Powell’s Pivot Isn’t About a Soft Landing (December 18, 2023)

Whether the Fed’s flip is about U.S. debt sustainability or something else, the upshot is inflation that remains stubborn and is likely resurgent 

By Lisa Beilfuss

The motivation behind Fed Chairman Jerome Powell’s apparent pivot, surprising both in its timing and aplomb, is unclear. What is clear: The central bank is effectively abandoning its 2% inflation target.

The ostensible rationale for Powell’s dovish turn–sticking a soft landing–is unconvincing because such an outcome would be fleeting at best. Whether the pivot is about systemic stress, U.S. debt sustainability, or plain election-year politics, investors should enjoy broad market gains for now. So too should they prepare for inflation that remains elevated and is potentially resurgent.

In a note to clients following Wednesday’s Fed policy meeting and Powell’s press conference, MUFG head of U.S. macro strategy George Goncalves addressed the elephant in the room: “Do they know something that we do not know?” It is an obvious question given Fedspeak and upside economic data leading up to the latest decision. What is more, U.S. financial conditions are the most accommodative since the Fed started lifting rates last year, according to the Bloomberg U.S. Financial Conditions index, and Powell seemed unbothered by the effective unwinding of his tightening campaign. 

First the good news. Policy accommodation tends to lift most boats, says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. At least in the short term, she says equity returns are apt to broaden as the Fed’s pivot supports a material rotation away from mega-cap secular growth stocks to cyclical and value-style names and large- and small and mid-cap stocks.The U.S. dollar’s decline meanwhile supports a resurgence of non-U.S. stocks, especially in emerging markets, while falling rates sustain bonds of all stripes, Shalett says.

There is more good news, depending on how one sees it. Pimco economists Tiffany Wilding and Allison Boxer say an analysis of 140 central bank rate-cutting cycles across 14 developed markets from the 1960s to today shows that central banks tend to cut more aggressively than markets initially expect. That partly reflects the difficulty forecasters have in anticipating recessions–and the tendency of central banks to not cut until they are confident the economy has entered recession.

Even in the handful of instances central banks have cut absent recession, they still delivered an average 200 basis points of cuts in the first year, Wilding and Boxer say. That is twice the pace of cuts signaled in the Fed’s latest Summary of Economic Projections, meaning market expectations for six cuts next year may not be unreasonable.

But, as Shalett warns, “euphoria feels good in the moment but may come at a price.” The price, of course, is higher prices. 

Consider the so-called supercore measure of inflation emphasized by Powell himself. The metric excludes rental and owner-occupied housing, and it is stuck around 4%--double the Fed’s annual target. The Fed has suggested wages are behind the hot supercore readings and that the threat is over because immigration is boosting labor supply.

That optimism seems misplaced. Average hourly earnings recently reaccelerated in November to a monthly pace of 0.4% and rose 4% from a year earlier. The Atlanta Fed’s wage-growth tracker rose 5.2% in the latest month, matching the previous gain, as pay for job switchers sped up to a 5.7% pace. The University of Michigan’s sentiment survey shows consumers see year-ahead inflation above 4%. 

That isn’t to mention the money supply. Despite the reversal in M2’s rate of growth, money supply in the system continues to run at roughly $3.5 to $4.0 trillion, implying inflationary threats, says Shalett. Nor is it to mention key long-term drivers of inflation–expectations, currency weakness and labor activism–what Vincent Deluard of StoneX says are all stronger than they were at the 2022 inflation peak.

Underpinning the idea that wage inflation isn’t over, Bleakley Financial Group chief investment officer Peter Boockvar points to ABM Industries, a large provider of services from janitorial work to landscape maintenance. On its earnings call last week, executives said labor-cost inflation would rise 4% to 5% in 2024. Connecting the dots between higher wages and higher overall consumer prices, ABM executives said they expect to recover two-thirds of their higher labor costs via price hikes. 

Given all that, the question from MUFG’s Goncalves–what does the Fed know that we don’t–seems more salient. There are several possible explanations for the Fed’s pivot. Here are two.

The first is that the Fed is worried about the availability of credit. A quick scan of Powell’s calendar shows a series of recent phone calls with bank CEOs, including Jamie Dimon of JP Morgan, James Gorman of Morgan Stanley, David Solomon of Goldman Sachs, Brian Moynihan of Bank of America, and John Turner of Regions Financial. 

A Fed chair speaking with bank CEOs isn’t unusual. But the timing and volume of the calls come as credit growth slows. Nancy Lazar of Piper Sandler notes that despite assumptions to the contrary, private credit growth isn’t offsetting weakening bank loan growth to support business spending.

More likely: Powell’s about face is about the struggles of Treasury Secretary Yellen and the conundrum of U.S. debt sustainability. Shalett notes that interest costs on the debt, now close to 125% of GDP, are on pace to approach 60% of discretionary spending by 2030. 

“We are concerned that the central bank may be going beyond its mandate in order to address U.S. debt sustainability and enable the Treasury to issue long bonds below 4%,” Shalett says, calling third-quarter Treasury issuance “disastrous” and noting that financing has since been dominated by bill issuance and largely funded by swelling money market funds. 

“That game has a short shelf life,” Shalett says. “This strategy—essentially echoing Modern Monetary Theory—may yet be long-run inflationary and extremely damaging to the U.S. dollar.”

The Fed’s recent pivot isn’t about executing a soft landing. Inflation data and inflation expectations across households and businesses don’t, at this point, allow for that to be a valid explanation. Whatever the true reason for the abrupt turn, investors should plan for a prolonged stretch of above-target inflation–even if recession unfolds.

The Silver Lining In a Rate-Cut Disappointment (December 11, 2023)

March is probably too soon to expect a rate cut. But economic cracks beneath the headlines suggest more intervention will be needed the longer the Fed pauses. 

Investors betting on March interest-rate cuts are probably on track for disappointment. It may be to their benefit.

Some recent pain points ebbed in the November employment report’s household survey: The historic gap in employment indicated by households versus businesses narrowed as household employment grew the most since January. Multiple job holders fell by 15,000 from October, when the metric was near record highs. And after rising to 3.9% and sparking concerns that the Sahm Rule was about to signal recession, the unemployment rate slipped to 3.7%.   

As David Rosenberg of Rosenberg Research summed it up, “the household survey really stole the show. The message is that the labor market tightened in November.” The bottom line, at least as far as the latest jobs report goes: The Federal Reserve will “think twice about cutting rates as early as the first quarter of next year,” Rosenberg says.

But there are at least two reasons to bet that the risk assets will rise in the coming months.

First, a deeper look at the latest employment data reveals an ongoing slowdown, with weakness in the most economically sensitive areas of the economy.  Second, the longer it takes for the Fed to cut rates, the more government intervention will be required.  

On the first point. Rosenberg argues that the establishment side of the November jobs report–where a 199,000 gain in nonfarm payrolls was the main takeaway–has less verve than headlines suggest. Consider downward revisions of 35,000 to the prior two months, a 49,000 increase in government jobs, a 99,000 rise in education and health-related jobs, and some 30,000 returning auto strikers.

Government, healthcare and education jobs “tell you nothing about the economy,” Rosenberg says, so he strips them out. He then adjusts for the last two months’ downward revisions, accounts for the returning UAW workers, and replaces the 40,000 surge in leisure and hospitality jobs with the 7,000 decline reported by payroll provider ADP.  

“It’s as if the payroll report showed a 61,000 decline,” he concludes, “which definitely is more in keeping with what business contacts were telling the Fed in the most recent Beige Book.” 

Whether or not one appreciates Rosenberg’s engineering, the bigger point is that the more cyclical parts of the economy look weak. Heading into the holiday season, retailers shed more than 38,000 jobs as transportation and warehousing employment fell 5,000. Banks cut 3,300 employees in November to mark the fifth straight month of shrinking payrolls. Temp agency employment–one of the few leading indicators in the monthly jobs report– fell by about 14,000 and has been flat or down for 10 consecutive months. 

Stephen Miran, co-founder of investment manager Amberwave Partners, says the job-market slowdown has momentum. He points to the Labor Markets Conditions Index, produced by the Kansas City Fed, which has been weakening all year. But while markets have interpreted labor-market cooling as indicative of normalization and a soft landing, Miran questions the logic. “Why [would] a weakening labor market just stop weakening?” 

That question is particularly important given that the labor-market slowdown is happening as inflation still looks stubborn. Deutsche Bank economists say their own monthly median inflation estimate rose 12 basis points in the latest month, to 3.6%. The November jobs report showed average hourly earnings rose 0.4% from a month earlier, the fastest pace since July. Wages rose 4% from a year earlier, matching the prior month’s increase. Fed Chairman Jerome Powell has suggested that wage inflation would need to slow to 3% for the Fed to achieve its 2% inflation target. 

As Miran puts it, the slowdown in the labor market “will require a pretty big shock to turn around.  The slowdown in inflation is brittle and will require only a small shock to turn around.”

Put it all together and it seems reasonable to suspect that while March may be too soon to cut rates because of inflation, economic conditions are nonetheless deteriorating. Therein lies a second reason why risk assets may continue to gain even if markets are overly optimistic about the timing of rate cuts. The longer the Fed pauses, the amount of fiscal and monetary intervention inevitably required will grow.  

There are signs already of fiscal support. This week’s Treasury sales are on track to surpass the record set in 2020. Joseph Wang calls fiscal deficit spending “the other printer,” because such spending creates a Treasury security that increases the purchasing power of the private sector. 

He explains it like this. When an investor buys a Treasury, the cash goes to the government to spend and ends up back in a private-sector account. Despite holding less cash, the investor can easily monetize the Treasury security by selling it in the Treasury cash market or borrowing against it in the Treasury repo market.  

Meanwhile, the Biden administration announced another $4.8 billion in student debt cancellation for 80,300 people, with student-debt forgiveness now totaling $132 billion and affecting roughly 3.6 million borrowers. That is alongside bipartisan legislation to promote homeownership for about 500,000 households via a new federal tax credit. Lael Brainard, director of the White House's National Economic Council and former Fed governor, suggested the administration may not wait for Congress to act to offer down-payment assistance and expand rental assistance to hundreds of thousands of people.

Then there is the Fed's Bank Term Funding Program, or BTFP, launched in the wake of March 2023 bank failures. The emergency program, which offers loans for up to a year to banks and other eligible institutions, has more than doubled from mid-March and sits at $121.7 billion. 

The BTFP seems all but guaranteed to be extended beyond its March 2024 expiration date. Analysts have debated whether it amounts to a form of quantitative easing. While the Fed isn't directly buying securities off banks' balance sheets, it is creating bank reserves. And because there aren't restrictions around the use of emergency funds, it can't be assumed that none of the new money flows out of bank reserves and into the real economy.

More important than the semantics around the BTFP is the idea that the Fed will revive old emergency programs and create new ones as trouble spots emerge, says one bank adviser and former regulator. “They will do whatever it takes,” he said, whether or not the Fed is concurrently cutting rates.

Investors may soon find they have gotten ahead of themselves about the timing of rate cuts. But there is a silver lining of sorts, with under-acknowledged economic cracks setting up the need for a stimulus wave that may benefit risk assets more than rate cuts themselves.

Economic Sentiment Probably Isn’t Disconnected from Reality (December 3, 2023)

Don’t like private sentiment surveys? Census pulse data are worth heeding.

There is a popular assumption that Americans’ economic sentiment is at odds with economic reality. But that logic may be backward–meaning consumer surveys might now warrant more investor attention, not less. 

Many economists say they are perplexed by sour sentiment reports alongside ongoing strength across several major economic indicators. The head scratching continued in the latest week: Third-quarter gross domestic product was revised upward, to a 5.2% annualized pace, from an already strong initial print. Retailers reported a record-setting start to the holiday shopping season, mortgage applications rose, and two measures of home prices increased. 

And yet the Conference Board’s consumer expectations index for the third straight month remained below the threshold that signals recession within the next 12 months. The report followed the University of Michigan's index of consumer sentiment, which fell for a fourth consecutive month and dropped 4% from the prior month alone.

There are several reasons why many economists and investors downplay consumer confidence surveys. Here are a few. What people say and do don’t always line up. Politics has historically affected consumer sentiment, and survey data show a clear gap in sentiment based on political affiliation that flips with the presidential party. The latter reason gives way to a newer justification for dismissing consumer sentiment: Americans simply don’t understand that they are better off now than before the pandemic, some economists and commentators say. 

As economist Claudia Sahm recently put it, “the wheels have come off the bus of the Michigan survey. This is not economics.” She argues that for most families, jobs, paychecks, spending, wealth, and financial security have made big gains that offset the burden of higher inflation. 

It seems a mistake, though, to assume that worried consumers are altogether wrong. It also seems worth considering the idea that perception often is reality, not least so in economics. 

What is more, the presumed disconnect between economic mood and reality comes at a time when hard economic data is increasingly dubious. Economists at Goldman Sachs issued a recent report on the topic.

“The market’s sensitivity to individual data releases has increased sharply over the last couple of years, as those releases will ultimately decide Fed policy,” Goldman says, focusing on  seasonal distortions and falling response rates in warning that data-quality issues have made “assessing the implications of data releases for the outlook in real time more difficult.”

Take the Job Openings and Labor Turnover Survey. Aside from being a particularly delayed release (October data will hit on Tuesday), the JOLTS business survey’s response rate has halved since the pandemic to just 30%. 

Responses are imputed, meaning existing JOLTS data are used to fill in missing responses. The upshot: healthy businesses are counted more than once, effectively inflating job-opening stats.

Consider as well the record gap in the number of jobs reflected in the establishment and household surveys comprising the monthly employment situation report. Double counting–one person can be counted multiple times in the establishment survey–explains about half of the 2.6 million difference. As Warren Pies of 3Fourteen Research notes, multiple job holders have surged by about 700,000 just since the April low in the unemployment rate.

