Wednesday, January 1, 2020

QE4, Repo, Inflation, Debt: A decade of monetary stimulus and the consequences of more

It’s been over 6 years since I’ve written anything on the Federal Reserve (Fed) and the economy. Truth be told, in mid-2013 with the Fed Funds Rate (FFR) pegged at essentially zero, real interest rates quite negative, and global debt ever increasing, I threw up my hands and gave up trying to convince people that we had a problem. It didn’t help that the stock markets propelled forward year after year, supported and backstopped by the Fed’s monetary easing policies, without an end in sight. 

Then came the Fed Funds Rate increases, starting in December 2015, after a 7-year peg at a record low of 0-0.25%. Only a 25-basis point increase, until a long year later in December 2016 when the rate was increased again by 25bp, to 0.50-0.75%. In 2017, the Fed increased rates thrice, in March, June and December by a collective 75bp. In 2018, the Fed continued to increase rates four times, in March, June, September and December by a collective 100bp increase, until the markets had a collective fit at being starved of monetary easing, with the Fed commensurately reducing its balance sheet from some $4.5T at the end of 2017 (pegged at $4.5T high for 3 straight years) to $3.77T interim low on September 9, 2019. 

Then came a Repo Market intervention by the Fed on September 16, 2019, the first in some 7 years since the failure of MF Global, a response to a spike in repo rates to ~10% that sent a shock wave through this short-term funding market, now linked to money markets and cash liquidity. For those looking for definitions of the Repo market and its history in the tumultuous years of the last financial crisis and after, please refer to my previous well-researched article “Repo Markets and Financial Instability” [1]. Below I have included updates to the size of the Repo markets as they have progressed over the last decade, and the Repo Rate and Fed Funds Rate compiled from FRED








So why did this spike in repo rates occur, prompting a Fed response that looks an awful lot like more monetary easing (call it QE4)? For those questioning whether this response is monetary easing or something limited to quell the repo markets and a short-term cash crunch, refer to the chart below showing the Fed balance sheet, which shows a reverse course of balance reduction to balance increases. Some have argued that the increases in the Fed Funds Rate and the reduction of the balance sheet put undue pressure on the markets, indicating that the Fed has to remain an active and continual participant (buyer), not a “lender of last resort”. Indeed, if the Fed continues to ease, by increasing its balance sheet (buying Treasury, Mortgage-Backed Securities (MBS) and other debt) it will leave little room for a real response should much greater shocks occur, such as Treasury or other market interest rate spikes, an indication that there is selling pressure or a serious lack of market buyers for debt, particularly as the debt issuances increase, and they only will increase. 





Critics of this scenario, and supporters of what the Fed does and can do, will just say that the Fed can “invent money” to buy up debt until the markets calm. They will continue to say that inflation is too low, and that rates can continue to come down and the balance sheet can continue to grow until inflation hits the target of 2% or greater. In fact, the Fed recently revised this target to 4%, stating that it miscalculated the inflation response when unemployment rates hit what the Fed thought was a level requiring a 2% target inflation response: that level was 5% around January 2016 and then 4% around March 2018. The unemployment rate now stands at 3.5% and the Fed tells us that the inflation target of 2% still hasn’t been met – refer to the comparison chart below that I compiled from FRED, including what the Fed reportedly [2] uses as its measure for target inflation, the chain weighted Personal Consumption Expenditures (PCE) against the broad Employment Cost Index and the U3 Unemployment Rate. I also include the Fed Funds Rate for comparison.








I have continually asked how far this “strategy” can go until it doesn’t work anymore. Eventually it will weaken the dollar and inflation will increase. How sharply might that happen? By the time those sharp increases are realized, we may have been boiling for some time and reverse courses might require increasing the Fed Funds Rate substantially. Most worrisome is that the Fed will lose control of manipulating the Treasury curve in both level and steepness, the amount of tool wielding becoming impotent. 

We should all be asking three questions here: (1) What is the real inflation and what does the Fed measure and report to gauge their target responses? (2) What is the real unemployment and what does the Fed measure and report to gauge their target responses? (3) Are the reported statistics (inflation, unemployment, interest rates, GDP, dollar index, debt levels) becoming more correlated or more uncorrelated?

