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.


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