Friday, 9 July 2021

How far behind the curve is the Fed?

Over the last few months Treasury yields have dropped and retraced a large amount of the Q1 sell off.


Commodity prices have peaked, in my view, stimulus has or is peaking, and the usual suspect deflationists are calling for lower bond yields. 

Set against this is the ongoing economic recovery and, in my experience, without a massive unexpected shock and with the ongoing fiscal and monetary stimulus, its hard to see why the US economy would relapse into a recession and deflation. 

The fact that the US Current Account has widened suggests that there is ongoing excess demand in the economy.

Instead, the drop in US 10yr yields since March is probably more down to the combination of a normal consolidation phase following a large move and then some short term supply/ demand technicals, concentrated positioning, stop losses and regulated buyers vs the fact that the 10yr-plus part of the Treasury market is a relatively small amount of the outstanding, with 10-30 year bonds being about 20% of new Treasury issuance.

Instead we are likely to see a normal reflationary cycle of unemployment falling, capex rising/ service industry job creation, wages rising and ultimately a hiking cycle followed by a recession. 

So where are we in this cycle? 

The Fed today published its monetary policy report. Their ongoing conviction is that yes the economy needs more support in the form of ZIRP and continuing QE and that they are not ready to commit to tapering, but might be later in the year. In fact, over half of the FOMC participants expect Fed funds to have zero to two hikes by the end of 2023 with 5 of those expecting zero hikes! 



Unfortunately for them, the strong recovery in the US economy has now led the number of job openings to be larger than the number of U3 unemployed.

The last and only time this has happened before was in early 2018 when Trump was stimulating the late cycle economy and the Fed was half way through their hiking cycle. US 10yr Treasuries were yielding around 2.4-2.5% and fed funds were at 1.4%. 


So even by the Fed's own track record in the most recent cycle, they are far behind the curve, their projections are absurd and the excess stimulus and Fed balance sheet growth is causing many asset bubbles to extend. 

The excess balance sheet growth in the last cycle never really led to a wage-price inflation spiral. So the Fed never got trapped with a large balance sheet leading to excess reserves in the system that then lead to credit growth and rising monetary velocity. 

When asked about when the Fed would unwind its balance sheet, Bill Gross famously quipped 'never'. And for the most part he was right. 


In this cycle however the starting point is with over 3% wage growth whereas in 2009 it was well under 2%. In the last cycle job switcher wage growth almost hit 5% before the recession. 


In this cycle, given we already have more job ads than employable unemployed, most probably wage growth will exceed 5%.

If that combines with credit growth and a weak Dollar then the Fed will be forced to act much earlier than expected. 

Dec 2022 and Dec 2023 Eurodollar futures have diverged this year but Dec 2023 is only pricing in 3-4 hikes and Dec 22 only 2.

 


As mentioend above the last time the employment market was this strong the Fed was already at 1.40% in early 2018 and by year end had hiked to 2.4%. That sent the 10yr from 2.4% in early 2018 to 3.2% by year end, the cycle high, as in 2019 the economy slowed and manufacturing went into recession.

Fed funds rate:



So if wage inflation starts to rise and point towards higher inflation going into 2022 the Fed will be under immense pressure to speed up policy normalization and hike rates.







Wednesday, 24 March 2021

Inflation? What inflation?

I had a break from posting, partly due to other commitments and partly as I had similar views as what the market was doing, namely looking for a liquidity fueled recovery. 

I did expect a correction in the summer or Autumn, particularly into the Corona re-outbreaks and US election, but in the end the power of stimulus was too much and it was more of a temporary sideways move. 

So in a world of ZIRP, QE, unprecedented fiscal deficits, modest curve steepness, sky high asset values, what can derail this?

We hear a lot about inflation and the impending USD collapse, but the USD has risen this year against the majors on the yield differentials. 

 

Modern inflation

Under the gold standard, with mostly industrial economies, inflation was certainly a monetary phenomenon and the gold standard prevented it. 

As we have moved towards a services economy with open goods trade and a fiat monetary system where credit, the financial system and the money supply can grow faster than the real economy for long periods, there has become really two forms of inflation; firstly money supply/ credit/ financial economy growth and secondly skilled wages.