I submit that the real wage inflation is lower, and core CPI inflation and actual unemployment much higher than the reported numbers used by Fed policy makers, which I have already reprinted here from FRED compilations (above graphs). I also submit that the reported statistics have decoupled somewhat from each other, to the point that has allowed the Fed cover for applying whatever policy response they want, nominally to control the Treasury curve and the Fed Funds Rate. In fact, the Fed has already admitted this by stating that the expected wage inflation and core PCE have not correlated to the U3 unemployment numbers, as they expected [3]. 

What are the real numbers and why doesn’t the government report them, or the Fed track them? I discuss alternate statistics for inflation, unemployment, GDP and the USD Index in the previous article, “Inflation, Unemployment, GDP and USD Index Statistics: What can we really believe?”. In summary, alternate measures for inflation are running around 5.7% vs. the Fed’s core PCE measure of 1.6% and the official CPI measure of 2%. Basically, wage inflation has been far outpaced by real inflation for costs of living. Alternate measures for unemployment are around 21.5% vs. 3.5% for U3 unemployment and 7.5% for U6 unemployment. Alternate GDP is around -2% (contraction since 2004) vs. 2% reported by the BEA and tracked by the Fed. Alternate financial weighted USD Index is around 60 vs. the reported FRB trade weighted dollar of 67 (indexed to January 1995). 

What is reported as real and growing at more than a 5% annual rate is the national debt, which can be measured as a %GDP. This is shown in the following compilation from FRED, data sourced from the Treasury and BEA. The national debt level at almost $23T is 106% of the overstated GDP, and much higher for the alternate GDP. The U.S. has over $42T (33%) of the total global marketable debt outstanding, which includes not only the national debt financed by Treasuries but also all other types of debt, such as Mortgage and Asset Backed Securities (MBS, ABS), Corporate debt, Muni debt, Consumer debt, etc. This is more than triple the next highest debtor nation, now China. 





Given the amount of understated inflation and unemployment, and the amount of overstated GDP and USD Index, the Fed’s policy of continued easing in the face of increasing debt may make more sense, but it does not fix the serious structural problems that we still have with high debt growth, real unemployment, sagging productivity and industrial production, and a continuing negative balance of trade. All of these issues are fiscal and business macro in nature, and the Fed chooses to plaster over these problems with continued easing to stave off real interest rate risk. As I mentioned at the beginning of this article, I have been waving this flag for a decade, but the proverbial can just keeps getting kicked. If you missed out on the market growth of the last decade, asset price inflation or Ponzi Finance, it was a spectacular miss. Regardless, perpetual motion machines don’t exist, and therefore all of these structural problems will manifest themselves in a much more obvious way (recession or worse), with the Fed finding it much tougher to use its policy tools to fight the consequences. 

As a comparison to the situation over two decades ago when the debt levels were much lower, the reported unemployment and core inflation around the same levels, productivity and industrial production much higher and a much lesser negative balance of trade, the Greenspan Fed chose to raise the Fed Funds Rate from around 4.5%. [Specifically, for January 1999: National Debt $5.6T (60.4%GDP), U3 Unemployment 4.3%, Core PCE 1.3%, Productivity and Industrial Production in excess of 4% (now 1% and negative), Current Balance -$60.8B (presently -$124B).]

I’ve primarily written about the hazards of cheap money and monetary easing, here and elsewhere. Admittedly, it is hard to convince many of the hazards when the markets (stock and bond) have a record decade, as they have had from 2010-2019. Markets love monetary easing (chart below). The hazards: risk asset price inflation that puts markets into overvalued territory for significant periods of time, placing volatility risk and interest rate risk into greater territory. One only has to look at the monetary easing love chart to see this volatility in the stock markets when the Fed signaled tapering its asset purchases (2013), or actually started tightening (2016 with the FFR and again in 2018 with the balance sheet). The markets and rates become volatile when the Fed does not provide a continuous backstop. 