Now think about the record spread between the year-over-year changes in GDP and GDI, or gross domestic income. MacroMavens founder Steph Pompboy notes that GDI has only been negative at the same time GDP was positive twice before–in 2001 and 2007, leading into recessions.

This brings us to the Census Bureau’s Household Pulse Survey. 

Launched during the pandemic in an effort to gather higher-frequency data about households’ economic well being, the survey covers everything from employment to housing security and food sufficiency. The sample sizes are large compared with those of the University of Michigan and the Conference Board. A wide swath of ages, incomes, and other characteristics are represented, and the survey is conducted every two weeks as opposed to monthly. 

Investors worried about the integrity of sentiment indexes or looking for more on-the-ground data to supplement official reports can find a treasure trove of data in the household pulse data. 

The latest batch of Census stats doesn’t just reinforce the picture sentiment reports are painting. In some respects, the Census reports suggest household economics are worse than many seem to assume and data reflect, with particular deterioration over the past one-to-two months.

Some 63% of respondents reported difficulty paying for usual household expenses in the last seven days. Nearly one in five said doing so was “very difficult,” and more than a quarter of overall respondents said they tapped savings or sold assets or possessions–including withdrawals from retirement accounts–to meet spending needs. A tenth reported borrowing from family or friends.

Asked about the likelihood of having to leave their house in the next two months due to foreclosure, 21% answered “very” or “somewhat” likely. About 35% of respondents said they are a month behind on mortgage payments, and 24% are two months behind. (7% are behind by eight months or more). 

Census appends a disclaimer that the pulse data are “experimental” and that standard errors may be large, referring to how different the population mean may be from the sample mean. Even so, the data cast doubt over officially reported mortgage delinquencies. For the third quarter, which is the most recently available data, the Fed reported only 1.72% of single-family mortgages were delinquent.

Renters expressed even bigger concerns. Some 37% said they are “very” or “somewhat” likely to face eviction in the next two months. About a third of the respondents say they are a month behind on rent, and roughly a quarter say they are two months late. 

Sentiment surveys have plenty of drawbacks. But given hard data-quality issues and inconsistencies, it doesn’t seem like the right time to disregard what households say about their economic well being and outlook. Census pulse data are one way to try to bridge sentiment with reality, and the message is worth heeding. 

Why Deflation is Neither Imminent Nor Likely (November 20, 2023)

Concerns over outright price declines seem exaggerated, and the level of public debt means economy-wide deflation is implausible.  

Buzz is building around deflation, but investors should remain skeptical of impending price declines across the economy. 

First, a close reading of recent data suggests deflation concerns so far are exaggerated. Take the producer price index. Headline PPI fell 0.5% in October from a month earlier, the first drop since May and the biggest decline since March 2020. From a year earlier, the metric slowed to a rate of 1.3%. Energy fell 6.5% from September and 9.4% from a year earlier, driving the decline. Without it, the PPI was flat in October versus September and up 2.2% from a year earlier. 

To bet on deflation–where prices decline, versus disinflation, where the rate of inflation falls–is to bet that oil falls. Consider some recent estimates from Goldman Sachs. The investment bank predicts a 2024 average of $92 a barrel for Brent crude, up 12% from current levels. Goldman sees West Texas Intermediate crude trading at $80 or higher next year, up at least 3% from its most recent closing price. 

Underlining the point, data from commodity intelligence provider Kpler shows that global oil inventories have erased the builds of the past two months and stand at their lowest levels since at least 2017. That isn’t to mention geopolitics. Helima Croft, RBC’s head of global commodity strategy, says that while a temporary ceasefire between Israel and Hamas may reduce geopolitical concerns, “the wake-up risk from this six-week conflict remains elevated.”

Second, Walmart’s recent mention of possible deflation is worth putting in context. On the retailer’s earnings call last week, CEO Doug McMillon said that while prices are still up mid-double digits from a year ago, “we may see dry grocery and consumables start to deflate in the coming weeks and months.” Looking ahead to 2024, “we could find ourselves in Walmart U.S. with a deflationary environment,” he said.

But even if goods deflation materializes, it isn’t necessarily enough to spur broader deflation. The U.S. goods-producing sector represents just about a fifth of overall economic output. And recall that economists have counted on goods-price deflation to offset stubborn service-sector inflation (see our Aug. 20 article). McMillon’s comments, then, probably support expectations for overall disinflation more than they portend overall deflation. 

Service-sector inflation remains elevated. Excluding energy services, the price of services rose 5.5% in last month’s consumer price index from a year earlier. The price of a haircut, what StoneX Group director of global macro Vincent Deluard calls his favorite measure of sticky inflation, accelerated to a 0.4% pace in October from September. Deluard notes the category has been rising at a steady 5% year-over-year rate since the onset of Covid. The point: most wage-sensitive services have risen similarly. Deluard extrapolates to say wage growth of 5% suggests an inflation rate of 3-4%.  

There are more reasons to at once appreciate disinflation in many categories while betting that that inflation risk remains skewed to the upside, where price changes are more likely to overshoot the Fed’s 2% target than they are to fall below zero. 

Here are a few. Survey data suggest consumers still see 3.5% inflation a year from now. The St. Louis Fed pegs the probability of PCE inflation exceeding 2.5% over the next 12 months at roughly 80%. The bank meanwhile puts the current deflation probability at 0.00005%. Deutsche Bank economists say the chance of higher inflation over the next five years derived from caps (>3%) and floors (<1%) pricing are stabilizing at higher levels, with the former the highest in about a decade. 

But the most compelling reason to expect persistent above-target prices over deflation may be the level of public debt in the U.S. In a 2015 paper, the International Monetary Fund warned of the perils of price deflation at a time when the U.S. debt-to-GDP ratio was about 100. Now that ratio is 120.

“In a deflationary or low-inflation environment, public finance management becomes more challenging,” the IMF said. “With debt ratios already elevated, a deflationary spiral could propel debt ratios into unsustainable zones.” 

The researchers found that, on average, a “mild” rate of deflation increases public debt ratios by almost 2% of GDP a year, with the impact larger during recessionary deflations. “Recessionary deflations are most dangerous for fiscal sustainability, and authorities should be primarily concerned by such episodes of deflation, in which aggregate demand collapses and growth slips into negative territory,” the researchers warned.

Consider as well a 2021 study by the Penn Wharton Budget Model. Researchers there estimated that the total inflation-adjusted liability of the federal debt falls by 4%, 7%, 13%, and 19% for unexpected inflation of 2.5%, 3%, 4%, and 5%, respectively. A permanent increase in the inflation target to 3% from 2% would cut the real obligation of current federal debt by 7% by 2051, they said. Since that estimate was published, total public debt in the U.S. has grown by 11%.

The Fed is unlikely to explicitly raise its inflation target anytime soon. But if economic data were to break from disinflation to economy-wide deflation, it’s a good bet that the central bank will undertake more drastic measures to fight deflation than it has taken to fend off inflation. 

How Fiscal Dominance Matters for Investors (November 11, 2023)

As the Treasury encroaches on the Fed, inflation will persist and politics may have a bigger impact on markets. 

Risks around fiscal dominance–the idea that government spending can compromise a central bank’s ability to fight inflation–are growing more concrete with real implications for investors. 

Two events during the past week underpin concerns over the U.S. fiscal situation. First came credit-rating firm Moody’s downgrade of the U.S. outlook to "negative" from "stable,” with Moody’s citing large fiscal deficits, a decline in debt affordability due to rising interest rates, and political polarization exacerbating fiscal problems. 

Another credit downgrade, should Moody’s take that step, may not immediately bite in ways investors might expect.  As Jim Bianco of Bianco Research notes, the downgrade of the U.S. credit rating by S&P in 2011 was a shock as many financial contracts specified that collateral had to be ‘AAA’-rated. Since that initial downgrade, Bianco says most of those contracts have been rewritten to include “AAA or debt backed by the U.S. Government,” or similar language to that effect. 

The warning is nonetheless worth heeding, particularly as it came a day after another poor Treasury auction. The $24 billion 30-year bond sale was “breathtakingly bad and just short of catastrophic,” says newsletter writer and former hedge-fund manager James Lavish, with a bid-to-cover ratio of 2.24. 

That is a “C or C-, if this were graded as a test,” says Lavish, down from a recent norm of around 2.4 that is already lower than pre-Covid levels because of shrinking foreign demand for U.S. Treasuries. With foreign demand down sharply from even a month ago and institutions and individuals failing to pick up the difference, primary dealers were left with a quarter of the issuance–more than double their average in recent 30-year auctions, notes BMO Capital Markets. 

Taking the credit-outlook cut and another poor bond auction together, a few takeaways seem particularly salient. 

First, the gap between the government’s debt and the share absorbed by the Federal Reserve continues to grow. Thus the Fed will inevitably need to return as a buyer of last resort, says Jurrien Timmer, head of global macro at Fidelity. 

“The fiscal side of the house is on a seemingly unstoppable track, which could leave the Fed trying to thread a needle—counteracting that fiscal dominance through policy restriction, while potentially also supporting it through market-stabilizing bond purchases,” says Timmer. 

Second, the Treasury announced in May plans to implement a regular buyback program in 2024. It is the first such program in over two decades and should help markets function at a time when liquidity concerns abound. As SMBC Nikko Securities chief economist Joseph LaVorgna notes, the issue of evaporating liquidity in the $26 trillion Treasury market is worse than in March when regional banking woes forced the Fed to increase bank reserves by nearly $400 billion. 

While such buybacks may aid liquidity and market operations, they are a tool that gives the Treasury more direct influence and opportunity to encroach on the Fed, says Joseph Wang, CIO at Monetary Macro and a former trader on the New York Fed’s open markets desk. 

Wang explains it this way. The buyback program appears modest, starting with just $30 billion a quarter in purchases made for liquidity support and $120 billion in first-year buybacks made for cash management purchases. But it allows the Treasury to both add and remove duration, a significant development because removing duration from the market has been up to the Fed and done via quantitative easing.

Treasury has said it wouldn’t modify the maturity profile of its debt with buybacks, but Wang says the program gives it the capability to do so. 

“For now they’re clear that they won’t change duration. But once these programs exist, they grow and they change,” Wang says. One worry: An administration worried about an election could effectively ease financial conditions by issuing short-dated debt to purchase longer-dated debt.  

Fiscal dominance isn’t a new concept. But as Gray Howard, senior portfolio manager at UBS notes, the last time the U.S. reached the current level of fiscal involvement was in the 1930s and 1940s, in response to the Great Depression and too long ago for most current investors to have experienced. 

To Howard, tough talk in Washington about deficit reduction is simply performative, with other central banks fully aware that the U.S. is attempting to inflate its way out of its conundrum. He offers two bits of advice for investors. 

First, Howard rejects the notion that stocks are risky and bonds are safe. Given where we are in the cycle, and as the U.S. tries to inflate its way out of a fiscal mess, stocks, real estate and commodities are probably better stores of value as compared to bonds, he says.

Second, follow the money. “In a world of fiscal dominance there’s a long line of lobbyists and CEOs in Washington with their hands out ready to catch a piece of the trillions and trillions of dollars flowing through the city,” says Howard. 

That is a comment ripe for more research and reporting. For now, we will leave you with takeaways from a quick scan of top spenders as tracked by Open Secrets, the nonpartisan platform tracking money in politics. 

Topping the list of top lobbyists by money spent this year, after the U.S. Chamber of Commerce and the National Association of Realtors, are insurance, pharmaceutical and hospital groups. Individual companies spending the most on lobbying include Amazon (ticker: AMZN), Meta (META), Pfizer (PFE), General Motors (GM), Alphabet (GOOGL), Boeing (BA), Amgen (AMGN), and CVS Health (CVS). 

The fiscal situation in the U.S. will get worse before it gets better. The implications are broad and just starting to unfold. 

A Close Read of the Jobs Report Suggests Recession May Be Underway (November 5, 2023)

The BLS household survey reveals a labor market that is weaker than many assume

By Lisa Beilfuss
November 5, 2023

In the not so distant future, it may become evident that the U.S. economy ended 2023 in the recession many news outlets and commentators are certain it will avoid.

Economic data over the past week has been widely characterized as just right. Moody’s chief economist Mark Zandi called the October jobs report “as good as it gets,” showing “resilient, but moderating, job growth and easing wage pressures.” It followed a “stellar” third-quarter GDP report and came as the price of oil fell back to around $80 a barrel and the 10-year Treasury yield receded to around 4.5%, making it “tough not to think there will be a soft landing,” says Zandi.

Let’s focus on the latest jobs data. Headlines and analysis centered on a still-robust nonfarm payrolls increase of 150,000, a lagging indicator that is based on the monthly survey of establishments. But that figure belies weakness across the report’s 25 tables–many of them overlooked. A deeper dive into the data suggests the prevailing economic narrative is naive at best.

First, the household survey showed a 348,000 decline in jobs last month. The drop isn’t an anomaly. The household survey shows an average increase of just 32,000 jobs over the past six months, compared with 205,000 in the establishment survey. Over the past three months, jobs declined an average 13,000 a month according to the household survey, while the establishment survey shows an average monthly increase of 204,000.  

And despite some reports to the contrary, the steep decline in household employment wasn’t due to labor strikes. Those with a job but not at work because of a labor dispute are still counted as employed in that survey, says E.J. Antoni, an economist at the conservative think tank the Heritage Foundation. 

There are at least three reasons to pay more attention now to the BLS household survey than the establishment survey. The latter has been revised lower in eight of the last nine months, wiping out roughly a quarter of the increase in jobs initially reported so far in 2023. The household survey tends to be more accurate at economic turning points, says Wellington-Altus chief market strategist James Thorne. And, perhaps most importantly, more workers have taken on additional jobs in order to make ends meet.

