Monday, February 8, 2016

We need another round of QE

I've long argued that the Fed's three Quantitative Easing episodes were never really about "stimulus." Instead, I thought QE was the correct response to a surge in the world's demand for money, money equivalents, and safe, risk-free assets that followed in the wake of the financial crisis of 2008. In recent months I have argued that the Fed was justified in raising short-term interest rates, because the world's demand for money and safety appeared to be slowly declining.

Unfortunately, it looks like both I and the Fed have been wrong of late. I'm not sure what the exact underlying cause of the latest "panic attack" to hit the markets is, but signs point to 1) the ongoing slowdown in the Chinese economy, 2) the collapse of oil prices, 3) rising geopolitical tensions in the Middle East, and 4) a sense that policymakers are clueless. In this latter category we have the rise of Bernie Sanders and Donald Trump, and the apparent tone-deafness to all these problems on the part of the Fed, as reasons for investors to worry about the future economic and policy direction of the U.S. economy. At a time when major economies appear to be wallowing in turbulent seas, it's terrifying to think that the ships' captains might be clueless.

Many commentators have argued that we're also in trouble because central banks are "out of ammunition" since rates are at or near zero. Those who believe this were cheered when the Bank of Japan announced negative interest rates.

However, I think that's the wrong way to think about monetary policy, because it assumes that moving rates up or down is a way of slowing down or goosing economic activity, respectively. As we've seen, central bank purchases haven't had the intended effect on interest rates, and they have not resulted in any meaningful stimulus to any economy. It bears repeating that monetary policy cannot create growth out of thin air: growth only happens when productivity rises, and productivity rises only as a result of more work and more investment. Fiscal policy needs to focus on increasing the rewards to risk and investment; lower interest rates are not the cure-all for chronically weak economies.

Trying to manipulate interest rates hasn't helped, but the Fed's provision of additional reserves to the banking system via QE has addressed liquidity issues and systemic risk issues. U.S. banks have effectively invested $4 trillion in deposit inflows into bank reserves, bolstering their balance sheets in the process. More QE purchases can be a good thing, especially in times like these when markets are very nervous, because the demand for money and safe assets has increased meaningfully. What's needed now is not lower interest rates, but more T-bills (aka bank reserves in an IOR regime).

Things began to heat up beginning right around the end of last year. Since then—just over 5 weeks ago—gold is up some $130, HY spreads are up 150 bps (led by HY energy spreads which have spiked to 1850 bps), crude oil is down 20%, 10-yr Treasury yields have dropped 55 bps, real yields on 5-yr TIPS are down 30 bps, and global equity markets are down 10-20%.

The chart above shows the total of retail money market funds, one of the components of M2. After declining for years, it has spiked by over $100 billion in the past few weeks. Thanks to the fact that the Fed is paying interest on bank reserves—which has been extended, via reverse repo agreements, to non-major banks and other financial institutions—money market funds now pay some interest whereas before they paid almost nothing. That may be the reason for the huge increase in demand for these funds, but it may also be that a lot of money is fleeing China and Europe and these funds look like easy-to-get, attractive safe havens.

The chart above shows required reserves (reserves that the Fed requires banks to have to collateralize their deposits). This component of the monetary base has soared at an annualized rate of 350% in just the past month!  It also explains why the much broader measure of money supply, M2, is up at an annualized rate of 15% in the past month, after growing for 6-7% per year for the past several years.

When the world rushes for the risk exits and into the welcoming arms of banks and money market funds, central banks need to respond by increasing the supply of money. If the Fed doesn't accommodate increased money demand with increased money supply, that can lead to deflation and other sorts of nasty consequences.

Fortunately there are some offsetting factors which today make the situation less than critical. Total Bank Credit (now $11.8 trillion) is rising at a relatively strong clip (8-10%) in recent months, and Commercial & Industrial Loans (now over $2 trillion) are rising at double-digit rates. Oil prices are still weak, but the CRB Raw Industrial commodity index (no energy included) is up over 6% in the past few months. Meanwhile, the dollar has declined because the world figures that the likelihood of further Fed rate hikes has gone down dramatically—and a weaker dollar should provide good support for all commodity prices.

Still, it would be very helpful if the Fed were to make it clear that at the very least, rate hikes are off the table for the foreseeable future and that it probably makes sense to fire up another round of QE. Adding more risk-free money to the system at a time when risk aversion has spiked is just what the monetary doctor would order.

The chart above tells the big-picture story of money demand: the ratio of M2 to nominal GDP. Think of this as being roughly equivalent to the percentage of the average person's annual income that is held in liquid form (cash, savings accounts, checking accounts, money market funds). I've been expecting this ratio to top out for the past several years, but it just keeps growing. The world just keeps stockpiling cash and cash equivalents for a variety of reasons, with fear and uncertainty likely topping the list. People want to hold more and more money, even though it pays a paltry rate of interest. We won't be out of the "fear" woods until this ratio stops rising and starts declining.

