Riding the Fed's Trading Train

It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and the Treasury's ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issue by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From a policymaker's perspective, that remains a distant threat. What - and how many - global distortions will emerge as a result of the Fed's extended zero-interest rate policy? And what will bring the new house of cards crashing down?

The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmanufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month.

Adding to the manufacturing upswing are leaner inventories, with the inventory to sales ratio falling to 1.38 from its cycle high of 1.46 in January of this year. Even that much beleaguered housing sector is showing signs of life, with housing starts apparently bottoming in the spring; the cessation of freefall is certain to support third quarter GDP. Finally, households are feeling a bit more confident, and that translated in consumption growth in July. Anecdotally, the word on the street is more positive, as summarized in the opening paragraph of the most recent Beige Book:

Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.

All in all, it seems a fair bet that the NBER recession cycle dating team will pin the end of the recession sometime during the summer of 2009.

That said, even the most optimistic bull will note that I just cherry-picked the data. While time and inventory control have come into play, firming activity has been inexorably linked to a host of fiscal and monetary stimulus measures. Consumption and manufacturing have both been boosted by the now concluded "Cash for Clunkers" program; we are now anxiously waiting for the likely painful hangover from that spectacular demolition derby where all contestants won a prize. And, interestingly, despite the car buying binge, consumer credit contracted by a whopping 10% annualized in July, a testament to the mix of restriction to and aversion of credit that continues to weigh on household spending plans.

Likewise, housing sales have been supported by the $8,000 tax credit for "first-time" buyers, which has been estimated to fatten real estate agent wallets with the addition of almost 400,000 home sales. Like the Clunkers program, the homebuyer's tax credit is set to expire, threatening to pull the rug out of the housing market just as foreclosure activity looks to be heading higher. Should it be extended? Not just real estate agents and home builders think extension - and enhancement - is a no brainer:

“There will be some payback, particularly late this year and early next and that’s one of the reason house prices are going to begin weakening,” Mr. Zandi says.

Mr. Zandi’s reasoning could provide fuel to those in Congress and the administration who want to extend the tax credit. While some in the administration think it should be extended, concerns about the mounting deficit may make such an argument politically tricky.

For his part, Mr. Zandi says the tax credit should be extended and possibly expanded to all home buyers — not just those purchasing for the first time. He says the credit could have a bigger impact once the job market recovers and fewer people are out of work and able to buy homes

Leaving aside the issue of whether or not it is wise to create a fresh entitlement for housing purchases (not), the likely all-out push for an extension points to the current vulnerability of the recovery. It looks neither durable nor sustainable at this juncture; moreover, once again the recovery falls short of providing a significant boost to the labor market. Yes, the pace of deterioration in nonfarm payrolls is clearly improving, and a turning point has been reached. But payrolls data continues to deteriorate nonetheless, with only the health care and social assistance sector proving a significant supporting role during the month of August. Moreover, unemployment is staring at the 10% mark while underemployment is just shy of 16%. The pace of improvement in initial claims has become anemic, and soon claimants will begin dropping off the roles, another headwind for consumption spending (let alone the human cost) if hiring intentions don't soon head significantly higher.

The weak labor market is clearly weighing on inflationary pressures. From the Beige Book:

Wage pressures remained low across all Districts. Several Districts noted businesses and local governments imposing wage freezes or even reducing employee compensation in some instances. Boston noted that several manufacturers who have cut wage rates do not expect to restore pay levels until next year. Kansas City, Philadelphia, Chicago, Minneapolis, San Francisco, Dallas, and Richmond noted an increase in the cost of some raw materials, including fuel, metals, and steel. Chicago and Dallas mentioned that excess supply was putting substantial downward pressure on natural gas prices. Retail prices were described as generally steady in most Districts, although Kansas City and San Francisco noted continued discounting and downward pressure on consumer prices.