The government’s two employment surveys began diverging in March 2022. The BLS has told this writer that its establishment survey has no way to prevent double counting. As the Federal Reserve Bank of St. Louis explains, employees working at more than one job and thus appearing on more than one payroll are counted separately for each appearance. By contrast, the household survey has no duplication because individuals are counted only once, even if they hold more than one job. 

Double counting explains about 1.3 million of the record 2.6 million job gap between the two surveys, says Antoni. The weeds of the employment situation reports help flesh out this point. Those holding a part-time job in addition to a full-time job jumped 5.2% in October from September and 12% from a year earlier, to the highest level since at least 1994, when the government started collecting that data. 

The number of people holding two full-time jobs, meanwhile, was up 14% in October from a year earlier. It seems fair to wonder if employers’ inability to recall a greater share of employees working from home is in part because many people can’t afford to drop one of their jobs. Consider that inflation appears to again be outpacing weekly earnings growth in October, reversing some recent modest improvement in real wages. One anecdote: Stuart Sopp of the fintech Current, which provides banking services through partner banks, said on CNBC last week that almost half of his company’s customers have more than one job.  

Other elements of the household survey are similarly worrisome. The rise in the unemployment rate to 3.9% was the highest since January 2022. As Antoni notes, labor force participation shrank in October, meaning the increase in the number of unemployed wasn’t because more people were looking for work. Instead, the number of people not in the labor force rose and is now roughly 5 million above pre-pandemic levels, he says, estimating that somewhere between 4.7 and 6.3 million people are being excluded from the unemployment rate calculation. Adding them back produces an unemployment rate upwards of 6.5%, Antoli says.  

To evaluate where we stand, many economists point to the Sahm Rule. Developed by economist Claudia Sahm, it says the economy is in a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage point or more relative to its low during the previous 12 months. 

As Harvard economist Jason Furman notes, the unemployment rate is now 0.5 percentage point above its low. That doesn’t meet the Sahm Rule threshold because it is one month, not the three-month moving average. Still, the three-month average is now 0.33 percentage point, and we’ve only been above 0.3 percentage point twice without going into recession (in 1951 and 2003), Furman says.

Sahm’s own caveat to her soft-landing call is worth heeding. “The Sahm rule triggers within the early months of a recession, so technically, we could be in a recession, and the rule is catching up,” she says.  

Jobs data are mostly lagging indicators. That reality makes the household survey data all the more concerning, especially given the uptrend in those working multiple jobs and thus being counted more than once in the sunnier establishment survey. The U.S. economy may well be contracting already, regardless of what oft-cited data say and despite an ongoing consensus expectation that a hard landing will be dashed.

Why the Bank of Japan May Matter More Than the Fed for Now (October 29, 2023)

Expectations are rising for the BoJ to tighten policy and roil global markets.

By Lisa Beilfuss
October 29, 2023

Financial-media attention in the coming days will likely focus on the Federal Reserve’s meeting that ends Nov. 1. But what the Bank of Japan decides a day earlier may be more important.

The BoJ on Tuesday is expected to leave its short-term interest rate target at -0.1%. But there are rumblings of a sooner than expected move out of negative territory. Tokyo reported hotter-than-expected consumer price inflation for October, with headline CPI rising 3.3% from a year earlier versus a 2.8% consensus expectation, notes Peter Boockvar, chief investment officer at Bleakley Financial Group. Tokyo CPI leads the national number, he says, due November 24. Boockvar is betting that the BoJ will get rid of negative interest rates either this week or in December.  

What is more, there are growing expectations that the central bank will further adjust its yield curve control policy, or YCC. Under current policy, the bank guides the 10-year government bond yield around 0%, with an allowance band of 50 basis points in either direction and a hard cap of 1%.  

A rate hike and/or a YCC tweak by the BoJ would be bearish for global bonds at a time when U.S. Treasuries are already under pressure and yields are rising. “While we need to rethink even harder where the FOMC may be heading, it may be time to pay greater attention to growing pressures on the BOJ,” says economist Harald Malmgren. Tightening by Japan’s central bank “could potentially shock the entire world bond market,” he says.

Japan’s 10-year yield hit a new decade high last week, touching the 0.875% level–about double the level just three months ago. While there is still room before it tests the BoJ’s 1% upper limit, the relentless rise in Japan’s 10-year yield reflects resilience to the six rounds of bond-buying operations by the BoJ since July 2023 and is prompting hawkish bets for further policy normalization, says IG strategist Yeap Jun Rong. 

Leaving the ceiling for the 10-year yield unchanged could force the BoJ to buy more government debt and expand its already massive balance sheet, worth roughly $5 trillion or 120% of Japan’s gross domestic product. 

That is as the Japanese yen again weakened past the key 150 level against the dollar–trading near its lowest level since August 1990, tumbling more than 10% this year, and making it the worst currency among its G-10 peers, Deutsche Bank analysts note. In addition to potentially triggering intervention by Japanese authorities, the currency depreciation puts pressure on the BoJ to consider tightening monetary policy, they say.   

All of this matters in part because of the yen’s role as a carry-trade funding currency. With rates in Japan so low for so long, investors have long borrowed yen to buy assets denominated in higher-yielding currencies. The BoJ’s surprise move late last year to start relaxing YCC meant the yen lost some carry-trade luster, but it still plays a big role in global financial markets.

Bob Michele, global head of fixed income at JP Morgan Asset Management, warned last month that tighter BoJ policy could unwind the carry trade and spark a decade-long patriation of Japanese capital parked in foreign assets, triggering global volatility. He flagged the 150 level in the yen versus the dollar, warning that the central bank could be forced to hike rates sooner than expected if the yen weakens beyond 150. 

“I worry as the yield curve normalizes and rates go up, you could see a decade or longer of repatriation,” he said on CNBC. “This is the one risk I worry about.”

Former hedge-fund manager James Lavish explains how this all comes back to haunt the U.S. bond market. Yield-hungry Japanese investors have been selling Japanese Government Bonds, or JGBs, and then the yen received for them in order to buy U.S. dollars to buy Treasuries. Meanwhile, the U.S. has its own problems with a growing deficit, a mountain of debt, and worries from investors who are pushing the yield of that debt higher to be compensated for long-term inflation risks. 

Japan is the largest non-U.S. owner of Treasuries. And the BoJ is either allowing the Treasuries they hold to mature off their books or outright selling them and using the dollars to buy and stabilize the yen, says Lavish. 

While expectations are rising for the BoJ to tighten policy as early as this week, some in Japan are betting the bank won’t move so quickly. 

As one Japanese trader told Praxis, “they aren't going anywhere, or changing anything, and nor should they,” referring to the BoJ and chiding foreign investors and commentators for misunderstanding the bank’s view of its currency. The “BoJ and [Ministry of Finance] don't gaf about the yen. It can go to 250 for all they care, as long as it goes slowly.”

The person adds that the ongoing slowdown in the central bank’s ETF buying program gives “them more fire power to conduct and maintain YCC,” where the BoJ slowly allows a higher 10-year yield cap. 

Moreover, Japan’s Nikkei newspaper reported last week that four of Japan's biggest life insurance companies are planning to increase foreign bond holdings with no currency hedge in the coming months. Those Japanese life insurers–among the world’s most closely watched bond investors–are judging that the benefit of lower hedging costs currently outweigh the risk of a spike in the yen, the kind of move one might expect from a hawkish central bank announcement. In other words, they are betting the yen will hold steady versus the dollar.  

Betting the yen holds steady versus the dollar could be as much or more about the Fed than the BoJ. A BoJ that doesn’t tighten policy in the coming week may signal that the world’s biggest creditor nation doesn’t expect the Fed to be as hawkish as Fed officials themselves suggest, meaning they expect relief is coming for Japan’s domestic markets. 

What the BoJ decides to do this week may for now may matter more than what the Fed says–not only because of the direct implications on U.S. markets, but because of what Japan might signal about the path of U.S. monetary policy.  

Two Ways to Monitor Economic Reality (October 22, 2023)

Fed SLOOS data and bank loan-loss reserves tell a different story than oft-cited loan growth. Market breadth is worth heeding.

By Lisa Beilfuss
October 22, 2023

The Wall Street consensus has swung back to predicting a soft economic landing. Investors should remain skeptical.

A recent survey by The Wall Street Journal showed that economists cut recession odds below 50%. This week, Praxis looked at two indicators that, together, suggest neither the economy nor the stock market is poised to land gracefully. First, the signal from bank-lending growth may be a false positive. Second, stock-market gains are masking deterioration under the service, as reflected in market breadth.   

On bank lending. Continued loan growth in the face of over 500 basis points in Federal Reserve interest-rate increases is one reason many strategists say a soft landing is likely.  

The latest weekly bank-lending data from the Fed show that bank loans and leases are still growing. But the pace of acceleration has cooled, with net loan growth lower than the pre-Covid average, notes Parker Ross, chief economist at Arch Capital Group. And while small banks are still lending, lending by large banks has stalled over recent months, says Cornerstone Macro’s chief economist Nancy Lazar.

What is more, fuzzy accounting may be flattering the data. 

First, consider the lead up to the Great Financial Crisis. Commercial and industrial, or C&I, loans reported on the aggregate balance sheet of the U.S. banking sector rose by about $100 billion from September to mid-October 2008. But the increase wasn’t driven by a rise in new loans, Harvard Business School professors Victoria Ivashina and David Scharfstein found. Instead, the increase was a result of businesses drawing down on existing credit lines. Based on news reports alone, the pair recorded credit-line drawdowns that accounted for roughly a quarter of the increase in C&I loans reported on bank balance sheets between September and mid-October 2008.

Second, as banks increasingly work with borrowers to renegotiate the terms of troubled loans, they may be “extending and pretending,” as Lazar puts it. It is unclear how many amended loans wind up classified as new loans. Lenders have significant latitude in amending loans to help borrowers avoid default, and in some cases banks would label the modified agreement as a new loan instead of a troubled debt restructuring, or TDR, says one former bank regulator. Banks may also defer foreclosure proceedings in hopes that the value of the collateral will rise prospectively in the face of interest-rate cuts. 

All that said, bank loans are a lagging macroeconomic indicator, says Lazar, making the measure more useful in confirming what we know to have happened than predicting what will happen. Better indicators are the quarterly Senior Loan Officer Opinion Surveys on Bank Lending (SLOOS) and banks’ provisions for loan losses.  

The Fed will report third-quarter SLOOS data in early November. The survey covers up to 80 large domestic banks and 24 U.S. branches and agencies of foreign banks. The second-quarter report issued in July showed that banks reported tighter credit standards and weaker loan demand from both businesses and consumers, and it showed that banks expect to further tighten standards over the rest of the year. 

While overall U.S. bank loans rose 4% in September from a year earlier, Lazar flags one specific SLOOS data point that she says leads loans by roughly six quarters. The net percentage of domestic banks reporting an increased willingness to make consumer loans was most recently negative 21.8 after a reading of negative 22.8 a quarter earlier–already a level that always signals recessions, according to Lazar.   

Banks’ allocations for loan losses are meanwhile rising. Data from the Fed Bank of St. Louis show that loan-loss provisions have risen 9.3% since the start of 2023, and they are 67% higher than pre-Covid levels. Bank lending doesn’t cool until well after lenders raise loan-loss provisions, Lazar says, adding that the pattern unfolding now resembles the runup to the 2001 and 2008 recessions.   

The stock market isn’t the economy, but the wealth effect is one reason many strategists point to market resilience as indication that a soft landing is likely. The S&P 500 is up 11% so far this year, but it is worth considering what is happening beneath the surface.

The percentage of S&P 500 stocks that are trading above their 200 day moving average is now just 33%, a year-to-date low, notes Warren Pies, founder of 3F Research. A market held up by a handful of stocks is inherently less stable than one with broad participation, he says, adding that outside of mega-cap tech the rest of the market is breaking down. “Entering earnings season, the market is more unstable than it was one month ago,” Pies says.

Rising interest rates have hollowed out market breadth, says Pies, adding that there will be no fourth-quarter rally without improving breadth and that there will be no improvement in breadth without rates “chilling out.” 

Put another way, when you remove the so-called magnificent seven–Apple (ticker: AAPL), Microsoft (MSFT), Alphabet (GOOG), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA) and Meta (META)--from the Russell 3000, the remaining 2993 stocks are down on the year, notes Jim Bianco of Bianco Research. 

The belief is that last year’s bear market ended on Oct 12, 2022, but “this looks more like a big bear market correction than the second year of a bull market,” Bianco says.

Soft-landing calls are based on various data points that are incomplete, misinterpreted or otherwise faulty indicators. Bank-lending growth and gains in major stock indexes are just two of them. Investors should continue to question Wall Street’s confidence in the Fed’s ability to sufficiently cool inflation without reversing growth–and in the stock market’s ability to fit that narrative.    

Bond-Market Volatility Portends Trouble for Stocks (October 15, 2023)

The MOVE index may be near an inflection point that coincides with negative stock returns

By Lisa Beilfuss
October 15, 2023

Renewed bond-market volatility is likely to persist. Stock investors should beware.  

Investors have been increasingly concerned about demand for large amounts of U.S. Treasuries the government is issuing to finance its high and rising public debt. Those fears became less abstract last week after a series of disappointing auctions that was capped off by a $20 billion sale of 30-year bonds.

Primary dealers–required to buy what other bidders don’t–were left with 18% of the 30-year sale. That was the biggest share since December 2021. The high yield came in at 4.837%, the highest level since 2007. The auction was “disastrous,” says money manager Florian Kronawitter. He warns that despite recent short covering and geopolitical flight-to-safety bids, what has been a relatively orderly rise in 10- and 30-year yields is becoming disorderly. 

First, as the government sells hundreds of billions of bills, notes and bonds weekly, important buyers–foreigners, banks and the Federal Reserve–have retreated. But even the appetite for bonds from those left to absorb the supply is waning. 

