling that the U.S. economy is on the brink of a recession (see here and here), the bulls are desperately clinging to the yield curve as “proof” the economy is still growing.

There are a couple of points that need to be addressed based on the chart below.

Yield-Curve-GDP-021116-3

  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 is likely skewing 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.” 

Just as the yield spread was negative in 2006, and was warning of the onset of a recession, Bernanke and Wall Street all proclaimed that it was a “Goldilocks Economy.” It wasn’t.

Here is the point, as shown in the chart above, the Fed should have started lifting rates as the spike in economic growth occurred in 2010-2011. If they had, 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 would have been negative some time ago predicting the onset of a recession in the economy about…now.  Of course, such would simply be a confirmation of a majority of other economic indicators that are already suggesting the same.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Fed Late, Rate Review, Pricing In “R”

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


The Fed Is Behind The Curve…Again

Over the last couple of months, I have been discussing the technical deterioration of the market that is occurring beneath the surface of the major indices. I have also suggested there is more than sufficient evidence to suggest we may be entering into a more protracted “bear market cycle.”

The caveat to this, of course, has been the potential for a renewed round of Central Bank interventions that would theoretically once again postpone the onset of such a decline. To wit:

“The top section of the chart is a basic ‘overbought / oversold’ indicator with extreme levels of ‘oversold’ conditions circled. The shaded area on the main part of the chart represents 2-standard deviations of price movement above and below the short-term moving average.”

SP500-MarketUpdate-020416

“There a couple of very important things to take away from this chart.

  • When markets begin a ‘bear market’ cycle [which is identified by a moving average crossover (red circles) combined with a MACD sell-signal (lower part of chart)], the market remains in an oversold condition for extended periods (yellow highlighted areas.)
  • More importantly, during these corrective cycles, market rallies fail to reach higher levels than the previous rally as the negative trend is reinforced.

Both of these conditions currently exist.

Could I be wrong? Absolutely.

This entire outlook could literally change overnight if the Federal Reserve leaps into action with a rate cut, another liquidity program or direct market intervention.”

This is just the most recent observation. I begin discussing the deterioration in the markets beginning last summer as early signs of the topping process began and I lowered portfolio model exposures to 50% of normal allocations.

However, despite the fact that interest rates have continued to trend lower, economic data and corporate profits have deteriorated, and inflationary pressures non-existent; most Fed speakers have sounded consistently hawkish and steadfast in their views of 4-rate hikes in 2016.

I have been steadfast in my claims that hiking rates given the current economic conditions is a mistake and will rapidly push the markets and economy towards a reversion. To wit:

“Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession. However, the timing between the first rate hike and the next recession is dependent on the level of economic growth at that time.

When looking at historical time frames, one must not look at averages of all rate hikes but rather what happened when a rate hiking campaign began from similar economic growth levels. Looking back in history we can only identify TWO previous times when the Fed began tightening monetary policy when economic growth rates were at 2% or less.

(There is a vast difference in timing for the economy to slide into recession from 6%, 4%, and 2% annual growth rates.)”

Fed-Funds-GDP-5yr-Avg-Table-121715

“With economic growth currently running at THE LOWEST average growth rate in American history, the time frame between the first rate and next recession will not be long.”

It is now becoming quite apparent that the majority of economists, analysts, and Fed members have been quite mistaken in their assessments of the impact of global turmoil and the collapse in commodity prices on the domestic economy. (Read my previous commentary on oil and China)

From Market News: (Via ZeroHedge)

“Top Federal Reserve policymakers are leaving little doubt the financial turbulence and souring of the global economy could have significant implications for U.S. monetary policy, but they are loathe to draw too many conclusions about the appropriate path of interest rates at this juncture.

One thing is for certain: The tightening of financial conditions that has taken place since the Fed began raising short-term rates in mid-December is a matter of considerable concern to the Fed, New York Federal Reserve Bank President William Dudley said in an exclusive interview with MNI Tuesday.

But, it was supposed to signal the US economy is ‘strong enough’ to sustain a lift off and decouple from the rest of the world which is scrambling to cut rates. Guess not.

As MNI adds, “a weakening of the global economy accompanied by further appreciation in an already strong dollar could also have “significant consequences” for the U.S. economy, Dudley told MNI.”