From the Fed's perspective, the flow of data and anecdotal evidence points to an economy that is definitely improving but not so much as to generate inflationary pressures. Moreover, the profound and persistent weakness in the job market leaves open the question the sustainability of an external inflation pressures (from commodity prices, for example). If high prices do not trigger higher wages, the much feared inflationary spiral cannot take hold. And thus is why Fed officials keep warning that a rate rise is not in the cards in the near term; Chicago Federal Reserve President Charles Evans reiterated this position Wednesday:

Evans also said that when it comes to rate hikes and major unwinding of other emergency support programs now, a shift lies “some time down the road.” In reaching a determination of whether rate hikes are needed, Evans said that “we are going to be looking very carefully at how the economic recovery is preceding,” and will be watching inflation and unemployment measures.

“As the economy continues to improve, and when we see rising inflation pressures, Fed policy will respond aggressively,” Evans said. When the time does come to raise rates, “we could have a pretty reasonable withdrawal of accommodation.”

Remember, in the last jobless recovery the Fed was still cutting rates well after the official end of the recession. Of course, the Fed could very well move faster when the signs of sustainable recovery emerge - but if sustainability and inflation potential are based on the labor market, that recovery is easily a long way off. Moreover, the Fed will not be keen on risking a premature reversal of policy; such reversals never did the Japanese economy any favors. Speaking of Japan, another prime example of start-stop "recovery":

Japanese machinery orders fell more than economists forecast in July, signaling companies are wary that a rebound in sales abroad will last.

Orders, an indicator of capital spending in the next three to six months, declined 9.3 percent from June, when they jumped 9.7 percent, the Cabinet Office said today in Tokyo. Economists surveyed by Bloomberg News predicted a 3.5 percent decline...

...“There’s been an enormous wave of confidence in the stock markets but that hasn’t been shared by business leaders,” said Martin Schulz, senior economist at Fujitsu Research Institute in Tokyo. “Producers know that lots of the improvement in exports and in the overall outlook has been on the back of government programs and they’re still troubled by the outlook.”

It is not easier to pull one over on Japanese business leaders; they have been living this dynamic for nearly two decades.

To be sure, there will be consequences of the Fed's extended ZIRP policy; pump enough money in the economy, and it has to show up somewhere. Pump enough of a reserve currency into the global economy, and things can get interesting fast. From Bloomberg today:

“Over the next few months, we see the yen strengthening against the dollar and European currencies,” Greg Gibbs, a foreign-exchange strategist at RBS in Sydney, wrote today in a report. “We expect the yen to continue to be replaced by the dollar, and even possibly European currencies, as the preferred funding vehicle for higher-risk, higher-yielding assets and currencies.”

Consider what has occurred - the principle reserve currency, that which is supposed to be an effective facilitator of exchange and a store of wealth, is threatening to overtake the yen and become the primary financing vehicle of hot money gambling. Under such circumstances, the current market dynamic should come as little surprise - commodities stronger (Gold again breached the $1,000 mark before retreating) while the Dollar is substantially weaker and US equities get a lift. Seriously, can this really end well?

The game is on. And we all know it. According to China Investment Corporation Chairman Lou Jiwei (HT Baseline Scenario):

"It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we're just taking advantage of that. So we can't lose," he said.

When will it come crashing down, as all free money pyramids eventually do? As always, when some aspect of policy or economic activity makes a fundamental shift. We need to be on the watch those changes. Renewed financial crisis that sparks a flight to safety, assuming the Dollar is still considered safe? But what is the likelihood of true counterparty risk when US policymakers have effectively implemented a too-big-to-fail policy that will soon evolve into a too-big-to-regulate policy - even as, according to the Wall Street Journal, the appetite for risk of the top five banks has risen to record levels. Sure, if your counterparty is Podunk Bank in Nowhere, North Dakota, you have risk. But Bank of America (BAC) or Morgan Stanley (MS)? Get real - they have tighter security than President Obama. Domestic policy change?