Consider an anecdote Pershing Square’s Bill Ackman shared last month:  

“I bumped into the CIO of one of the world’s largest fixed-income asset managers the other night and asked him how it was going. He looked like he had had a tough day. He greeted me by saying: ‘There are just too many bonds’--a veritable tsunami of new issuance each week. I asked him what he was going to do about it. He said: ‘The only thing you can do is step away.’”

Second, inflation may remain elevated for the foreseeable future. “The long-term inflation rate is not going back to 2% no matter how many times Chairman Powell reiterates it as his target,” says Ackman, noting that the target was “arbitrarily set” after the 2008 financial crisis “in a world very different from the one we live in now.” Another 3.7% year-over-year increase in the September consumer price index underlines that point.

Ackman says 5.5% may be an appropriate yield for 30-year bonds. He cautions that yields may go even higher, though, particularly in the short term. 

Stock-market volatility is historically low compared with bond-market volatility. But stock investors may be particularly vulnerable to ongoing bond-market turmoil. Aside from the fact that the long end of the U.S. bond market functions as the backbone of global financial markets, Kronawitter points to red flags in positioning data from the Commodity Futures Trading Commission.

Large fast-money accounts are the most long in at least a year, S&P 500 positioning data from the CFTC show, a signal that the market is buying the dip instead of shorting it, says Kronawitter. While more shorts would provide fuel for a sustained move higher because they would need to be covered, he says the inverse is true when traders are buying the dip as it increases the number of potential sellers in a move lower.

It is worth noting that volatility in the bond market is still well off March 2023 highs, when Silicon Valley Bank and Signature Bank failed. Yet at 128, The MOVE index, short for the Merrill Lynch Option Volatility Estimate, is at the highest level in three months. It is also significantly above the roughly 60 level heading into the Covid-19 pandemic.

Harley Bassman, managing partner at Simplify Asset Management and known as the Convexity Maven, created the MOVE index years ago while at Merrill Lynch. He describes the index as the VIX for bonds, referring to the CBOE Volatility Index that represents expectations for 30-day stock-market volatility.

In a recent discussion with economist David Rosenberg, founder of Rosenberg Research, Bassman explained that the MOVE is a real number more than it is an actual index. You could make it into a daily number, he said, by dividing the current level by the square root of 252, or the number of trading days in a year. 

The result? “We’re going to move eight basis points a day every day on interest rates for a month,” says Bassman. “That’s a pretty fat number.”

In the decade before Covid, low inflation, interest rates pinned near zero and quantitative easing kept interest-rate volatility suppressed. But given stubborn inflation, a record fiscal deficit and lower demand for U.S. Treasuries, it will be hard for interest-rate volatility to return to pre-covid levels, strategists at Deutsche Bank say.

Jim Reid, the bank’s head of global fundamental credit strategy, notes that equities are negatively correlated with the MOVE index. Since calculations started in 1988, the average in the MOVE index is about 93. The gauge has been below 100 about 60% of the time, with average weekly stock-market returns “comfortably positive,” Reid says.

Since the Fed started hiking 19 months ago, the MOVE index has averaged around 120. Reid notes that after dipping below 100 for four days in mid-September, it popped again and has been back in the 110-140 range over the last two weeks. 

It is somewhere in the 100-150 bucket for the MOVE index when stock performance pivots from positive to negative, Reid says, with recent MOVE levels “broadly consistent with that pivot point.”

Inflation returning to target would allow the Fed to move away from tighter policy and wrap up its balance-sheet shrinkage, encouraging more Treasury buyers. In that scenario, Reid says the MOVE index could easily and sustainably fall below 100, improving the outlook for risk assets.   

The risk, however, is that inflation is more or less stuck around current levels and/or deficits dominate the agenda for a long time. That translates to a MOVE index that is higher for longer and a headwind for risk assets, says Reid. 

In other words, stock investors should enjoy relative calm while it lasts. The bond market says halcyon days may be numbered.

A Conversation With Michael Ashton, the “Inflation Guy” (October 8, 2023)

From money velocity to trade and fiscal deficits, Ashton lays out why inflation will remain elevated

By Lisa Beilfuss
October 8, 2023

Where the U.S. economy and financial markets go from here hinges in large part on inflation. For each economist expecting ongoing disinflation, it seems another predicts sticky price inflation that may keep interest rates higher for longer and continue to erode Americans’ purchasing power.

Michael Ashton is one of this writer’s favorite sources to call about inflation. Known as the “Inflation Guy” on his blog and podcast, Ashton is the founder of Enduring Investments LLC, a consulting and investment management boutique focused on inflation. 

Ashton is a pioneer in inflation markets. He traded the first interbank U.S. inflation swaps, which are used by market participants to hedge inflation risk and to speculate on the course of inflation. He has worked in research and trading for several investment banks including Natixis, J.P. Morgan, Deutsche Bank and Barclays. 

This week, Praxis spoke with Ashton at length. Here is an edited Q&A of the conversation.

Praxis:
The Federal Reserve’s latest projections show central bankers expect inflation to fall to their annual 2% target by the end of 2026. Is that realistic?

Michael Ashton:
Inflation is coming down, and we all agree on that. The question is the destination. I differ from a lot of mainstream economists in that I don't think there's any natural reason that inflation will fall back to 2%. I think that we're going to end up with core [where food and energy prices are excluded] and median inflation in the high 3s to low 4s, and that it's going to be very difficult to get inflation persistently below that.

What are the biggest implications for investors if inflation rises 3%, instead of 2%, annually for an extended period?
There are at least two big implications. One of them is that the level of market volatility is going to be higher. Historically, when you have higher inflation, the volatility of equity prices is higher and the volatility of bond prices is higher. Over the last 20 years, we’ve gotten used to pretty docile financial markets. When the stock market goes down 1%, it used to be a fairly standard day. Now it's a headline. We're going to go back to periods of lots more choppiness.

The other implication is important for investors but one that I think many people miss. When you have inflation of about 3% or higher for at least three years, stocks and bonds become correlated. We're so used to the idea that having a 60% stock and 40% bond portfolio is lower risk because they move in opposite directions. But that has only been true for the last 20 years of low inflation.

When people are concerned about inflation, it is inflation–not growth–that drives the value of stocks and bonds. While growth has the opposite effect on stocks and bonds, inflation affects stocks and bonds in similar ways. With stocks and bonds correlated, and amid higher market volatility, it means the amount of risk you have to take for a given level of return is going to be higher. It’s going to take people a while to adjust back to that reality. As for commodities, they will remain a portfolio diversifier.

What is the biggest risk to your call that inflation will remain higher for longer?
We could get back to the 2% target if the Fed continues to shrink its balance sheet for a considerably longer period than people think they will, though we would still have trouble maintaining inflation at that rate. If the Fed keeps doing what they're doing, then, we might be back to something fairly normal in 2025. By “fairly normal,” we’re talking about 3% being the average around what we fluctuate–not 2%. 

How likely is the Fed to continue quantitative tightening (QT), or the reversal of quantitative easing (QE), to shrink its balance sheet? One problem is that normally when the Fed is tightening, they generally have had a strong economy and so there really isn’t a question about which part of their mandate [inflation or employment] is more important. It will be more difficult to continue shrinking the balance sheet when the economy is contracting.

What are the odds the Fed doesn’t just end QT early but conducts QE before reaching its inflation target?
I would assess it as a lower probability than I would have a year ago. I put the odds at maybe 20%--fairly low, but still way higher than it should be. 

The Powell Fed has raised rates far more than I ever thought they would, and far more than a Yellen Fed or a Bernanke Fed or a Greenspan Fed would have. Now this Fed has been tightening amid robust economic growth, so it hasn’t been that big a challenge, but it still has been a change in the demeanor of the Fed from the prior quarter century. 

But at some point, if interest rates start spiking and you believe that one of the Fed’s goals is to help keep the economy from crashing, then their dual mandate of price stability and maximum employment will conflict. My guess is that they would try to walk some middle ground, meaning they wouldn’t grow their balance sheet as much as they have previously. 

Why do you expect inflation to remain elevated?
A lot of the stuff that was pushing inflation lower over the past 25 years is now pushing inflation higher. 

There is deglobalization. From the fall of the Berlin Wall until roughly Brexit and the election of Donald Trump, we had globalization and we were exporting production to lower and lower cost centers around the world. And so we had this “globalization dividend,” where we got a much better mix of growth and inflation for a given level of money supply growth. That has all stopped, even reversed, as Covid emphasized the costs of long supply chains and higher interest rates made long supply chains more expensive. And of course there's plenty of political tension around the world.

Globalization may have been holding down inflation by at least half a percentage point. And now it is pushing inflation up by that much. An upshot: for a given level of money supply growth we’re going to get a bad mix of growth and inflation–meaning lower growth and higher inflation.  

There is also the problem of the developed world’s aging workforce. We have a decline in the growth rate of labor supply, and in a lot of cases an outright decrease in the labor supply. 

And then there is the fact that we still have quite a bit of remaining momentum from the initial rise in the money supply. [M2 increased 40% during the pandemic]. Money supply is now contracting, but money velocity is coming back. And so there's still quite a bit of upward momentum there, and that's the reason that inflation hasn't come down faster.  

The renewed rise in money velocity isn't getting much attention. Why does money velocity matter?
You can think about the pressure on prices as the product of the quantity of money in the system times how often each dollar is spent. If you have lots more dollars, then that can cause pressure on output and lead to inflation. Or if you have the same number of dollars but spend them lots more, it has the same effect.

Typically the main driver of money velocity over long periods of time is interest rates. Higher interest rates mean higher money velocity. And so one of the things that I had been saying–long before Covid, even–was that eventually you'll get this vicious cycle where higher inflation causes higher interest rates and higher interest rates cause higher money velocity, which causes higher inflation. I didn't realize it would happen quite this fast. But one of the perils of having interest rates go back up to the norm is you'll have velocity eventually go back up to the norm.

Why is money velocity an underappreciated inflation risk?
When the Fed and the federal government flushed lots of money into the system during Covid, money supply shot up while money velocity crashed because a lot of that money flew into bank accounts. People just couldn't spend it quickly enough. There was also an element of precaution–consumers wanted to hang onto their money longer. And so a lot of people thought, okay, money velocity will stay down even when money supply growth goes down. But that's not how it works.

It’s sort of like you have a car attached to a trailer with a spring. Money velocity is the spring. As the car goes speeding away, initially the spring stretches out as the trailer starts moving. But eventually the spring compresses and the trailer catches up with the car. That's what we're seeing right now. 

The monetary issue we have here is that velocity was kind of a one-way street for a generation, as interest rates were a one-way street lower. As rates go back up, so does money velocity. And so just like we had this virtuous cycle from the early 1980s until the late 2010s, we're now in the phase now where we're going to a vicious cycle. Higher velocity is going to keep inflation higher than it otherwise would be, which keeps interest rates higher than they otherwise would be, which keeps money velocity high, and so on. This is part of why I don't think we're going to get inflation back to 2%.

How high will money velocity go, in turn undermining improvement in inflation?
The initial stop would be where we were prior to Covid. Before the pandemic, the velocity of M2 money supply was 1.4. [Calculated as the ratio of quarterly nominal GDP to the quarterly average of M2 money stock]. It got as low as 1.1 and has so far recovered to 1.3. So there is still another roughly 7% just to get back to that level.  

But if you look at where money velocity was when interest rates were last here at this level, it is more like 1.6 or 1.7. What that means is that even if the Fed is successful in continuing to shrink its balance sheet and the money supply just goes flat for years, we're still going to have inflation coming from velocity rebounding. People will spend the same number of dollars, they'll just gradually spend it more and more quickly.

Would a recession short circuit the money velocity that you see in the pipeline?
Velocity is the inverse of the demand for cash. The two things that drive money velocity in the long run are interest rates–the main factor–and precautionary demand. When interest rates are really low, people hold more cash because they don't earn much interest on investments. They also tend to hold more cash when they’re scared, such as during a downturn. 

If interest rates fall quite a bit with a recession, then you might have money velocity go back down to where it was at the beginning of 2020 but not all the way back to where it was in early 2000, when rates were last around current levels. But the flipside is that a deep recession, the same one that would result in lower rates, might spur renewed money supply growth if the Fed conducts another round of quantitative easing. 

If quantitative tightening is the primary way to shrink the money supply and it ends prematurely, will the focus on reining in fiscal spending become sharper?
To get inflation, you either need crazy money supply growth or you need a lot of money supply growth and expansionary fiscal policy. Similarly, to get inflation back down, you either need very tight monetary policy or somewhat tight monetary policy and somewhat tight fiscal policy. 

It would be good for a lot of reasons to have smaller deficits. Among other things, a federal government running very large deficits creates a potential need for the central bank to buy some of the debt issued to fund the spending so that interest rates don't spiral out of control. 

We may be seeing some of that now. Rates are around fair value after years of being too low. But if rates continue to rise in a sloppy way, and the government is running multi-trillion dollar deficits, at some point the Fed is going to be expected to come in and keep interest rates from spiraling higher. The only way they can do that is by buying long bonds. That would mean the Fed is effectively monetizing the U.S. debt, meaning that money printing is financing the deficit.

So for all the debate around who will be the new marginal buyer of Treasuries, will it inevitably be the Fed?
Ultimately the Fed becomes the buyer of last resort.

If you have a large trade deficit alongside a large federal deficit, that's kind of okay because you're sending all these dollars overseas. Foreigners have to buy something with those dollars, and they buy the additional Treasury supply issued to fund the deficit spending. It's a nice closed loop.

But if you're going to have a lower trade deficit–a result of deglobalization–and you also have a large federal deficit, then somebody's got to make up the difference and buy those bonds. A smaller trade deficit means that the marginal buyer won’t be foreign buyers.   