The Fed’s “mandate” is low employment and price stability, but it has obviously become primarily a put option on the stock and bond markets, a subset of the economy. These interventions are far from the original “Lender of Last Resort” function envisioned in 1913, though the Fed has for a long while been active in hedging interventions in the Treasury markets to maintain stability there. The resultant asset price inflation of Fed intervention has many economic consequences covered up by inaccurately reported economic metrics. 

The stock markets are supposedly at a level that reflects strong corporate profit growth, but the data suggests that corporate profits plateaued in 2015 yet the S&P 500 has continued to increase substantially. Financial engineering and Fed easing have propelled equity and corporate bond markets to new highs. 




Recently bond king Jeff Gundlach and economist David Rosenberg gave excellent interviews [4,5] touching upon some of the issues I discuss in this article. I leave the reader with final charts and a set of quotes from Gundlach and Rosenberg. 

Happy New Decade 2020-2029. 

                 ~~~~ * ~~~~






Quotes from Gundlach:

“Powell [Fed chair] said in late October [2019] that they’d have to see a significant rise in inflation that is persistent to even consider raising interest rates to fight inflation…so the Fed wants inflation to be higher, and they’ve contextualized this by saying 2% was our target for many years and we fell short, so now we need to “fill the gap” which makes no sense to me. I think it’s cover for wanting interest rates to be below the inflation rate, which seems to be the game plan for central banks in developed countries around the world, so now we have the 10 year Treasury yield below the inflation rate, the CPI is up at 2%, the core CPI higher than 2% and interest rates are kept below that. The Fed knows that we have a debt problem in the United States and to push out the day of reckoning into the future is to have interest rates below the inflation rate. Negative interest rates in the U.S. would really be a problem for the global financial markets. In the next recession, left alone to market forces, long-term interest rates would probably rise. Powell has told us that he will control long term interest rates to fight the next recession through quantitative easing.”

“The overnight Repo market had been struggling to stay in line with the Fed Funds Rate, until it blew out on September 17 [16]…That suggests that the market doesn’t ratify the Fed Funds Rate. The Fed has the FFR at a level that isn’t clearing the market in a free market way for overnight money…they are adding reserves to try to counteract that.”

“In the next recession the amount of bonds that would be issued at the long end would be so horrifically high that I think interest rates in a normal free market clearing mechanism would rise, and they’d rise fairly significantly, and that’s what the Repo market is kind of telling us. On September 17, overnight money was over 2% and the 10-year Treasury was below 2%. It is really telling that you can’t find buyers for overnight money in excess of 2% and yet the 10-year Treasury is below 2% with inflation at or above 2%. That tells you that the interest rate levels being maintained by the Fed are really not market levels, they are manipulated levels. The national debt is growing at over 6% of the economy, $1.27T is the growth in nominal dollars of the national debt which is greater than the growth in the economy.”

“Credit risk is very dangerous. Time to be exiting the corporate bond market is presently…it is enormously bigger than it was prior to the global financial crisis $5T vs. $11T…it is misrated…39% of the corporate bond market should be rated junk…net debt to EBITDA is at all-time record highs…spreads are very narrow by historical standards…foreign buyers are driving up this market chasing yield, not hedging their bets in USD terms…the USD Index should be falling…the USD has held up due to this naked buying…waves of selling in this market will put serious pressure on the USD and tremendous losses in the corporate bond market.” 

“One of the reasons the stock market has gone up substantially is that when you cut taxes you turbocharge the bottom line, profits go up.”

“Foreign currency investments should top USD investments.”

“JPY (1980-89)…EUR (1990-99)…EM (2000-2009)…USD (2010-2019)…my view is that pattern will repeat…the USD will be weaker because of exploding deficits.”

“MBS are relatively cheap compared to Corp Debt…Mortgages have lagged due to prepayment rates…Much more concerned about the over-indebtedness in the Corp Bond markets.”

Quotes from Rosenberg:

“That liquidity injection that’s ongoing, that’s actually QE4, has caused the money supply numbers to go gangbusters, at a time when business credit is actually contracting…that excess liquidity hasn’t found its way into the real economy, it has found its way into risk assets…in the last three months we’ve had this run-up in risk assets that’s had nothing at all to do with the fundamentals despite what the gurus are telling you.”