The Fed is trying to get credit flowing to consumers, but the data is saying that just is not happening. Would the situation improve by raising rates? No, and assuming the jobless recovery scenario emerges, there will be no pressing domestic reason to rush to tighten. And if markets stumble as the Fed winds down its purchases of Treasuries and mortgage securities, the best bet is that the Fed would reverse course and expand the balance sheet further. Lack of political will to maintain US stimulus? Goodness knows that when push comes to shove, the US Congress loves to spend as much as any drunken sailor. External changes? China becomes unwilling to hold its Dollar portfolio in response to rising protectionism and makes a bid for the Renminbi to supplant the Dollar as the global reserve currency? Or rising commodity prices foster foreign inflation, which in turn prompt foreign central banks to raise rates and choke off growth?

The Fed is fueling a nice little train of trading, if not economic, activity. The Fed will fuel the ride until inflation pressures truly emerge, a ride that can last for a long time given the current state of the labor market. Everyone should join in for that ride. But train rides fueled by cheap money always end the same - we pretend the ride can continue indefinitely, but eventually the train moves on to a track that policymakers can not tolerate. We need to be watching for that track. The risk: That track could be a ways off, and we will become complacent before we get to it.

Comments

[Moon Kil Woong:]

The government is also supporting the housing market with unusually low rates from Fannie Mae and Freddie Mac. In fact, since 90% of the market is controlled by these two now, you could rightly say the market is totally socialized and not reflective of any reality whatsoever. The $8,000 homeowner tax credit is a joke on top of that.

If you doubt me, just try selling a home that's still worth something, say a home needing a jumbo loan. Good luck.

There is a lot of stimulus going on and the fantasy party is just getting started. The brunt of the stimulus begins the end of this year and runs into 2010. Enjoy the ride and remember that you need to make enough money to cover the deflation of the currency in your pocket. The buck is already down about 5% this year and 15% from this years highs against major currencies.

After that, like the author says, we need to be cautious. The political will for more stimulus ridiculousness is already wearing thin. This is especially true because so little of it is going to you or me. So then where will the market get its moxie? After the run up in the 1930's when the political will for spending ran out the Great Depression ensued. A lingering, prolonged, government drageed out recession which saps public trust and incurs government wastefulness and encourages economic inefficiency can lead to a depression. How many of those components are already in place? You decide.

Sep 10 04:55 AM

[User 353732:]

Excessive debt, overconsumption, serial asset/financial bubbles and unwarranted reliance on energy imports have been the primary sources of our current and endemic economic woes(for 90% of Americans, anyway) and social pathologies.

Our Bosses have responded, in 2009, with the notion that the antidote to wretched excess is even more wretched excess.
1. The antidote to housing and financial bubbles is to reinflate these bubbles via all means possible, esp. the demented printing of fiat money in amounts never before experienced in US economic history
2. The antidote to overconsumption is to further subsidize consumption( the Govt believes alcoholism is best cured by another bottle of whisky and heroin addiction by free needles and heavily subsidized narcotics)
3. The antidote to over borrowing is to facilitate and subsidize more borrowing while penalizing savings: glorify consumption and instant gratification while vilifying thrift and self control
4. The antidote to unwarranted reliance on energy imports that debilitate the economy and destroy jobs is to further discourage the development of domestic energy resources

The policies that were destroying American wealth creating capacity, global stature and civil society slowly have now been replaced by policies that achieve the same 3 malign objectives rapidly.

Sep 10 06:50 AM

[CautiousInv...:]

The moneatry base has doubled while private sector credit has contracted. There is no new lending.

The mirage of improvement is a result of direct liquidty injections through expansion of the Fed balance sheet and massive, both in scale and in waste, fiscal spending. All economist agree that this is the source of improvement; private sector investment is seriously lagging and there are no hints of gains in employment.

This unpleasant reality stems from the fact that we do not have at hand a base of science and technology to draw upon to create one of more new industries; historically new industries ( PC, Internet and cell phone) have helped us crawl out of economic holes. Most recently we relied upon small busineses but they have been thrown beneath the bus and will fall as fast as the banks that lend to them.

Things are looking better but what will be the growth catalyst capable of offsetting the contraction in consumer demand? A more profound question is whether the stock market has sufficiently grasped the nature of the post-crisis model of capitalism the world is moving towards.