Maybe we'll get control of the deficit. The interest cost of the debt is starting to go up really fast. I would say that’s the biggest disaster risk if we don't get control of the deficit really quickly. Then there is no easy way out. The Fed will end up having to buy as a stop gap, and that leads to more inflation.

Higher for Longer? Maybe for Inflation (October 1, 2023)

Higher energy prices are excluded from the Fed’s favored inflation data, but not from real-world budgets

By Lisa Beilfuss
October 1, 2023

The Federal Reserve may already have cover to abandon the higher-for-longer interest-rate stance it is telegraphing, potentially setting up a period of elevated inflation that the real world feels but data clouds.

Last week, Praxis wrote about why it is worth maintaining some skepticism over the central bank’s pledge to keep rates higher for longer, where cuts don’t happen in 2024, and rates through 2026 remain above what officials think is the roughly neutral policy rate of 2.5%.

Of all the monthly and quarterly inflation metrics, the Fed favors the core PCE, or the personal consumption expenditure index excluding food and energy. The government on Friday reported a 3.9% increase in the August index from a year earlier, still about twice the Fed’s target. From a month earlier, however, the core PCE rose only 0.1%--the smallest monthly gain since November 2020. 

What is more, the core PCE increased just 2.2% when you use a 3-month annualized rate. That is down from a 6-month annualized rate of 3%, and within striking distance of the Fed’s 2% target.

The latest inflation data was interpreted by economists as unambiguously good and scrambled expectations across Wall Street. Goldman Sachs chief economist Jan Hatzius says the risk to his forecast for a year-over-year core PCE of between 2-2.5% by late 2024 is now on the earlier side. And the Fed’s own recently-updated forecasts look too high. For the central bank to hit officials’ median expectation for 3.7% core PCE at the end of the 2023, it would take an acceleration to at least a 0.31% average rate in the month-over-month core PCE for September through December, says Inflation Insights founder Omair Sharif.

The faster-than-expected downtrend in the core PCE means that, barring a reversal, the Fed is probably done lifting rates this cycle, even as traders place about 35% odds on another 0.25% increase in December. It also means the central bank may have what it wants to begin easing policy sooner than it says and earlier than markets have lately come to believe.

The problem, though, is that the core measures of inflation that shape monetary policy don’t capture the inflation consumers feel. That may be especially true for the PCE, which tends to reflect less inflation than the CPI, or consumer price index. As Cleveland Fed economists have explained, the CPI is based on a survey of what households are buying, while the PCE is based on surveys of what businesses are selling.

As for using core measures, it makes sense in theory to exclude often-volatile food and energy prices in order to smooth out the inflation picture. But methodology aside, households and businesses don’t have the luxury of backing out the prices of essentials. Government data show food and energy categories represented about a fifth of overall consumer spending in the second quarter.

For the past six months, headline, or total, PCE has been running below core inflation as energy prices fell from year-earlier levels. But that dynamic looks set to flip back, with core inflation metrics masking some real-world pricing pressure.  

U.S. West Texas Intermediate futures topped $95 a barrel last week, the highest since August 2022. Even after pulling back to about $90 a barrel, WTI is up 23% this year and 28% over the past three months. Oil is a major input for U.S. food prices, which rose 4% in the latest month from a year earlier. 

Many analysts say slowing or reversing growth in the U.S., China and elsewhere will pinch energy demand, in turn lowering prices. But there aren’t yet real signs of falling energy demand. Moreover, oil supply remains short.

U.S. Energy Information Administration data show crude oil inventories are down 3.3% from a year ago and off 4% from the 5-year average for this time of year. While the U.S. is now pumping an extra million barrels per day versus January 2022, extended production cuts by Saudi Arabia and Russia are outpacing that increase. 

That isn’t to mention the 40-year low in the U.S. Strategic Petroleum Reserve, or SPR. The Biden administration had said it would replenish emergency reserves when oil was roughly $70 a barrel. It didn’t, and the government may wind up supporting higher oil prices when it inevitably has to restock the SPR.

Natural-resource investors Leigh Goehring and Adam Rozencwajg of Goehring & Rozencwajg say that oil is on the verge of a sharp rally. “We are adamant in our belief that this bull market has only begun and prices will increase,” they wrote in a memo last week, adding that they are “amazed at the level of investor apathy.”

One factor behind Goehring and Rozencwajg’s bullish sentiment may be underappreciated. The U.S. in 2022 released 220 million barrels from its SPR, amounting to 607,000 barrels per day. The liquidation continued into 2023, in part because the Bipartisan Budget Act of 2018 mandated that the U.S. sell oil from the SPR to fund spending bills. During the second quarter, the US released 25 million barrels, or 260,000 barrels per day, from the SPR.

But ongoing SPR sales under the 2018 act are now done. The deal said SPR sales would end if reserves fell to 350 million barrels, from about 650 million barrels at the time the act was passed. After emergency reserves recently fell below that threshold, the Biden administration said it would cancel all planned sales from the SPR. With the U.S. no longer selling several hundred thousand barrels per day from its strategic reserves, Goehring and Rozencwajg say commercial inventories are set to fall sharply, pushing prices higher.

All of this suggests that one main factor behind cooling inflation–lower oil prices–may be fleeting. But core inflation measures won’t directly reflect renewed energy-price strength, potentially allowing Fed officials to begin easing policy sooner than predicted. 

For households and businesses, it may be inflation that stays higher for longer–regardless of what policy-setting data portrays.

Higher-for-Longer? Maybe Not. (September 24, 2023)

The intention to leave rates relatively high for an extended period of time may prove naive, even if inflation remains above the Fed’s 2% target. 

By Lisa Beilfuss
September 24, 2023

Federal Reserve Chairman Jerome Powell stressed in his latest press conference a commitment to holding interest rates higher for longer to quell inflation. But the inevitable cleanup may short circuit even the most earnest pledge. 

Powell said that even if monetary policy is already sufficiently restrictive, “we're going to need that to remain to be the case for some time.” It is unclear just how long “higher for longer” might be. If it is any indication, the Federal Open Market Committee’s updated forecasts show that policy makers expect rates will end 2026 above the roughly 2.5% that most of them think is the longer-run neutral rate.   

The intention to leave rates relatively high for an extended period of time may prove naive, however, even if inflation remains above the Fed’s 2% target. 

First, the Fed may have already overtightened. Looking back at all 18 tightening cycles since 1951, the average time from the last rate hike to the first rate cut is only three months, says Joe LaVorgna, chief economist at SMBC Nikko Securities America. The last five cycles have had an eight-month lag. If the Fed is done raising rates, it means the clock started in July. If history is a guide, it suggests the first cut comes in or before March 2024. 

“This implicitly means the Fed has always overtightened. If it did not, then the Fed would not have to reverse course so quickly,” says LaVorgna.  

Second, the Fed has never tightened rates from such a precarious fiscal position, says Luke Gromen, founder of research firm FFTT. The government debt-to-GDP ratio is 121%, the fiscal deficit-to-GDP ratio is about 6%, and the net international investment position, or NIIP, to-GDP ratio is roughly negative 70%, he notes. 

Consider that fiscal year-to-date federal interest payments are up 33% versus the year-ago period. That is equivalent to an extra $150 billion annually and represents one of the government’s fastest-growing budgetary line items, LaVorgna says. For context, that amount is roughly equal to the money allocated to veterans’ benefits each year.  

Third, truly higher for longer probably corresponds with intolerable market and economic devastation. 

Myrmikan Capital founder Daniel Oliver likens historical government and Fed efforts to stem economic and market declines to attempts to keep a cresting wave from crashing. He invokes historian Frederick Lewis Allen, writing in 1935 about the onset of the Great Depression. 

“Watch a great roller surging in upon a shelving shoal. It may seem to be about to break several times before it really does; several times its crest may gleam with white, and yet the wall of water will maintain its balance and sweep on undiminished. But at last the wall becomes precariously narrow. The shoal trips it. The crest, crumbling over more, topples down, and what was a serenely moving mass of water becomes a thundering welter of foam,” Allen wrote.

Fast-forwarding to more recent history, Oliver says the Greenspan Fed’s effort to keep the credit wave from cresting expanded from bank balance sheets to stock market prices. “With Greenspan’s aid, the credit wave swept over the shoals of 1987, the 1990s, the internet bust, and then the housing bust with Bernanke’s help,” says Oliver. The wave was cresting again and about to tumble in 2019 when Powell intervened to reverse QT and bail out the multi-trillion dollar repo market, propelling the credit wave to new heights, he adds.

Oliver warns we are now reaching the point where the shoals become shallower and the wave narrower. Consider that the Fed’s Bank Term Funding Program has grown to $108 billion from $64 billion at the end of March, after Silicon Valley Bank failed and prompted the creation of the emergency program. That is as losses on banks’ investment securities soar, the average credit card interest rate has risen to 24% from a pre-pandemic 17%, and bankruptcy filings have risen to 2008 levels. 

Even modestly negative assumptions–the S&P 500 earnings yield returning to 8% (the average yield from 1871 to 1990), profit margins falling by 20%, and revenues remaining static–would produce a 61% plunge in the stock market, Oliver says. But if anything like that scenario transpires, “it would topple the largest wave of all, the largest in history, the U.S. Treasury bond market.”  

The Congressional Budget Office recently said that the federal deficit this year will roughly double from 2022, to about $2 trillion. The CBO partly attributes the increase to a 20% decline in individual income taxes, reflecting shortfalls in capital gains taxes. For all the talk of a Fed put that no longer exists–or the idea that the central bank won’t come to the market’s rescue–the Fed can’t avoid worrying about the stock market because it is key to the bigger picture.

The CBO’s projections suggest that the Treasury will need to issue $3.1 trillion in new bonds over the next two years, adding to the existing stock of $32.3 trillion. That isn’t to mention the roughly $3 trillion of maturing Treasuries it will have to replace. As Oliver puts it, the question isn’t who will buy these $6 trillion in bonds; the question is at what price.

This all means that while the Fed might want to stand its ground on higher-for-longer interest rates in the face of stubborn inflation, a pivot isn’t just inevitable but probably coming sooner than telegraphed. 

The difference this time is that the wave may be too steep, says Oliver. “The degree of QE needed to lower rates will be stunning,” he says, referring to quantitative easing, or Fed bond purchases. “[It’s] not that they will not try, but they will quail at the magnitude necessary,” he says. 

The upshot, then, is potentially even bigger intervention and more inflation. The alternative is pain that financial markets and the economy may not be able to bear, even if another attempt to subvert it only makes it all the more intolerable. 

The Real Economic Picture Isn’t What It Seems (September 17, 2023)

Inflation continues to bloat economic data 

September 17, 2023
By Lisa Beilfuss

Stronger than expected retail sales reported during the latest week seemed to support the idea that the U.S. consumer is invincible. But that interpretation is flawed, with downside implications for economic growth and corporate earnings. 

Monthly retail and food-service sales jumped 0.6% in August from a month earlier, up from July and three times the rate of increase economists expected. That was the headline print, which is in nominal terms and is the number most news stories and Wall Street strategists emphasize.

But the real story is under the hood. Adjusting for last month’s goods inflation, real–inflation-adjusted–retail sales dropped 0.4% month-over-month, says Piper Sandler chief economist Nancy Lazar. What is more, real retail sales have been negative year-over-year since February. That is the longest stretch since the period from December 2007 through November 2009, according to data from the Federal Reserve Bank of St. Louis. 

Bigger picture, all of the increase in corporate revenue over recent quarters is simply due to inflation, as opposed to unit growth. In the second quarter from a year earlier, Lazar calculates that U.S. domestic corporate revenue rose 2.4% in nominal terms but fell 1.1% in real terms.

As Morgan Stanley chief investment officer Lisa Shalett puts it, investors have cheered nominal results that have been flattered by above average inflation. While it is fair to acknowledge that consumers have been willing and able to pay the higher prices supporting nominal sales numbers, investors should be wary for at least two reasons.

First, recessions are predicated on real variables as opposed to nominal numbers, says David Rosenberg, economist and founder of Rosenberg Research. 

As Shalett puts it, negative real corporate sales growth means declining volumes, and falling sales volumes have historically correlated with payrolls. Shalett warns that the recent rise in unemployment, to 3.8% in August and the highest since February 2022, will persist. Even if rising joblessness encourages the Fed to back off its tightening campaign, higher unemployment will nonetheless produce economic headwinds as consumers account for two-thirds of GDP, Shalett says.

Second, nominal sales growth appears to be stalling–and doing so well below the pre-pandemic levels–even as inflation remains elevated. In other words, the mirage of shocking economic strength may crumble in a way that surprises some investors banking on a soft economic landing.

When you combine the latest worker earnings data–which rose to a record high in August–with consumer price data, wages fell both on an hourly and weekly basis from a month earlier. That is as the Fed reported a record high in seasonally-adjusted consumer credit, led by revolving credit (credit cards). 

According to Lazar, consumers’ excess pandemic savings are meanwhile running out as lending standards are tightening, and the lagged impact of Fed interest-rate hikes will continue to squeeze unit growth. She warns that momentum will weaken at the end of this year and into next, hitting corporate revenue and profit and presenting major headwinds for capital spending as well as employment.

There are already signs of weakness unfolding across small businesses. They are often economic canaries in the coal mine as they have less cushion than big businesses and because they account for roughly half of domestic employment and half of GDP. 

In its August report released during the latest week, the National Association of Independent Business said the percentage of small-business owners reporting higher nominal sales in the past three months fell to the lowest level since August 2020. That is as compensation plans rose to the highest level this year and capital spending plans dropped to the lowest since April. Overall, the NFIB’s small-business optimism index fell to a lower-than-expected 91.3, snapping a run of three consecutive increases. 