“I can give you my own interpretation,” the committee’s vice chairman replied. “I read that as saying we’re acknowledging that things have happened in financial markets and in the flow of the economic data that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward.”

But it’s a little soon to draw any firm conclusions from what we’ve seen,” he cautioned.”

If history serves as any guide, with the entire flow of data from economic underpinnings, high-yield markets, commodity prices and deteriorating profits screaming for help, by the time the Fed “draws any firm conclusions” it will be far too late to make any real difference. 

Interest Rate Predictions Come To Fruition

Well, that didn’t take long.  At the beginning of this year, I wrote in the 2016 Market Outlook & Forecast the following:

“With the Federal Reserve raising interest rates on the short-end (Fed Funds), it will likely push the long-end of the curve lower as the economy begins to slow from the effects of monetary policy tightening.

From a purely technical perspective, rates have been in a long-term process of a tightening wedge. A breakout to the upside would suggest 10-year treasury rates would soar to 3.6% or higher, the consequence of which would be an almost immediate push of an economy growing at 2% into recession. The most likely path, given the current economic and monetary policy backdrop, will be a decline in rates toward the previous lows of 1.6-1.8%.(Inflation will also remain well below the Fed’s 2% target rate for the same reasons.)

InterestRate-Update-020416

“Of course, falling rates means the ongoing “bond bull market” will remain intact for another year. In fact, if my outlook is correct, bonds will likely be one of the best performing asset classes in the next year.”

When I wrote that missive, rates were at 2.3%. Yesterday, they touched 1.8% and intermediate and long duration bonds have been the asset class to own this year.

While rates will likely bounce in the short-term, I still suspect rates will finish this year closer to the low-end of my range.

Have Stocks Priced In A Recession?

I have read a significant amount of commentary as of late suggesting that the current decline in stocks have “priced in” the economic and earnings weakness we are currently witnessing.

Such is hardly the case.  There are two primary indicators that warrant such skepticism.

The first is valuations.

CAPE-5yrAvg-020416

The chart above is a 5-year Cyclically Adjusted Price Earnings (CAPE) ratio (data source: Dr. Robert Shiller.)  By speeding up the time frame from 10-years to 5-years, we find that valuation changes have shifted from being more coincident prior to 1970, to more leading currently. As shown, the downturn in valuations has been a leading indication of more severe market corrections particularly since the turn of the century.

The second is profits.

SP500-Ann-Pct-Chg-Earnings-020416

While still early into 2016, it already appears that earnings will post an annual decline for the second year running. Annual declines in earnings have historically been more evident during recessionary economic cycles (which only makes sense as consumption slows.)

It is not just me suggesting that risk is currently high either. Here is a note from RBC:

“Based on current valuations, the prices of most stocks don’t appear to have factored in a recession scenario, ‘hence the downside should we see a recession could be rather severe,’ RBC Capital Markets’ global equity team wrote in a research note to clients who believe the shares of most companies could still fall another 50% or more from current levels.”

Such declines have been consistent with past economic/earnings recessions as “overvaluation” reverts back to “undervaluation.”

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: Fed Error, Houston R/E, No Bounce?

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


The Potential Of A Policy Error Has Risen

Yesterday, the Fed clearly showed they are trapped in their decision to raise rates. Despite an ongoing deterioration in the underlying economic and financial market fabric, Yellen & Co. stayed firm in their commitment to a gradual increase in interest rates.

What is most interesting is their focus on headline employment data while ignoring their very own Labor Market Conditions Index (LMCI) which shows a clear deterioration in the employment underpinnings.

Employment-LMCI-012816

But here is the potential problem for the Fed’s dependence on current employment data as justification for tightening monetary policy – it is likely wrong. Economic data is very subject future revisions. While the current employment data has indeed been the strongest since the late 1990’s, there is a probability that the data is currently being overestimated.

The reason is shown in the chart below.

Employment-FullTime-LFPR-012816

If the employment gains were indeed as strong as the Fed, and the BLS, currently suggest; the labor force participation rate should be rising. This has been the case during every other period in history where employment growth increased. Since the financial crisis, despite employment gains, the labor force participation rate has continued to fall.