Governments will be exercising greater control over the management and levels of profit in banking, the motor industry and elsewhere. Regulation will increase, as will taxes. And the populist backlash against bank bonuses threatens to spill over into a wider resentment of profits and wealth creation.

Sep 10 07:50 AM

[Michael Clark:]

1-2-3: lets all push on the string.

Very good post, Cautious. Great observations.


On Sep 10 07:50 AM CautiousInvestor wrote:

> The moneatry base has doubled while private sector credit has contracted.
> There is no new lending.
>
> The mirage of improvement is a result of direct liquidty injections
> through expansion of the Fed balance sheet and massive, both in scale
> and in waste, fiscal spending. All economist agree that this is the
> source of improvement; private sector investment is seriously lagging
> and there are no hints of gains in employment.
>
> This unpleasant reality stems from the fact that we do not have at
> hand a base of science and technology to draw upon to create one
> of more new industries; historically new industries ( PC, Internet
> and cell phone) have helped us crawl out of economic holes. Most
> recently we relied upon small busineses but they have been thrown
> beneath the bus and will fall as fast as the banks that lend to them.
>
>
> Things are looking better but what will be the growth catalyst capable
> of offsetting the contraction in consumer demand? A more profound
> question is whether the stock market has sufficiently grasped the
> nature of the post-crisis model of capitalism the world is moving
> towards.
>
> Governments will be exercising greater control over the management
> and levels of profit in banking, the motor industry and elsewhere.
> Regulation will increase, as will taxes. And the populist backlash
> against bank bonuses threatens to spill over into a wider resentment
> of profits and wealth creation.

Sep 10 08:10 AM

[nobby73:]

Very good article, bang on the money.

I wonder if there has ever been a different plan other than the magic bullet of inflation? It's a bit like the instructions for a firework - light the fuse and stand well back...

No wonder the Chinese government is advising its citizens to buy gold and silver.

Sep 10 02:10 PM

[NUCLEAR1929:]

nice title, bravo

Sep 10 02:19 PM

[conceptwizard:]

The $11 trillion in short-term government debt. The interest on that debt is $340 billion, or a 3.04% rate of interest. Our current president says in ten years $9 billion will be added bringing that debt to $20 trillion. In ten years that is more than $600 billion a year. No nation can survive such debt not to mention mandated payments such as pensions, Social Security, Medicare, Medicaid, etc. That takes the number to over $100 trillion. The debt service will be 30% or more of the budget if nothing is added to debt via shortfalls to mandated programs.

The flipside of maintaining high deficits is that if they are not continued the economy will fall into deep depression. This monetization and debt will eventually take down the bond market. Presently the Fed is keeping the bond market from going lower and keeping interest rates lower. They cannot do that indefinitely. Witness what has begun to happen in the gold and silver markets. The treasury and the Fed eventually lost control.

The undertow is deflationary; there is major worldwide overcapacity and low capacity utilization, high and rising unemployment worldwide, falling real incomes and more ongoing deleveraging going on constantly. What people miss is that deflation is being held at bay by massive money and credit creation. The minute that stops the bottom will fall out and deflation will take over. As a result of the program set in place by G-20 there has been and will continue to be inflation. It is a question of overkill because the central banks never knew when enough is too much. That is why we could easily face hyperinflation.

Sep 10 08:02 PM

[Old Trader:]

"Orders, an indicator of capital spending in the next three to six months, declined 9.3 percent from June, when they jumped 9.7 percent, the Cabinet Office said today in Tokyo. Economists surveyed by Bloomberg News predicted a 3.5 percent decline..."

There was article yesterday on Bloomberg, or perhaps it was Reuters, but any case, evidently that giant 9.7% June jump in orders related to a contract for a nuke power plant, so its roughly comparable to US exports jumping up for a month because Boeing happened to sell a dozen jumbo jets.

Sep 10 09:22 PM

[GotLife:]

Having lived through periods of high inflation, I see consumers jumping into a spending fury if they perceive prices next year, or month, will be significantly higher than the present. They will be more encouraged to buy on credit given an inflation scenario, factoring the interest rate as "savings."