All of this suggests investors should question Wall Street’s earnings expectations. As Merion Capital chief investment strategist Richard Farr notes, earnings estimates for 2024 were  declining over the past several months but have recently started to climb. The consensus is now at $248 per share for the S&P 500, up 12% from an estimated $223 a share this year. 

“We would not put 2024 earnings above 2023. We struggle to see how the consumer will be so resilient,” says Farr, who sees a consumer that is increasingly tapped out by high interest rates, inflated prices and indebtedness. Farr says a good assumption for S&P 500 operating earnings next year is between $215 and $225 a share, with the risk skewed to the downside. 

Lazar is even more skeptical. She forecasts $185 a share, annualized, for the first half of 2024. That would be down about 14% from where analysts think 2023 earnings will land and down 12% from the $210 she predicts. Lazar says S&P 500 earnings have never accelerated after a tightening cycle until after the Fed has eased, meaning it will take rate cuts for earnings to rise again once they do move lower.  

Growth data, such as the recent retail sales report, continue to positively surprise economists and investors. But the reality is less sunny. Inflation continues to bloat nominal data, masking cracks beneath the surface that suggest economic growth and corporate earnings are set to weaken. 

Fed Tightening May Be Just Starting to Hit Businesses (September 10, 2023)

A third of corporate debt may be at risk of default during this cycle of monetary tightening, Boston Fed economists find

By Lisa Beilfuss
September 10, 2023

Recent Federal Reserve research suggests there is significant economic pain in the pipeline–implying that any soft landing would be temporary.

Two recent papers out of regional Fed banks, taken together, undermine the notion that aggressive interest-rate increases won’t hinder U.S. economic growth. Already-implemented Fed tightening may have only just started to hit corporate balance sheets, meaning defaults are coming and significant job losses are more likely than an immaculate rebalancing of labor supply and demand.  

First, a paper published over the last week by Chicago Fed economists Stefania D’Amico and Thomas King received quite a bit of buzz. The pair estimates that about 65% and 75%, respectively, of the total tightening effect on the levels of real, or inflation-adjusted, gross domestic product and the consumer price index has already happened. What is left, they say, amounts to downward pressure of about 3 percentage points on real GDP over the next five quarters and 2.5 points on the CPI over the next 4 quarters.

On its face, the Chicago Fed paper’s conclusions for growth and inflation look like evidence that a soft landing is all but certain. The authors say Fed guidance shaped policy expectations, effectively speeding up the impact of rate hikes via longer-term private credit costs, expected future prices, and incomes. If they are right, CPI will fall below 2.3% by mid-2024 as real GDP growth remains positive.

But there is a wrinkle. D’Amico and King estimate that only 40% of the total impact of tightening has hit the labor market. Using hours worked as the proxy, they forecast a 6 percentage point hit coming over the next eight quarters.

That brings us to a separate paper published by Boston Fed economists at the end of August. In it, Falk Bräuning, Gustavo Joaquim and Hillary Stein focus on the transmission of monetary policy through the balance sheets of nonfinancial corporations. 

The team acknowledges that the corporate interest expense ratio–the amount of gross income that is being spent to pay the interest on borrowed money–is still at historically low levels. That is as the share of floating-rate debt is relatively small. Because firms issued a large volume of bonds during the COVID-19 pandemic and recovery, and because they refinanced en masse in 2020 and 2021 while rates were still low, companies increased the share of fixed-rate debt and extended the average maturity. Goldman Sachs says the share of corporate bonds maturing within the next two years is at the low end of its 15-year range–16% today versus 26% in 2007. 

Like households locked into low mortgage rates, many have assumed companies are largely immune to this cycle of rate increases. But the Boston Fed economists find that pass-through is gradual and peaks five quarters after the initial 1 percentage point increase in the Fed funds rate. That means that only the initial rate increase of 25 basis points in March 2022 may have fully passed through into the corporate interest expense ratio, they say. Said another way, firms have yet to see the impact of the subsequent 500 percentage points of rate hikes. The point is especially salient when you consider that it is businesses–not consumers–that usually lead downturns.

From there, the Boston researchers looked at implications for firms’ interest-coverage ratio, a measure of a company's ability to meet required interest expense payments. They note that the metric is crucial for debt and equity investors and is prevalent in debt contracts, often referenced in financial covenants included in most commercial loan agreements. 

Because an increase in interest expense can cause a violation of a financial covenant and effectively lead to default, firms tend to make adjustments to stay above their contractual ICR limit. That translates to less investment spending, less hiring and potentially more layoffs. Goldman says that for every additional dollar of interest expense, firms lower their capital expenditures by 10 cents and cut labor costs by 20 cents.

To estimate how much corporate debt is at risk of default, the Boston Fed economists took the recent monetary policy tightening and coupled it with various future corporate income scenarios. They then calculated the share of debt outstanding in firms that could have an ICR of less than 4 at the end of this year–what the researchers used as the threshold to capture firms that could violate their financial covenants and thus be at default risk.

Two main takeaways: Firms’ interest expenses are projected to grow about 23% by the end of 2023, and about a third of corporate debt is at risk of default during this cycle of monetary tightening. That share is roughly equivalent to the share at risk of default at the onset of the Covid-19 pandemic. For context, the share of company debt at risk of default coming out of the pandemic recession fell to a low of about 17%.

This brings us back to the Chicago Fed economists’ estimate that more than half of the already-announced Fed tightening has yet to hit the labor market. That estimate may wind up optimistic in light of the Boston Fed economists’ findings, in addition to a huge number of unprofitable U.S. firms. 

Economists at Goldman Sachs recently flagged the number of unprofitable firms as a reason to prepare for an outsized hit to economic activity from rising interest expenses. They say that the number of unprofitable firms has continued to proliferate, with nearly 50% of all publicly-listed companies unprofitable in 2022. 

What is more, the “exit rate” of unprofitable firms has declined since the start of the pandemic. That exit-rate decline is likely in part due to generous fiscal support that is no longer being provided, Goldman says, adding that unprofitable firms disproportionately cut back on employment and capex when faced with margin pressure. 

It may soon appear that the Fed has pulled off a soft, or softish, landing. But any victory by the Fed is likely to be transitory. Even if the hiking cycle is over, its impact on companies and the labor market seems far from finished. 

Boom Or Bust? It Depends On Where You Look (September 3, 2023)

GDP’s overlooked twin, GDI, is signaling that a recession has already started. 

By Lisa Beilfuss
September 3, 2023

There is a divergence developing in a pair of economic indicators, and it is sending a message investors should heed. 

For those looking ahead, gross domestic product reports aren’t usually worth much. GDP is especially backward looking given its quarterly frequency, and the staleness is compounded by a series of revisions. By the time a final, twice-revised number is released, it is already the end of the subsequent quarter. 

The latest GDP report is, however, worth considering. Within the revised second-quarter release came gross domestic income, or GDI, GDP’s overlooked twin. Where GDP reflects the value of the final goods and services an economy produces, GDI represents the incomes earned along the way. They are conceptually identical measures of domestic output: The price a consumer pays for a loaf of bread should match the profit plus the salaries, rent, and other inputs paid to make it.

Measurement errors mean the two measures never perfectly match, but the current gap between GDP and GDI is more than a statistical discrepancy and one that investors should observe. That difference has been widening for the past three quarters, and real, or inflation- adjusted, GDP is now outpacing real GDI by the most since at least 1947. 

Quarter-over-quarter, inflation-adjusted GDI was barely positive in the second quarter, following negative prints in both the first quarter of 2023 and the fourth quarter of 2022. Over the past year, real GDI has fallen 0.5% while real GDP is up 2.5%. That is as market focus has been on still-robust GDP despite ongoing monetary-policy tightening, with particular attention on a huge 5.6% third-quarter GDP projection by the Atlanta Fed’s GDPNow model. 

But while investors and economists debate whether such an acceleration is indicative of a soft landing or no landing, GDI suggests that a recession may already be underway. 

“GDI is firmly in contraction and it’s been that way since last year,” says Jeffrey Snider, chief strategist at Atlas Financial and host of the Eurodollar University podcast. The timing, he notes, dovetails with Treasury yield-curve inversions that have largely been dismissed this time. (Please see the July 26, 2023 Praxis article for our interview with Arturo Estrella, the former Fed economist responsible for discovering that the yield-curve slope is a reliable recession predictor). 

Some economists have acknowledged the difference. “One of the most interesting puzzles of the current expansion is why real GDI has been so weak,” says Justin Wolfers, professor of public policy and economics at the University of Michigan. But it probably isn’t as much of a puzzle as it is an inconvenient reality, partly because Wall Street, government, and the media tend to focus on GDP, and partly because GDI is released with an even bigger delay than GDP. 

Some research shows that real GDI leads real GDP into recessions. In a 2010 paper, Jeremy Nalewaik, an economist at the Federal Reserve Board of Governors, found that GDI better reflects business cycle fluctuations because it is more correlated with a wide range of business-cycle indicators, including changes in unemployment, purchasing manager surveys, and changes in stock prices. Nalewaik found that GDP tends to be revised toward GDI; on top of flagging downturns GDP initially misses, GDI better reflects the severity and length of recessions. 

More recently, Francesco Renno, economist at labor-market data provider Chmura, quantified the relationships between both measures of output and the job market. Active job postings are more strongly correlated with GDI, he says, with a correlation coefficient of 82.5 versus 76.8 with GDP.

In recommending that GDI should be emphasized over GDP, Nalewaik is suggesting that income-related statistics are better recession indicators than expenditure-related figures. In that context, it is worth considering household-level personal income and outlays data published in the latest week. 

From a month earlier, personal income rose just 0.2% in July, the slowest pace since December 2022. That is as personal consumption expenditures jumped 0.8%, the fastest since June 2022. Spending growth has outpaced income growth in seven of the past 12 months, subsidized by debt and excess savings accumulated during the pandemic. But that gap seems unsustainable as the cost of credit rises and excess savings, according to the San Francisco Fed, are on track to run out in the third quarter.

“The income numbers look nothing like what most people assume has been a red-hot economy and labor market,” says Snider. Take away government transfer payments, and the situation looks much different. Once the [excess] savings are gone, almost-flat income growth is what is left, he says.  

A precipitous decline in tax receipts underlines the point. Federal government tax receipts fell 8% and 5% year-over-year in the first quarter of 2023 and the fourth quarter of 2022, respectively, the first back-to-back declines since the summer of 2017. “Natural tax receipts are declining as the economy produces less income,” a change that is more consistent with GDI than with GDP, says George Goncalves, head of U.S. macro strategy at MUFG’s institutional client group.

All of this is a red flag for stocks. Piper Sandler chief global economist Nancy Lazar warns that stalling (nominal) or falling (real) GDI is a “very negative” backdrop for corporate revenue. Even when you average GDP and GDI, growth was only 1.2% in the second quarter. Blame higher interest rates and tighter bank lending standards, she says, predicting that economic growth will continue to weaken at least through the second quarter of 2024.  

“​​Looking ahead, it doesn't look too rosy for company earnings,” says Lazar.  “Altogether [it is] a recipe for more layoffs, and a hard landing, most likely starting in 4Q.”

As for the Fed, minutes from the July 5 Federal Open Market Committee meeting showed that “several” participants noted a discrepancy between GDP and GDI. Of them, “most suggested that economic momentum may not be as strong as indicated by the GDP readings,” the minutes said. 

It isn’t clear whether Fed Chairman Jerome Powell is among the “several” concerned with GDI. In his Jackson Hole speech last month, Powell pointed to GDP as indication that the economy isn’t cooling as expected and may require further tightening. 

When it comes to broad output measures, it is possible that the Powell Fed follows GDP over GDI–especially if it wants a reason to remain hawkish in the face of stubborn inflation. But even as inflation remains elevated, recession is probably already unfolding. If GDI is right, it is now a question of how severe the downturn will be. 

Reports of China’s Economic Implosion Distract from Trouble in the U.S. Bond Market (August 26, 2023)

Reported weakness in China isn’t lifting Treasuries at a time when quantitative tightening is increasingly important 

By Lisa Beilfuss
August 26, 2023

Headlines across financial media lately have focused on an economic meltdown in China. But one of the most consequential developments for investors isn’t getting much airtime.

While it may be true that China faces serious problems connected to real-estate bubbles, heavy debt burdens and an aging population, the situation may not be as dire as portrayed. Instead, this narrative may be distracting from a related, but underappreciated, situation unfolding in the U.S. Treasury market.

Louis-Vincent Gave, CEO of Gavekal Research, lays out several reasons why he is skeptical that China’s economy is heading off a cliff. First, he says bank shares are a leading indicator of financial trouble and notes that Chinese bank stocks have been roughly flat this year. Second, Gave points to a lack of weakness in global commodity markets, which runs contrary to the China-is-failing narrative as China is a top importer of nearly every major commodity. 

Third, Gave says the share prices of luxury-goods makers such as LVMH, Hermès and Ferrari don’t reflect concern over a crash in Chinese consumption. And fourth, he notes that Chinese renminbi is grinding higher against the Japanese yen and is rebounding against the South Korean won. This latter point is at odds with what normally happens to the currency of a spiraling economy versus currencies of its immediate neighbors and competitors. 

Most importantly, reports that the world’s second-largest economy is imploding aren’t accompanying a surge in demand for U.S. Treasuries, the place where investors tend to seek shelter. Instead, the opposite is happening. 

“Here is the biggest market in the world, the bedrock of the global financial system, falling by close to double digits in a month. And perhaps most amazing, this meltdown is occurring on limited news,” Gave says. “This should be the news.” 

Gave has a theory about why the bond-market meltdown isn't grabbing headlines. “Is the Chinese news so bad precisely because U.S. Treasuries are melting down?” he asks, suggesting that muted flight to safety isn’t just a reason to doubt the China narrative but an explanation for it. As he sees it, narratives are created by established powers and handed to the media for public dissemination. Because most of the media would rather be wrong with the consensus than be right alone, the result is a press that latches on to a narrative and lays it on thick, Gave says. 