“This is the weakest corporate spending cycle of all time in the context of the strongest corporate bond issuance…so where has the money gone? Two words: Financial Engineering, stock buybacks, and that explains why the EPS have been inflated, and that’s why we’ve had this very ongoing bull market in equity, in the context of the weakest economic recovery of all time.”

“We’re about to have back-to-back quarters of negative productivity growth in the U.S. so I’m looking for the employment numbers to soften up [in Q1 2020].”

“The U.S. Household Debt/Income Ratio is the highest it has ever been since 2007.”


REFERENCES

[2] “The Fed’s Inflation Target: Why 2 Percent?” January 2019, https://www.stlouisfed.org/open-vault/2019/january/fed-inflation-target-2-percent
[4] CNBC’s Full Interview with DoubleLine Capital CEO Jeff Gundlach, https://www.cnbc.com/video/2019/12/11/watch-cnbcs-full-interview-with-jeffrey-gundlach.html
[5] CNBC and Bloomberg interviews with David Rosenberg, December 2019. Bloomberg: https://www.youtube.com/watch?v=u5aIvU_bmrs.


Inflation, Unemployment, GDP and USD Index Statistics: What can we really believe?

In the next article, “QE4, Repo, Inflation, Debt”, I argue that key measures for inflation, unemployment, GDP and the US Dollar (USD) Index that the government reports and the Federal Reserve (Fed) closely watches are either understated (inflation, unemployment) or overstated (GDP, USD Index), and by a significant amount. Here I discuss in detail the alternate measures that are reported by “Shadow Government Statistics” (SGS), a long-time reputable source for alternate government statistics. I also provide some additional data reported by the U.S. government in each category. 

INFLATION

SGS has an alternate inflation measure that runs some 4% above the currently reported official CPI, and almost 4.5% above the Fed’s tracked core PCE for inflation targeting. The SGS measure diverged from the official government measure in 1983 when the Labor Dept. changed its methodology of reporting, and since 1990 substantially. Basically, the official CPI no longer measures the cost of maintaining a constant standard of living or full inflation for out-of-pocket expenditures. SGS has written a succinct account of these methodology changes and differences [1]. The bottom line is that wage inflation has been far outpaced by real inflation for costs of living and out-of-pocket expenditures. 

It doesn’t take much to look for significant inflation for critical cost of living expenditures, in particular the rise in rents. Housing prices have also risen substantially, forcing those who cannot buy and finance a home to rent, even though mortgage rates are at a secular low. A major contributor to these sharp housing price/cost increases over the last decade arise from sharply rising construction costs. Refer to the attached compiled chart from FRED showing the Case-Shiller Index vs. the official reported CPI for Rents, and the PPI for Construction for new residential homes and building materials from the BLS. The recent high numbers for YoY increases in building costs and new residential home construction are ~8% and 6% respectively. These numbers are probably understated, looking at the reported PPI index value growth over the decade. Even in my local area planners are quoting a whopping 70% increase in building costs over the same period, a real problem for localities with a short supply of rental properties, driving up rental costs substantially and making it difficult for builders to commit to building low income housing. The PCE for Healthcare and Durable Goods reported by BEA has increased to nearly a 5% annual rate, and that is likely understated. 

Given a more realistic inflation rate of 5.7% the Fed should surely be raising its Fed Funds Rate, right? Probably, but with rapidly increasing debt it has chosen not to, using a faux core PCE of 1.6% as its inflation target and stating that inflation is not an issue. 

Cost transparency is critical to gauging price stability. Sharply rising building costs and rising healthcare costs do have supply/demand contributors beyond monetary inflation, but the supply of cheap money has substantially driven up asset prices in certain speculative categories, namely real estate and healthcare. Separating the other contributors out from monetary inflation/risk asset price inflation is difficult but I argue it must be done and all of these cost factors addressed in a transparent set of inflation and cost metrics. Only then can real pressure be put on the Fed and government policy makers for a change. 