This is the predicament consumers in Brazil and Argentina faced and how they responded. It did not end well there but Bernanke and Geithner believe they are smarter, have better tools and, most importantly, have no other options.

Sep 10 09:39 PM

[Moon Kil Woong:]

It's hard to buy education and health insurance today to save for the higher cost tomorrow. With these componets going up 2-3x the average inflation rate year after year, no wonder Americans are poorer than ever. The real crisis is that health care and education is not unaffordable for just poor people, but everyone. Without Sallie Mae which students can indenture themselves to debt for decades after they graduate we would already have had a collapse in college education.

Sep 11 02:15 AM

[derryl:]

CautiousInvestor wrote, "And the populist backlash against bank bonuses threatens to spill over into a wider resentment of profits and wealth creation."

I hadn't really thought about it but this bankster backlash could very well metastasize into economically catastrophic political policies.

I share the populist sentiment against bankster bonuses. I don't care if bonuses are a contractual part of finance workers pay package. When your company is so broke that only $megabillion taxpayer bailouts can save you, you should be grateful to get unemployment insurance because your employer is bankrupt and cannot pay you ANYTHING and has to lay you off. Taking bonuses in this environment is almost identical to the employees collectively embezzling their company into bankruptcy.

It is clear to SA participants that these banks were not "creating wealth" and their "profits"--predistributed as bonuses to themselves--were not real but accounting fictions. But try explaining that to Mr and Mrs American in a 15 second sound bite. It is much easier for socialist wannabees to tell Mr and Mrs American that the economic problems were caused by "profits", period.

I've tried, with utter lack of success, to explain to the socially enlightened that everybody has to "profit" from their work. If it costs you $20/day in transportation and other employment related expenses, but you only receive a $10/day stipend for your work at the "Saving Kittens and other Cuddly Things Foundation", then where are you getting the other $10/day to afford to pay your work expenses? But this simple logic of the necessity of profiting from your work is lost on this kind of mind. "The government" should give me the extra $10 because the work I do is so "valuable". They don't have even the beginning of an understanding of money and they implicitly assume that money is some kind of automatic rewarder of whatever they call "value".

You and I might tremble in fear at the prospect of recurring multitrillion dollar deficits, but the virtuous cuddly people suffer no such concerns. As far as they are concerned the government should pay for everything. They don't know and don't care to know where the government is supposed to get the money. Everything they need to know they learned in kindergarten, and the teacher told them we are supposed to "share".

But the teacher failed to tell them there are two sides to the sharing trade. Some poor slob has to produce something before there is anything to 'share'. But the virtuous cuddly people only see that there is a 'thing', a shareable thing, and they need one of those so they should receive it. They are never surprised when it turns out they are always on the receiving end of the sharing trade, never on the giving end. Humans have a truly awesome capacity for myopic self-delusion, when it serves our interests.

So wealth creation is all about producing shareable goods and services. And "profit", Horrors!, only happens when some big rich greedy man does not want to share. So we must make him share. Tax his income. Tax his capital. Let's sit down and feast on our seed corn. Keep the sharing faith and the good lord of the revenues will provide.

This is entitlement devolving into kleptocracy. Kleptocrats big and small are expert at thinking up reasons why they 'should' have what they are stealing. They learn to believe in their own self-serving bullshit. They teach themselves that coveting what someone else earns is not being greedy, but wanting to keep what you have earned is greedy. The kleptocrats style themselves as the virtuous ones, while the evil profiteering producers of the evil wealth are, yes, they are the evil ones. Did I mention that profit is evil? The prophet Isaiah summed up this upside down morality best,

"Woe to those who call evil good and good evil,
who put darkness for light and light for darkness,
who put bitter for sweet and sweet for bitter.
Woe to those who are wise in their own eyes
and clever in their own sight."

I will add, "and woe to us all if we allow this perversion of economic morality to continue".

Sep 11 02:51 AM