All of this matters not least because it is happening as quantitative tightening, the quiet side of this monetary tightening cycle, continues. 

QT hasn’t gotten nearly as much attention as rates in the media and on Wall Street, in part because it is harder to model, and because Fed officials themselves have acknowledged that they don’t know what they don’t know about the reversal of pandemic-era bond buying that doubled the Fed’s balance sheet to roughly 40% of GDP.

Since QT began in June 2022, the Fed’s balance sheet has shrunk by about $900 billion. While that is only a fraction of the roughly $4.5 trillion in pandemic quantitative easing, some strategists predicted QT would be over by now. The logic in part traces to the latest debt-ceiling standoff, which left the U.S. Treasury General Account–the federal government's operating account–uncomfortably low. Some worried the subsequent replenishment would drain bank reserves and disrupt markets, but the refill instead mostly came out of the Fed’s reverse repo facility, or RRP, where nonbanks and money market funds have parked trillions to obtain additional yield. 

Successful draining of the Fed’s RRP to refill the TGA enables ongoing QT, says Joseph Wang, chief investment officer at Monetary Macro and a former New York Fed trader. Wang says it is underappreciated by markets that QT will continue, at least for now. What is more, it is happening at a time when the Treasury is selling an increased amount of debt to help finance a surging budget deficit. QT plus more issuance means more supply needs to be absorbed by investors, translating to upward pressure on Treasury yields as prices fall.

This brings us back to the observations by Gave of Gavekal Research. “A Chinese meltdown, reminiscent of the 1997 Asian crisis, would be just what the doctor ordered for an ailing U.S. Treasury market: a global deflationary shock that would unleash a new surge of demand and a ‘safety bid’ for U.S. Treasuries,” Gave says. “For now, this is not materializing, hence the continued sell-off in U.S. Treasuries.”  

QT is crucial for multiple reasons. First, as Bob Elliott, chief investment officer of Unlimited Funds, says, the Fed needs to lower asset prices to slow income versus spending. QT is the lever to do that most effectively and with the least amount of pain and financial-stability risk, he says. The alternatives are an unpalatable amount of rate hikes, or a failure to achieve 2% annual inflation. 

There is another, more abstract reason why ongoing QT is important. Because QE has blurred the separation between monetary and fiscal policies, balance-sheet shrinkage is one way to reduce the risk of so-called fiscal dominance. 

Economist and Columbia Business School professor Charles Calomiris describes fiscal dominance as the possibility that government debt and deficits produce increases in inflation that overpower a central bank’s intentions to keep inflation low. The idea is that as fiscal dominance forces money supply growth, inflation rises and creates a new means of funding government spending–what  Calomiris calls inflation taxation.

It remains to be seen whether Gave is right about the economic reality in China.  Either way, investors should heed his warning that headlines about an imminent implosion there are overshadowing trouble in the U.S. Treasury market. The Fed’s attempt to unwind QE may worsen bond-market conditions to the detriment of such attempted tightening, meaning that inflation may be harder to contain than investors appreciate and that fiscal dominance is not so far fetched. 

An Overlooked Inflation Indicator Is Going the Wrong Way (August 20, 2023)

Import prices jumped in July, a sign that goods-price deflation may be stalling or reversing

By Lisa Beilfuss
August 20, 2023

A key assumption behind inflation optimism may be less reliable than many investors believe.

The Labor Department said that import prices rose 0.4% in July from a month earlier, double the rate economists expected and the biggest increase since May 2022. While one month doesn’t make a trend, the July gain follows an upward revision in June and may represent an inflection point. 

Compared with other inflation gauges, the import price index commands little attention. One reason is because, naturally, the index is heavily weighted toward manufactured goods. Though the U.S. economy is tilted toward services, the goods-producing sector still represents about a fifth of gross domestic output. 

In addition to final-goods imports from cars to toys, a significant share of inputs for domestic production and consumption are imported. For context, the Commerce Department has said that only about half of total U.S. end-user demand for manufactured goods is domestically produced. The import price index is thus an underappreciated leading indicator for inflation as import prices affect producer prices and, ultimately, consumer prices. 

Falling goods prices have been something of a foregone conclusion across Wall Street. Even as economists and investors debate the path of inflation, interest rates, and whether the U.S. economy will land softly or with a thud, one thing that virtually everyone has agreed upon is that goods prices would deflate after surging during the pandemic. 

This all matters because goods-sector deflation has been expected to partially offset stubborn service-sector inflation, which has remained elevated in part because of short labor supply and generous fiscal spending. 

Until now, that proposition has mostly played out as expected. Looking back to July 2022, import prices fell month-over-month in 10 of the last 13 months. Over the same stretch, the index of durable goods in the consumer price index fell eight times from a month earlier. Stalling or reversing goods deflation now would leave that durables basket in the CPI up 22% from December 2019, down only slightly from a year earlier when those prices were up 24% from pre- pandemic levels. 

The reason some investors might be inclined to disregard the July rise in import prices is the same reason they should heed it. The fuels category rose a hefty 3.6% last month from June, pushing up the overall index. While economists and central bankers tend to exclude energy and food prices from inflation figures, the reality is that businesses and consumers can’t ignore the cost of essentials. Energy prices have posted double-digit percentage increases since June and some analysts expect further gains. 

Eric Nuttal, portfolio manager at Nine Point Partners, predicts historic inventory drawdowns will push crude oil up to $100 a barrel this year, up 24% from current levels. He notes global oil inventories are at an eight-month low and expects them to end the year at an eight-year low. Even if the International Energy Agency’s estimate for oil inventory drawdowns over the second half of this year through the end of 2024 is only half right, inventories would fall to the lowest level since 2007, he says. 

Economic weakness in China is a potential wildcard. While weakness there and elsewhere would inevitably hurt demand, Nuttall points to real-time data from research company Rystad Energy as evidence that oil demand in China and beyond has yet to falter. 

A related point: A downturn in China would seem to offer a silver lining for the U.S. in the form of exported deflation. But that effect may be less pronounced than many strategists expect. Recent trade data show that China’s share of U.S. goods imports fell to 13% in the first quarter, down from a peak of 22% in 2017 and putting China’s market share in the U.S. on track for the lowest annual level since 2004. Moreover, the price of imports from China fell in July at half the prior month’s rate. 

The recent rise in U.S. import prices isn’t only an energy story. Non-energy related import prices were flat in July for the first time since January, with the overall report signaling that deflation is gone from the import price index, says KPMG economist Meagan Martin-Schoenberger. Foods, building materials and transportation equipment, to name a few, rose respectively 2.5%, 1.6% and 1.4% in July from a month earlier.  

If import prices are an upswing, the impact on more closely watched inflation metrics may be bigger than what historically has been normal. Last August, researchers at the Federal Reserve Bank of New York found that the pass-through of import prices to the domestic producer price index more than doubled after the onset of the Covid-19 pandemic.  

Normalized supply chains have probably reversed some of the heightened correlation between import prices and producer prices. But some supply-chain issues persist while others may be reemerging.

Container freight rates from China to the U.S. have increased slightly in recent weeks, says Apollo Global Management chief economist Torsten Slok. The National Association of Realtors recently said home builders are still dealing with a shortage of distribution transformers, or devices that transfer power from the electrical grid to homes and other buildings, notes Bleakley Financial Group chief investment officer Peter Boockvar. The United Auto Workers (UAW) may strike, a major trucking company (Yellow) recently declared bankruptcy, and commodities remain disrupted by the war in Ukraine. The New York Fed’s global supply chain pressure index, while down significantly from a pandemic peak, has risen for the past two months.

The New York Fed researchers didn’t study the relationship between import prices and consumer prices because, unlike with the PPI, there isn’t a clear mapping between international products and domestic industry categories. But it is fair to assume that a renewed rise in wholesale prices would at least partially flow through to consumers. Consider a December 2021 survey by the Federal Reserve Bank of Richmond that found 80% of firms raised prices in response to their own cost increases. The balance absorbed higher costs, often by sacrificing margins. 

While often overlooked by media and market strategists, the import price index is worth watching in the coming months. The biggest upside risk to inflation isn’t from goods, but a premature reversal in goods-price deflation would upend inflation assumptions. Without that partial counterforce to sticky service-sector inflation, it may be harder than otherwise believed for inflation to glide back to target and for the Fed to begin cutting rates in early 2024.

Data Versus Reality: How a Soft Landing Could be a Mirage (July 26, 2023)

If the yield curve is wrong this time, it may be for the wrong reason

By Lisa Beilfuss
July 26, 2023

Investors and economists are increasingly sure the Federal Reserve will achieve a rare soft landing. Could this time really be different?

Two propositions underpin the soft-landing logic. First, the fact that there hasn’t been a recession yet in the face of 500 basis points of Fed rate increases means there won’t be a recession at all. Second, the logic goes, inflation is gliding back to the Fed’s 2% target and is no longer a threat. Recent indicators support the soft-landing case. Consider the June consumer price index alongside the Atlanta Fed’s GDPNow model. The former rose 3% from a year earlier, the slowest rate of increase since March 2021, while the latter predicts 2.4% growth in the second quarter, up from 2% in the first.

Neil Dutta, head of economics at Renaissance Macro Research, captured the zeitgeist in a research note. “There is only so long one can keep claiming that the recession is just six months away,” he said, calling for recession predictors to admit defeat. Even economists at Deutsche Bank, among the first on Wall Street to predict recession, now say it is now a toss up.

But a soft-landing bet ignores upside inflation risks, including double-digit increases in many commodity prices since the end of May. It overlooks clear slowdown signs, such as ongoing rises in high-yield and leveraged-loan defaults, and it assumes history doesn’t apply as the yield curve inverts to levels not seen in four decades.

Praxis recently spoke with Arturo Estrella, the former Fed economist and professor responsible for discovering that the yield-curve slope is a reliable predictor of economic activity. In particular, he found that the spread between the 10-year Treasury note and the 3-month Treasury bill is a perfect recession predictor, better even than the closely watched spread between 10- and 2-year Treasury notes. Estrella says a negative spread between 10-year and 3-month Treasury rates foreshadows an economic downturn starting between six and 17 months after the first inversion. The first such inversion of this cycle happened in November 2022, about eight months ago.

Estrella is used to impatience and this-time-is-different narratives, both in current abundance. “Every time I see the same thing–people are dismissive,” he says, counting former boss Alan Greenspan among naysayers. “And yet it is always the same. We have had eight incidents of [10-year/3-month yield curve] inversion since 1968, and there is always a recession,” he says.

Aside from serving as a recession signal, the yield curve has practical implications. Barry Knapp, director of research at Ironsides Macroeconomics, warns that the deeply inverted curve needs resolution prior to 2024’s surge in maturing commercial real estate and leveraged loans. Analysts at S&P Global Ratings say the amount of maturing speculative-grade nonfinancial debt will surge to $247.7 billion in 2024, more than double the amount maturing this year. The maturity wall grows to $389.3 billion in 2025, S&P estimates.

To normalize the yield curve, the Fed needs to cut rates by about 300 basis points, to 2.4% from a likely peak of 5.5%, economists at SMBC Nikko Securities say. In other words, interest rates that remain elevated into the surge in maturing debt would only exacerbate a recession that Estrella’s gauge says is 99.87% likely to happen in the next 12 months.

If the yield curve is wrong this time, it might be for the wrong reason.

Economist and fund manager Daniel Lacalle suggests the U.S. economy is already in recession. Official data don’t reflect it, he says, because government spending is disguising a private-sector downturn and declines in real, or inflation-adjusted, disposable income, real wages, and small-business margins.

Data from SMBC Nikko economist Troy Ludtka illustrates Lacalle’s point. Real, post-tax disposable personal income has fallen a record 9.7% since the economy exited the pandemic recession, meaning U.S. households are poorer now than they were in the spring of 2020, Ludtka says.

Government expenditures square Ludtka’s observation with still-robust GDP prints. Such spending comprises 35% of U.S. output. Data from the St. Louis Fed show that while that GDP share is down from a pandemic high of 54%, it is still above pre-Covid levels and has been climbing for the past three quarters.

When the government “continues to consume wealth and spend, gross domestic product does not show a recession even though consumption and private investment in real terms is declining,” Lacalle says. One might argue it is good, or at least neutral, if government spending goes straight to consumers and businesses. But it is zero sum. “The flip side of ‘no official recession yet’ is more public debt,” where deficit spending inevitably means higher taxes and lower real wages, he says.

A decline in money supply is core to inflation optimism and soft-landing prospects. M2, a broad measure of money supply that includes cash, savings deposits and balances in retail money-market funds, exploded 43% during the pandemic. M2 fell at record rates in late 2022, but given the huge base it is down just 6% from a mid-2022 high. What is more, it is only half of the money-supply story.

The other half is rising M2 velocity, or the number of times a dollar is spent per unit of time. Lacalle describes velocity as the glue between central bank action, government spending, and inflation, with velocity rising because much of the new money supply funded government spending. If not for the rise in velocity since the fourth quarter of 2021, Lacalle says a money-supply slump of the current magnitude means inflation would be half what it is now.

The point is that as M2 velocity counters the decline in M2 money supply, it threatens to boost inflation numbers and mask private-sector economic weakness in broad growth metrics like GDP.

Money velocity may still have room to run. Michael Ashton, investment manager at Enduring Investments, likens the velocity of M2 to a spring holding potential energy when money rushed into the system. He expects money velocity to bounce to at least pre-pandemic levels, implying a 13% increase or more. It is therefore critical for M2 money supply to keep falling, he says, for inflation progress to continue.