This suggests that at some point in the future, we will likely see negative revisions to the employment data showing weaker growth than currently thought.

The issue for the Fed is by fully committing to hiking interest rates, and promoting the economic recovery meme, changing direction now would lead to a loss of confidence and a more dramatic swoon in the financial markets. Such an event would create the very recession they are trying to avoid.

Inflation expectations are also a problem which compounds the probability of a policy error at this point. As Danielle DiMartino Booth, who left the Fed earlier this year, stated:

“Less anticipated was the adamancy of Committee members that inflation would hit their stated goal of ‘two percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.’

‘Strengthens further?’ Anyone bother to share the last few weekly jobless claims reports with monetary policymakers?

As for inflation’s prospects, a year and a half into crashing oil prices, the FOMC’s use of the word ‘transitory’ leads one to wonder if they are stuck in some space age time warp. Or maybe they declared it Opposite Day but failed to share that with the rest of us.

While the Fed clearly remains giddily detached from reality, the bond market communicated unequivocally what it thinks about the economy’s prospects: the 10-year Treasury closed below the two percent line in the sand that’s been drawn since the start of the year.

 

With fourth quarter GDP likely to be closer to 0% than 2%, the Fed has clearly gotten on the wrong side of the economic landscape. This puts the possibility of a monetary policy error at extremely high levels, the outcomes of which have historically been severe.

Houston Has A Problem – Commercial R/E

In February of 2015, I penned the following missive discussing the coming real estate crisis for the Houston market:

“Houston has a problem when it comes to tumbling oil prices.

As oil prices rise and fall so does the number of rigs being utilized to drill for oil which ultimately also impacts employment. This is shown in the chart below of rig count versus employment in the oil and gas sector of the economy.”

Oil-RigCount-Employment-012816

“Obviously, the drawdown in energy prices is going to start to weigh on the Texas economy rather sharply over the next several months. Several energy companies have already announced layoffs, rig count reductions and budgetary cuts going into 2015. It is still very early in the cycle so it is likely that things will get substantially worse before they get better.”

While much of the mainstream media continues to tout that falling oil prices are good for the economy, (read here for why that is incorrect ) the knock-off economic impacts are job losses through the manufacturing sector and all other related industries are quite significant.

However, most importantly as I pointed out at the beginning of 2015:

“One of those areas is commercial real estate.  If you look in any direction in Houston, you see nothing but cranes. The last time I saw such an event was just prior to 2008 when I commented then that overbuilding was a sign of the maturity of the boom. The same has happened yet again, and not surprisingly, the “sirens song” has been “this time is different.” 

Unfortunately, not only is this time not different, the economic impacts are likely to much more substantial, not only in the Houston economy, but nationwide. To wit:

“The jagged skyline of this oil-rich city is poised to be the latest victim of falling crude prices. As the energy sector boomed in recent years, developers flocked to Houston, so much so that one-sixth of all the office space under construction in the entire U.S. is in the metropolitan area of the Texas city.”

office-construction

But here is the economic problem:

“And as a reminder, every high-paying oil service jobs accounts for up to 4 downstream just as well-paying jobs. Case in point:

The rush of building has created thousands of jobs—not only at building sites, but also at window manufacturers, concrete companies, and restaurants that feed the workers.

But just as the wave of office-space supply approaches, energy companies, including Halliburton Co. , Baker Hughes Inc., Weatherford International and BP PLC, have collectively announced that more than 23,000 jobs would be cut, with many of them expected to be in Houston.

Fewer workers, of course, means less need for office space.

No one believed me then. However, here is the latest update from real-estate services firm Savills Studly via Business Insider:

“New sublease blocks are expected to hit the market in 2016, particularly in the CBD [Central Business District]. Shell is projected to vacate 250,000 sf in One Shell Plaza and EP Energy, likewise, is anticipated to leave 100,000 sf in the Kinder Morgan Building. Shell would likely also shed space at BG Group Place should its pending $70-billion acquisition of BG Group clear governmental hurdles and finalize.

Many large tenants who paid at the very top of the market in the last few years warehoused space in anticipation of continued headcount growth. As a result, many firms had surplus space even prior to the implementation of layoffs in the last year. In 2016, the office market should see more shadow space listings….