UNEMPLOYMENT

The SGS alternate unemployment numbers are probably the most alarmingly divergent metrics from official government reported statistics: 21.5% vs. 3.5% for U3 and 7.5% for U6. Once again, the SGS measure diverged from the government measure when the Labor department changed its methodology by dropping long-term discouraged workers from the U6 measure in 1994, and apparently there are many long-term discouraged workers out there that are unemployed (at least 14%). Where did they go and how do they subsist? Those that can not subsist on savings or the income of a family member are on public assistance or disability. The structural problems in the labor market that contribute to the number of long-term discouraged workers have only become more pernicious. They relate to the drops in productivity, industrial production, manufacturing, and an increasingly negative balance of trade (current balance). Skills gaps are certainly an issue, one business leaders complain about but do little to solve for this group, and any other employment group that might be productively employed in a skilled job. 

So why have long-term discouraged workers been “defined out of existence” as SGS succinctly puts it? Answer: It is politically expedient for both politicians and business leaders. Training costs money that hits the business bottom line and profits, and politicians gain from increasing welfare rolls. The long-term cost to our economy of this ignorance is much higher public debt and a waste of human resources, not to mention an unethical disregard for telling the truth about the real employment situation while taking a stage bow and victory lap for a ridiculous 3.5% number. It will only get worse unless the structural issues are fixed. 








GDP

The SGS alternate real GDP is some 4% below the Bureau of Economic Analysis (BEA) reported official real GDP in YoY terms watched by the Fed. The difference stems from adjusting the reported nominal GDP with an alternate measure of inflation that better reflects cost increases that were removed from inflation measures in the 1980s and 1990s, in particular from the PCE deflator, a woefully understated metric reported by the BEA, and used to calculate the reported real GDP. Additionally, the methodology for calculating the GDP was intentionally changed by the Commerce Department/BEA in March-July 2013 that “expanded” the reported gross investment (I) of the GDP (GDP=C+I+G+(X-M)), resulting in an increase to GDP of some 2.5-3%+ ($500B in 2017). Added to gross investment were R&D spending, and royalties/spending for film, music, books, art and theatre (from the BEA [3]: “Private fixed investment in R&D, entertainment, literary, and artistic originals”). Additional changes were made to the GDP calculation methodology in mid-2015 and in 2018 [4], primarily seasonal adjustments for defense spending that smooth out GDP from showing negative growth in certain quarters. 

Basically, between an understated PCE deflator, overstated additions to private fixed investment, and smoothing tricks for defense spending, we now have a reported headline real GDP that avoids any official indication of a recession. How is that useful? It’s politically motivated and it helps policy makers avoid addressing tough systemic problems. It probably also avoids scaring equity and bond markets into difficult volatility. 

Despite these numerous changes over the last 7 years, plus historic easing by the Fed and a marked rise in government spending, we still have rather anemic reported real GDP, <=2%. In reality, looking at the unmodified SGS GDP, we have been in recession for nearly 16 years. 






US DOLLAR INDEX

A strong US dollar is important for purchasing power and reserve currency status. The market US Dollar index DXY and the broader government reported trade-weighted US dollar index have been hovering around a local high since early 2015, likely in anticipation of better economic conditions in the US and a relative reduction of Fed easing. Reception of a strong dollar is mixed – US buyers purchasing imported items generally favor a strong dollar, but sellers (exporters) and multinational corporations generally benefit from a weaker dollar, or they must hedge the dollar in some way. “Beggar thy Neighbor” is an old term used to describe the international race of currencies to the bottom, through currency weakening tactics. Recently, the Fed has not intervened in an overtly major way to influence the dollar, as other central banks have done for their respective currencies. This may change as trade conditions and deals evolve between government “brokers” – the US government executive brokers are already clamoring for a weaker dollar to compete with other major trading partners that have an overtly active hand in weakening their currencies. In the past at various points, intervention to weaken the dollar has happened – serious dips in the U.S. dollar index reflect some amount of intervention contributing to the weakening, primarily of a monetary easing nature. 