The chart above tells the story of the Fed's three rounds of Quantitative Easing. The Fed always told us that the purpose of massive purchases of notes and bonds was to depress interest rates, which in turn was supposed to stimulate borrowing and thus boost the economy. But that's not what happened. Note that during each period of QE (green bars), interest rates actually rose. I think that was because the bond purchases—which effectively transmogrified notes and bonds into T-bill equivalents—was just what the world needed. QE satisfied the world's demand for safe assets, and that lubricated the wheels of finance; rates rose because risk aversion declined and the market felt more comfortable about future growth prospects. But after QE1 and QE2 were discontinued, yields plunged, which was a sign that the Fed hadn't done enough, and/or had ended its QE purchases prematurely. Recall that the periods between QE1, QE2 and QE3 were dominated by the emerging PIIGS crisis in the Eurozone. There was a lot of panic in Europe and a lot of money that fled to the U.S. as a consequence. Each time the Fed started a new QE program, markets breathed a sigh of relief and interest rates rose as a result.

Note that interest rates were relatively stable following the end of QE3. Until recently, that is. I think the recent decline in yields on 10-yr Treasuries is the market's way of saying "Help!" to the Fed. We can only hope that Janet Yellen and her fellow Fed board members hear this and respond before too much time goes by.

I've been showing the chart above for a number of years, since it helps to visualize the market's demand for safe assets (and by inference, the market's level of FUD). The red line is the price of gold, while the blue line is a proxy for the price of 5-yr TIPS (I use the inverse of the real yield on TIPS as a proxy for their price). Demand for safe assets has been declining ever since the PIIGS crisis was resolved in 2012, but it has jumped since the end of last year (i.e., the price of gold and TIPS has jumped). The jump is significant, but it's still relatively tame compared to what we saw back in the 2010-2012 period.

The chart above is also helpful, since 2-yr swap spreads are a good proxy for financial market liquidity and systemic risk. As two wrenching episodes of the PIIGS crisis unfolded in 2010 and 2012, swap spreads soared, especially in the Eurozone. Fortunately, today swap spreads are well-behaved, and that suggests that systemic risk is low and liquidity conditions are still healthy.

With a some more QE help from the Fed and some more time for markets to adjust, there's reason to think we can survive the current crisis.

Thursday, February 4, 2016

Productivity is the missing ingredient

We've know for years that this recovery is the weakest post-war recovery on record, and the chart above makes the case. If this had been a typical recovery, national income (GDP) would be about $2.8 trillion higher than it is today. That's like saying that average wages and salaries would be 17% higher. For a family earning $60,000, that's over $10,000 more income per year that has failed to materialize despite all their hard efforts.

What's been lacking is productivity (the additional output that each unit of labor produces), because productivity is the key to rising prosperity. We can only earn more if we work and produce more. We've had about the same rate of jobs growth during this recovery as we had in the 2001-2007 recovery, but GDP growth has been much weaker. The reason? Very low productivity growth, as seen in the chart above. I use a 2-yr rolling annualized growth rate to measure productivity, since it is quite volatile on a quarter-to-quarter basis. Over a 2-year period I think the quarterly volatility tends to wash out and a truer picture is revealed. Note that the productivity readings we've had in the past several years have always been associated in the past with recessions. It's no wonder that everyone keeps complaining about the economy. It's as if we've been living in recessionary conditions even though things have been slowly improving. Put another way, we've had to work unusually hard just to enjoy very modest improvements in our standard of living. 

The chart above uses the same data, but instead of a two-year rolling period, it uses a 5-yr rolling period. This, I believe, captures the effect of policies put in place by different presidential administrations. It can take years for policies to be put into effect and then have an impact on the economy, and good policies can have effects that last even after they have been reversed.

The colored bars correspond to different presidential terms, with the red bars reflecting a sustained period of declining productivity growth and the green bars a sustained period of very strong and/or rising productivity growth. I would be quick to note that Republican administrations have yielded three periods of declining productivity (Eisenhower, Nixon, and Bush II), while Democratic administrations have only yielded two periods of declining productivity (Carter and Obama). No political party can lay a claim to implementing policies that consistently lead to sustained rises in prosperity.

One thing that stands out is that the Obama years have seen productivity growth that rivals the malaise that characterized the Carter administration. For the five-year period ending last December, non-farm productivity rose at a miserably slow 0.3% annualized rate. In all of post-war history, only the five-year period ending in mid-1982 was worse (small footnote: Reagan's tax cuts did not take effect for almost two years, so his faulty implementation of tax cuts only served to prolong the declining productivity of the Carter years).