Occupancy, after five years in a row of increases, fell by 1.4 msf (“negative absorption”), the biggest decrease in occupancy since 2009. Going forward, M&A and bankruptcies “will contribute to additional negative absorption” and will hit the vacancy rate. It already spiked to 23.2%.

After a tremendous building boom in 2013 and 2014, a total of 17 msf is expected to hit the market over the next few years, with 7.9 msf scheduled for completion in 2016. Only about two-thirds have been pre-leased. Some of these pre-leased properties will enter the shadow inventory as soon as they’re completed. But 5.5 msf has not been leased.

These new buildings will hit the market at the worst possible time, competing with 7.9 msf of sublease space and large amounts of shadow inventory, during a period of negative absorption.

While the media and mainstream analysts discount the negative economic impact of falling energy costs, I have personally witnessed it in the mid-80’s, the late 90’s and just prior to 2008. In all cases, the negative outcomes were far worse than predicted which left economists scratching their heads as to what went wrong with their models.

This time won’t be different.

Markets May Not Bounce

Over the last few weeks, I have suggested the markets would likely provide a reflexive rally to allow investors to reduce equity risk in portfolios. This was due to the oversold condition that previously existed which would provide the “fuel” for a reflexive rally to sell into.

I traced out the potential for such a reflexive rally to weeks ago as shown in the chart below.

SP500-MarketUpdate-012816

The oversold conditions that once existed have been all but exhausted at this point due to the gyrations in the markets over the last couple of weeks without the markets making any significant advance.

Just as an oversold condition provides the necessary “fuel” for an advance, the opposite is also true. This almost overbought condition comes at a difficult time as I addressed earlier this week:

“February has followed those 20 losing January months by posting gains 5-times and declining 14-times. In other words, with January likely to close out the month in negative territory, there is a 70% chance that February will decline also.

The high degree of risk of further declines in February would likely result in a confirmation of the bear market. This is not a market to be trifled with. Caution is advised. “

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

3 Things: “R” Signs, Looks Like 2008, QE-4

“3 Things” is a weekly post of thoughts I am pondering, usually contrarian, with respect to the markets, economy or portfolio management. Comments and thoughts are always welcome via email,  Twitter, and/or Facebook.


Warning Signs Of A Recession

In late 2007, I was giving a presentation to a group of about 300 investors discussing the warning signs of an impending recessionary period in the economy. At that time, of course, it was near “blasphemy” to speak of such ills as there was “no recession in sight.”

Then, in December of that year, I penned that we were either in, or about to be in, the worst recession since the “Great Depression.” That warning too was ignored as then Fed Chairman Ben Bernanke stated that it was a “Goldilocks Economy.” The rest, as they say, is history.

I was reminded of this as I was reading an article by Myles Udland, via Business Insider, entitled “The US economy is nowhere near a recession.” 

It is an interesting thought. However, the problem for most analysts/economists is that they tend to view economic data as a stagnant data point without respect for either the trend of the data or for the possibility of future negative revisions. As shown in the chart below, this is why it SEEMS the financial markets lead economic recessions.

SP500-NBER-RecessionDating-012016

However, in reality, they are more coincident in nature. It is just that it takes roughly 6-12 months before the economic data is negatively revised to show the start of the recession. For example, the recession that started in 2007 was not known until a year later when the data had been revised enough to allow the NBER to make its official call.

The market decline beginning this year is likely an early warning of further economic weakness ahead. I have warned for some time now that the economic cycle was exceedingly long given the underlying weakness of the growth and that eventually, without support from monetary policy, would likely give way. The following charts are the same ones I viewed in 2007, updated through the most recent data periods, which suggested the economy was approaching a recessionary state. While not all are in negative territory yet, they are all headed in that direction.

PCE-Imports-012016

LEI-Coincident-Lagging-012016

LEI-vs-GDP-012016

SP500-Ann-Pct-Chg-Earnings-012016

SP500-NetProfit-Margins-012016

Retail-Sales-012016

Is the economy “nowhere near recession?” Maybe. Maybe not. But the charts above look extremely similar to where we were at this point in late 2007 and early 2008.