The US dollar index DXY is a market index measure of the value of the US dollar relative to a basket of foreign currencies, and is maintained and published by the Intercontinental Exchange (ICE). The data series extends back to March 1973, where it was defined at Index=100, but with backdating to January 1971 (before Bretton Woods!). This index has been a stable measure of the US dollar value relative to the Yen, GBP, Canadian dollar, Swedish krona, Swiss franc and other European currencies that got rolled into the Euro in 1999, the only time this series has been altered. The index measure clearly shows periods of sustained weakness in the US dollar that resulted from monetary easing intervention. 

An alternate measure that is reported by the Federal Reserve Board (FRB)/FRED is the trade-weighted US dollar index, “a weighted average of the foreign exchange value of the US dollar against the currencies of a broad group of major U.S. trading partners. Broad currency index includes the Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile and Colombia… Series is price adjusted.” Wikipedia defines this index as “a trade weighted index that improves on the older U.S. Dollar Index by using more currencies and the updating the weights yearly (rather than never). The base index value is 100 in Jan 1997.” I attach a comparison chart of the historic US dollar DXY with the revised FRB trade-weighted US dollar index in the attached graph, with my annotations. I hold back no punches. The FRB attempted to show that the USD index was stronger than the historic DXY, but both show systemic problems with currency manipulation, fiscal instability and economic weakness. 

Another alternate measure of the US dollar index is calculated by SGS as the Financial-weighted dollar index, defined as “a composite value of the foreign-exchange-weighted U.S. dollar, weighted by the proportionate trading volume of the USD versus the six highest volume currencies: EUR, JPY, GBP, CHF, AUD, CAD.” SGS publishes a comparison between the FRB trade-weighted US dollar index and its own SGS Financial-weighted US dollar index, and it shows a 7-10 point difference that indicates that the FRB index is understated as the so-much-better broader index defined in the 1990s to fix the original unaltered DXY series. SGS indicates that this difference stems from the FRB application of the “USD weighted by respective merchandise trade volume against the same currencies.” 







REFERENCES

[1] “Public Comment on Inflation Measurement and the Chained CPI,” April 2013, http://www.shadowstats.com/article/no-438-public-comment-on-inflation-measurement.
[2] “Public Comment on Unemployment”, June 2016, http://www.shadowstats.com/article/c810x.pdf.
[3] “Gross Domestic Product and Gross Domestic Income Revisions and Source Data,” https://apps.bea.gov/scb/pdf/2014/06%20June/0614_gross_domestic_product_and_gross_domestic_income.pdf; and “The Revisions to GDP, GDI, and Their Major Components,” https://apps.bea.gov/scb/pdf/2014/08%20August/0814_revisions_to_gdp_gdi_and_their_major_components.pdf
[4] “Updated Summary of NIPA Methodologies,” https://apps.bea.gov/scb/2018/11-november/1118-nipa-methodologies.htm


Global Debt Watch: $126.5 Trillion and Counting

Last time I tallied the global outstanding debt was in 2011 using 2010 data. At that point, the number stood at $95.5T. 

I recently updated this tally using mid-2019 data from the Bank of International Settlements (BIS), and the latest number stands at $126.5T, a 32%+ increase. U.S. debt outstanding is over 3x ($42.2T) the next highest debtor, now China, who surpassed Japan in the last two years. This follows significant growth in issuance of U.S. Treasury debt (funding an all-time high in the Federal public debt) and Corporate debt (fueling record levels in the corporate bond market), but also brisk growth in Mortgage and Household debt. China is dealing with its own issue of high debt levels amidst a slowing economy, and the Eurozone is struggling with wildly unpopular negative rates that do little to spur weak economies. 





In the next two articles I discuss the impact of this growing debt and the typical central bank response of greater easing, with a rather reckless disregard for the actual statistics that point to a 16+ year ongoing recession in the U.S. alone. 

“The US Federal debt is not like other debt” is an often-heard quote from those asked what the impact will be from growing U.S. public debt. Like ongoing Fed easing, growing debt has a serious consequence only to be revealed. 

I leave the reader with a set of charts that I prepared from the Federal Reserve Economic Data (FRED) database that specifically show various components of the growth in U.S. debt outstanding over the last several decades, and the trend in interest rates.