There are many factors that contribute to the slow growth of productivity, such as rising regulatory burdens that increase the cost of economic activity, high marginal tax rates that reduce the incentive to work and invest and take risk, and transfer payments that create a culture of dependency and a reluctance to seek out work.

The charts above show that a significant increase in transfer payments (money the government gives to people for a variety of reasons) beginning in late 2008 corresponded to the beginnings of a significant decline in the labor force participation rate. Many millions of workers have left the workforce, and it could be due at least in part to the fact that the benefits that accrue to those not working (e.g., food stamps, disability payments, welfare, earned income credits, assistance to single-parent families) are greater than the net benefits of working, especially on an after-tax basis. Transfer payments now equal almost 20% of disposable income, and that is a big number that currently totals $2.7 trillion and consumes fully 72.5% of all federal government spending. Yikes! Maybe it's simply the case that our government has grown to the point where it is now suffocating the private sector. Too few people are working and too many are on the receiving end of federal largesse. And for those who are still working, the burden of complying with regulations and the burden of taxes is simply inhibiting their ability to work and invest more.

We are not going to see significant improvement in productivity and living standards unless and until we adopt policies that are more conducive to work, investment, and risk-taking. It's that simple. Unfortunately, the proposals being discussed on the left (e.g., Sanders and Clinton) are only going to exacerbate the current situation. Can the right produce a candidate capable of winning and turning the policy ship around? That is the key question this year.

Tuesday, February 2, 2016

Are commodities bottoming out?

The world is still obsessed with the prospect of Chinese weakness, Fed tightening, collapsing commodity prices and super-low oil prices, all of which might—or so the thinking goes—tip us into a deflationary downward spiral. When a narrative such as this becomes so widespread, it's easy to miss important clues to the contrary. I note here a few contra-indicators which bear watching:

The first chart above shows a short-term view of the CRB Raw Industrials commodity index, while the second gives you the long-term view of the same index. This index is composed of some pretty mundane commodities (hides, tallow, copper scrap, lead scrap, steel scrap, since, tin, burlap, cotton, print cloth, wool tops, rosin, rubbers), most of which do not have associated futures contracts and are therefore relatively immune to speculative forces and thus more likely to reflect the changing balance between supply and demand. Since late November, the index is up more than 5%—after tumbling more than one-third from its early-2011 high. As the second chart shows, the plunge in recent years is similar—if not greater—in magnitude to other plunges, all of which were followed by reversals to the upside. Maybe the Great Commodity Price Collapse has come to an end?

As the chart above suggests. Commodities have a strong tendency to move inversely to the dollar's value vis a vis other currencies (note that the y-axis for the dollar is inverted). It might be the case that the dollar is topping out here, just as commodity prices bottom out. [Update: the original chart was mislabeled, now corrected with data as of Feb 3]

This index (see chart above) of the dollar's value against a small basket of major currencies shows that the dollar has been flat for almost a year, another indication the dollar is topping out.

What could be the impetus for the dollar to stop rising? Simple: the perception that the U.S. economy is weak and that therefore the Fed is unlikely to raise rates aggressively. Indeed, I think that process is already underway. Since June of last year, March '18 Eurodollar futures (tied to 3-mo. Libor) have fallen from 2.4% to 1.2%. The market was expecting at least four tightenings by the Fed and now it is only expecting two more over the next two years. With the greatly-reduced prospect of higher short-term rates (and less-than-previously-expected Fed tightening), the dollar is losing some of its appeal.

So, whatever it is that is slowing down the U.S. economy is also reducing the appeal of the dollar, and that in turn is helping to put a floor under commodity prices. And the end of declining commodity prices—particularly if this includes oil—should help alleviate fears of a deflationary death spiral. Markets have a way of resolving things if left to their own devices.

This is not a call for shorting the dollar or going long commodities. It should be taken more as a note of caution that the prevailing wisdom may be getting long in the tooth, and changes may be waiting in the wings.

UPDATE (Feb 3): Well, this change seems to be unfolding all of a sudden. The market senses that the economy is weak, and that therefore the Fed is unlikely to raise rates aggressively. That directly undermines the value of the dollar, which had been boosted by the perception that the US economy was doing much better than others, and that the Fed would be boosting rates. A weaker dollar (which  today is on track for its biggest drop in seven years) provides support to commodity prices, and that is showing up in a huge increase (7-8%) in oil prices today. The stock market is breathing a sigh of relief, as the threat of tight money recedes and higher oil prices reduce the risks of widespread bankruptcies in  the oil patch.