Could this time be “different?” Sure. But historically speaking, it never has been.

The Topping Process Completes

For the last several months I have repeatedly discussed the topping process in the markets and warned against dismissing the current market action lightly. To wit:

“Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.

The chart below is an example of asymmetric bubbles.

Asymmetric-bubbles

The pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals.

This pattern of bubbles can be clearly seen at every bull market peak in history.

Take a look at the graphic above, and the one below. See any similarities?

SP500-MarketUpdate-012016

As you will notice, the previous two bull-market cycles ended when the topping process ended by breaking the rising support levels (red line). The confirmation of the onset of the “bear market” was marked by a failed rally back to the previous rising support level. Currently, that has not occurred as of yet.

The next chart is another variation of the above showing the break-down of the rising bullish trend in the market.  In all cases, investors were given minor opportunities to reduce equity risk in portfolios well before the onset of the bear market decline. 

SP500-MarketUpdate-012016-2

I have been asked repeatedly as of late whether or not the markets will provide a similar “relief rally” to allow for escape. The answer is “yes.” However, as in the past, those relief rallies tend to be short-lived and don’t get investors “back to where they were previously.”

The risk to the downside has risen markedly in recent weeks as the technical, fundamental and economic deterioration escalates. This is not a time to be complacent with your investments.

“One & Done Yellen” And The Rise Of QE4.

Back in December, when Janet Yellen announced the first hike in the Fed Funds rate in eleven years from .25% to .50%, the general mainstream consensus was “not to worry.”  It was believed that a rate hike by the Fed would have little impact on equities given the strong economic recovery at hand. Well, that was what was believed anyway as even Ms. Yellen herself suggested the “odds were good” the economy would have ended up overshooting the Fed’s employment, growth and inflation goals had rates remained at low levels.

The problem for Ms. Yellen appears to have a been a gross misreading of the economic “tea leaves.” With economic growth weak, the tightening of monetary policy had a more negative impact on the markets and economy than most expected. As I wrote previously:

“Looking back through history, the evidence is quite compelling that from the time the first rate hike is induced into the system, it has started the countdown to the next recession. However, the timing between the first rate hike and the next recession is dependent on the level of economic growth at that time.

When looking at historical time frames, one must not look at averages of all rate hikes but rather what happened when a rate hiking campaign began from similar economic growth levels. Looking back in history we can only identify TWO previous times when the Fed began tightening monetary policy when economic growth rates were at 2% or less.

(There is a vast difference in timing for the economy to slide into recession from 6%, 4%, and 2% annual growth rates.)”

Fed-Funds-GDP-5yr-Avg-Table-121715

“With economic growth currently running at THE LOWEST average growth rate in American history, the time frame between the first rate and next recession will not be long.”

Given the reality that increases in interest rates is a monetary policy action that by its nature slows economic growth and quells inflation by raising borrowing costs, the only real issue is the timing.

With the markets appearing to have entered into a more severe correction mode, there is little ability for Ms. Yellen to raise interest rates any further. In fact, I would venture to guess that the rate hike in December was likely the only one we will see this year. Secondly, we are likely closer to the Federal Reserve beginning to drop “hints” about further accommodative actions (QE) if conditions continue to deteriorate.

It is important to remember that in 2010, when Ben Bernanke launched the second round of QE, the Fed added a third mandate of boosting asset prices to their roster of full employment and price stability. The reasoning was simple – create an artificial wealth effect encouraging consumer confidence and boosting consumption. It worked to some degree by pulling forward future consumption but failed to spark self-sustaining organic economic growth.

With market pricing deteriorating sharply since the beginning of the year, it will not take long for consumer confidence to slip putting further downward pressure on already weak economic growth. With Ms. Yellen already well aware she is caught in a “liquidity trap,” there would be little surprise, just as we saw in 2010, 2011 and 2013, for the Fed to implement another QE program in hopes of keeping consumer confidence alive.

SP500-QE-012016-2

The issue is at some point, just as China is discovering now with failure of their monetary policy tools to stem the bursting of their financial bubble, the same will happen in the U.S. With the Fed unable to raise rates to reload that particular policy tool, a failure of QE to stabilize the markets could be deeply problematic.

Just some things to think about.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In