QE and base money creation cause, by the portfolio channel effect, asset price inflation as investors seek higher returns than available in fixed income. To the extent that, with fiscal stimulus, delivers a recovery then broad credit/ M4 growth also happens. So you have credit supply and asset inflation underwritten by QE/ ZIRP/ fiscal stimulus. I think ZIRP/ QE is most relevant for financial assets while fiscal stimulus is most important for the real economy cycle. 

As Steve Keen has shown, in a financialised economy, private sector credit going from growth to contraction causes a final demand shock and that can lead to a deeper real economy recession and a credit crisis in the financial economy. So governments have stepped into the Covid crisis with unprecedented fiscal stimulus to support final demand. 

This demand support combined with supply chain issues had pushed up commodity prices. However rising or falling commodity prices, while they impact CPI, are really just a relative pricing power shift between goods producers.

So when people predict inflation from QE/ fiscal deficits, is it showing up in credit or the money supply?

The Fed's H8 survey suggests not, while Treasury supply is growing, large parts of private sector credit is contracting and overall bank credit is growing ~6%. So while the inflation has shown up in asset prices, there is no sign of it creating inflation in the real economy. 


 

The Fed's recent projections forecast a 6.5% GDP growth this year on a $21Tn Q4-20 economy, while bank credit is growing about 6% on a $15.6Tn banking balance sheet. So bank credit is currently growing at a disinflationary pace vs the economy. Mainly due to private sector deleveraging. I dont think non-bank credit will be doing much differently given the broad deleveraging by private borrowers. 

Q2 inflation outlook

The Fed is expecting YoY inflation numbers to peak in Q2, which is when the difference in commodity prices will be highest and there will likely still be some supply chain disruptions for goods. I agree and also expect inflation to drop back in the second half. 

The NY Fed UIG inflation prices only metric is at 2.3% and looks to be rising, while CPI is only 1.7%. If you look, CPI ranges and mean reverts around the red coloured UIG prices measure, so should overtake and overshoot to the upside, maybe 2.5-2.7% in Q2 or early summer. The Atlanta Fed's 1yr forward inflation expectation is rising strongly to 2.4%.  





Treasury yields should peak a month or two before all of this, so likely April or May in an upside squeeze. 

The recent topping in oil and renewed real estate foreclosures and rising mortgage yields should also soften owner equivalent rent and normalising supply chains should take the edge off goods price inflation. Service inflation has been sticky at a little under 2%. 

So I think 1.95-2.05% on the 10yr TSY is a reasonable target. It would give almost 200 bps steepness for the 10yr-2yr TSY spread, which is more or less as high as curve steepness gets in recent initial recovery phases before the spread moves into a range. 

 



After that I would expect some of these inflationary pressures to drop and TSY yields should also drop back to maybe 1.40-1.50% on the 10yr and the weak USD/ commodity reflation/ EM reflation trade should be back on. 

Service wages

However, if monetary inflation is not an issue, perhaps later this year going into next year skilled service wages will be. In most recessions wage inflation has reduced by about 2%:


But in this recession it has hardly moved and most of the job losses have been lower skilled jobs. 


Skilled worker employment is only down 2-3% YoY now while lower skilled it is more like 4-5%. The JOLTs job survey is also showing strong job growth, so over this year a lot of the employment slack should go and we get a tight market for skilled jobs. 

In fact the Atlanta Fed's job switcher wage inflation metric which peaked at 4.3% has hardly moved down this time. The last two recessions it dropped 3%.


To going into next year if job switcher wages are growing 4.5% or maybe more, the pace of the recovery is slowing, service inflation is picking up, maybe 10yr yields go for 2.5-3% with the market looking for a hiking cycle starting in mid-22. 

If this is coinciding with fiscal deficit reduction, while equities are likely to rally as the USD weakens in H2, maybe in 2022 if margins come under pressure, the outlook will be for lower equity valuations.

In the end it will be skilled wage inflation that will force the Fed to hike and tighten financial conditions and this wage pressure leading to hike pressure will only end with a genuine labour market recession.