Combine the pieces–the quantitative theory of money where money supply and money velocity are key, Lacalle’s view that government spending is behind rising velocity, and Ashton’s estimates for where it is heading–-and it is possible that official economic data won’t reflect a recession that households and smaller businesses probably can’t avoid.

A soft landing may thus be one in name only.

His Warnings On Inflation and QE Were Early and Right. What Worries Robert Kaplan Now? (May 19, 2023)

The banking crisis is only starting, fighting inflation will take years, and fiscal policy is undermining the Fed: former Dallas Fed President Kaplan lays out the risks for investors

By Lisa Beilfuss
May 19, 2023

While leading the Federal Reserve Bank of Dallas, Robert Kaplan warned that pandemic-era inflation wouldn’t be transitory and urged his colleagues to begin tightening monetary policy well before the central bank began doing so. He was at the time considered one of the Fed’s most hawkish members. More apt: Kaplan is an independent voice with a knack for connecting dots across monetary and fiscal policy, financial markets, and the business community.

Previously a professor at Harvard Business School and a 23-year veteran of Goldman Sachs, Kaplan now warns that the banking crisis is just getting started. He cautions that the U.S. economy is heading into a downturn with an undercapitalized banking system, and he thinks further interest-rate increases are futile and only risk premature rate cuts that will undermine the Fed’s inflation fight. That inflation fight, he says, is already being undercut by expansive fiscal policy.

Praxis recently caught up with Kaplan. An edited version of the conversation follows.

Praxis
While at the Fed, you were a dissenting voice on inflation and overly-accomodative monetary policy. What are the Fed’s blind spots now?

Robert Kaplan
Monetary policy is very important in terms of promoting full employment and price stability. However, it’s worth recognizing that it doesn’t work in isolation. While the Fed has raised the Federal Funds rate dramatically, in an effort to slam on the brakes to cool the economy and reduce the rate of inflation, you still have a number of other fiscal and structural factors that are limiting the Fed’s ability to make progress toward achieving its 2% inflation target.

On the fiscal side, my conversations with mayors and civic leaders suggest that there is still a substantial amount of unspent money from pandemic programs sitting in the bank accounts of cities and states around the country. For example, American Rescue Act (ARPA) money must be spent by states and municipalities between now and the end of 2024 or it’s lost. This local spending is increasing demand for goods, services, and labor at the same time the Fed is trying to cool demand for goods, services, and labor. Also, certain portions of the infrastructure bill and Inflation Reduction Act funds are earmarked for projects that are increasing demand for labor.

As a result of the substantial amount of fiscal spending, as well as higher interest rates, the Congressional Budget Office expects the federal government to run a deficit of almost $2 trillion dollars in fiscal 2024. That is nearly 10% of GDP. You normally run big deficits after a recession; typically you want more budget discipline in good times, because you know that tax revenues will likely decline in a downturn and you may want capacity for fiscal stimulus. Moreover, running this sizable deficit now is stimulative to the economy at a time when the Fed is trying to cool the economy.

From a structural point of view, we should recognize that we are an aging society and, as a result, workforce growth continues to decelerate. The rate of workforce growth was 2.5-3% in the 1970s and 1980s–-today it is closer to 0-0.5%–and the deceleration is expected to continue. The substantial fiscal and monetary stimulus of 2021 and most of 2022 has exacerbated shortages/imbalances in the U.S. workforce.

Additionally, while a sensitive topic, the important efforts to transition our economy away from fossil fuels have resulted in reduced levels of fossil-fuel production at a time when supply from alternative energy sources isn’t yet sufficiently robust to fill the gap. This is resulting in higher energy prices which particularly impact more than 50 million families that earn approximately $50,000 a year or less. These workers now need higher wages to make ends meet. The point is that structural forces and highly stimulative fiscal policy may be offsetting, to some degree, the impact of recent monetary tightening.

Where are we in the banking crisis and how will it unfold?
Phase one was an asset/liability mismatch at several banks. Alarmingly, two of the top 20 U.S. banks, Silicon Valley and First Republic, had mismatches large enough to wipe out substantially all of their capital. For whatever reason, supervisory oversight was insufficient to forcefully address at least these two highly visible situations.

Phase two began with the stock market deciding to do its own supervisory scrubbing. It analyzed every public bank’s hold-to-maturity, or HTM, account, and then marked-to-market each bank’s stock dollar for dollar. While they were at it, investors also scrutinized each bank’s loan book, focusing in particular on the loan-to-deposit ratio and the exposure to commercial real estate. Then investors screened for banks with a higher-than-average percentage of uninsured deposits. While all this was going on, depositors actively increased their scrutiny regarding the safety and wisdom of housing their savings or business accounts with their existing bank. Small businesses particularly questioned whether it was prudent to keep a $1 million plus payroll account at a small or midsized bank (when only $250,000 is insured by the FDIC).

We are now heading into the third phase. Bank leadership at small and midsize banks are considering how to shrink their loan books in order to address the mark-to-market loss of capital, as well as to guard against potential deposit instability in the future. Bank leadership is very aware that the economy is slowing, and that we are likely about to enter a challenging credit environment.

While asset/liability mismatches are relatively easy to spot, assessing the quality of loan portfolios is much more complicated. CEOs of many small and midsize banks are in a tough position. They can’t easily raise equity because their stock prices are down. As a result, they are turning to shrinking their loan books, finding places to pull back on existing loans and future loan commitments. This is making it much harder for small and midsize businesses to get and keep their bank loans. It is a quiet phase that won’t make headlines but is nevertheless relentlessly going on beneath the surface.

How undercapitalized is the banking system, and how did we get there?
First, we tolerated an accounting fiction. Banks were able to classify investment securities as hold-to-maturity, which allowed them to mark these securities at par even though, due to substantial increases in rates, their market values had declined to, say, 80 or 85 cents on the dollar. The idea was that underwater HTM bond portfolios didn’t reduce bank capital because Fed supervisors said that, for accounting purposes, the losses wouldn’t be marked against their capital. Once Silicon Valley Bank had sufficient deposit runoff to force sale of their HTM securities, the market realized that this practice was more widespread than they previously understood–and that the market value of bank capital was lower than previously understood.

In the aftermath of the last two months, bank depositors are now much more sensitive to deposit safety as well as deposit rates. On a market basis, bank capital is lower than two months ago. Most banks are now trading at a discount to book value. All of this is happening before we head into the tougher part of a credit cycle which is likely to occur as the economy weakens due to the Fed’s efforts to cool inflation.

Will the Fed succeed in getting inflation back to 2%--and is that still the right target?
I think it’s going to be a lengthy process to get inflation below 4% because inflation in the service sector is particularly sticky. However, I don’t think the Fed should in any way signal it is backing off its 2% target.

Why is service-sector inflation sticky? Consider the some 50 million workers in the country making $50,000 a year or less. That is ground zero in the inflation fight. Many of these workers are in the service sector or other jobs that have a physical component. Employers around the country tell me they are unable to find and hire enough of these workers to staff their businesses. If overall inflation is running at, say, 4.5%, the inflation rate for these workers and their families may feel more like 10% given the share of wallet they spend on food, rent, energy, transportation, and healthcare.

Employers are finding that these workers need higher wages to make ends meet and, in turn, employers are trying to pass these higher costs onto their customers. That fuels higher inflation which further leaves these workers still needing to catch up. This is why government programs that increase demand for these workers may help perpetuate this wage/price spiral.

What should the Fed be doing now?
All things considered, I would be inclined toward advocating a “hawkish pause” at this point, explaining that the Fed remains in a tightening stance but wants to digest the cumulative impact of the 10 or so rate hikes already executed over the past 12 months. I would also make clear that we may have to raise the Fed Funds rate in the future if we don’t see more progress in achieving the Fed’s 2% inflation target. I would particularly emphasize to market participants that they should not be expecting the Fed to be cutting rates later this year.

I would mention two related concerns. First, at this point in the tightening cycle, rate increases seem to be impacting the front end of the yield curve while the back end of the curve is now substantially inverted. Small and mid-sized companies borrow based on the Fed funds rate. Larger firms–those in the S&P 500–tend to borrow very little at the Fed funds rate other than for seasonal working capital needs and instead do most of their funding based on medium- and longer-term rates. As a result, Fed funds increases seem to be disproportionately impacting smaller businesses, creating an increased advantage to size and scale organizations. Is this distributional impact helpful to fighting inflation and strengthening job growth and price stability in the longer run? I’m not sure.

On a related point, the recent banking turmoil has highlighted the disparity between too-big-to-fail banks and smaller and midsize banks. I worry that increasing the Fed funds rate from here may create further strains on the deposit base for those smaller banks. I’m concerned that, as the Fed raises rates, it is tightening the vice on small and midsize banks and the small and midsize businesses that rely on those banks for funding.

Let’s face it: We need a greater slowing in the economy in order to get inflation under control. My worry is that after the downturn, how do we climb out? We may not be able to use the big cannon of monetary and fiscal policy because we are far more leveraged today as a country due to substantial use of these tools during and in the aftermath of COVID. We will need small- and midsize banks to lend to small- and midsize businesses to climb out of the next downturn.

Is over tightening or under tightening the bigger risk for the Fed right now?
Right now, the market seems to be pricing in that the Fed will be cutting rates later this year. That means that the forward interest rate curve is downward-sloping. Fed funds rate increases impact those that primarily borrow from banks, namely small and midsize businesses. At this point, I don’t think financial options for big companies are being materially negatively impacted. Pfizer just executed a $31 billion bond deal at rates below the Fed funds rate.

I don’t think that inflation is like a fever that can be broken by higher and higher Fed Funds rates. I think that, due to structural elements of the economy, the war on inflation is not going to be a six-month war. It is more likely to go on for the next couple of years. In that context, it is more important to hold rates at a sustainable level for longer than the market is currently expecting. Trying to squeeze in a couple of more rate increases in the near term may precipitate other strains that cause the Fed to have to cut rates prematurely and limit the consistency of the inflation campaign. So, from here, I think officials should express a tightening bias and warn markets to prepare for a Fed funds rate that stays higher for longer than markets think.

What, if anything, can the Fed do about fiscal policy offsetting its efforts?
I believe that the Fed might be well served to identify some of the forces away from monetary policy that are impacting the battle on inflation. I would like to see a “whole-of-government” approach to fighting inflation versus the Fed going it alone and saying it can win this battle on its own.

If I were in my old seat, I would be saying that monetary policy will do its part, but it’s not the only policy action needed to fight inflation. I’m concerned that, without more of a “whole of government” approach that incorporates fiscal and structural economic decisions, the Fed will need to keep rates higher for longer and, at a certain point, may find itself going too far or even pushing on a string in terms of fighting inflation.

What are your views on the current debt-ceiling debate?
I don’t like the tactics and threats of this debt ceiling standoff–default should never be a subject we are debating. But it is also true that we need a national discussion about government spending discipline.

Government debt-to-GDP is running at approximately 120%. The present value of unfunded entitlements is about $75 trillion and growing. Monetary policy is not the cause of this debt buildup, but it has certainly enabled it. The Fed now owns more than $8 trillion of treasury bonds and mortgage-backed securities and is working to runoff its balance sheet at $95 billion per month.

We are an aging society, so in order to grow GDP, we need to find ways to grow our workforce and improve its productivity. Our substantial government debt and spending choices might ultimately squeeze out investments in early childhood literacy, the digital divide, skills training, improving secondary education and so forth–investments that will improve productivity and GDP growth in the years and decades ahead. The current national debt situation will require additional focus on fiscal restraint and more discipline around spending decisions and tradeoffs so that we can fund our nation’s critical priorities.

The U.S. dollar is one place where growing concerns over fiscal and monetary policy coalesce. What do you make of the de-dollarization narrative?
Running at this size fiscal deficit gives some further credence to conversations between China and Brazil about denominating trade transactions in currencies other than the U.S. dollar, and/or OPEC discussing denominating oil purchases away from the dollar. I wouldn’t overreact to these discussions, but I do think it should remind us that fiscal discipline sooner rather than later would be appropriate and desirable in order to protect the dollar’s role as the world’s reserve currency.

I don’t believe there will be an issue with the dollar’s reserve status in the very near term, but I do believe it is a material risk over the horizon. Accordingly, I think we would be well-served to more explicitly consider this material risk as we debate fiscal and monetary policy over the horizon. You can debate probabilities, but if the U.S. dollar is no longer the reserve currency and we owe an additional 200 basis points more on some $30 trillion in debt, that is a problem.

We have to recognize that we spent and printed substantially, in great part to fight COVID, but also in the aftermath of COVID. Fiscal and monetary authorities drove the car at 120 miles per hour to get out of the COVID ditch but, instead of beginning to gently take the foot off the accelerator, they continued to drive at a high rate of speed into 2021 and most of 2022. As a result, the Fed ultimately has had to slam on the brakes.

In order to help the Fed in the inflation fight, I would suggest that the fiscal side of the house needs to play a key leadership role in order to create more of a “whole of government’ approach in order to make more progress in getting inflation back to the Fed’s longer-term target and restoring price stability to the U.S. economy.

Full Government Backstop of U.S. Deposits Would Do More Harm Than Good (April 6, 2023)

Japan illustrates the dangers of full deposit guarantees, where excessive fiscal spending undermines monetary policy

By Lisa Beilfuss
April 6, 2023

Discussion around a government backstop of all bank deposits highlights an underappreciated problem. Fiscal policy continues to undermine monetary policy, with the feedback loop threatening U.S. economic and financial stability.

The U.S. government action to ensure all deposits at recently failed Silicon Valley Bank and Signature Bank has prompted calls for a full government guarantee of $17.5 trillion in commercial-bank deposits. Roughly 43% of those deposits, or about $7.5 trillion, aren’t insured by the Federal Deposit Insurance Corporation. After fully repaying SVB and Signature Bank depositors, the FDIC has just over $105 billion–roughly equivalent in size by assets to the thirty-second largest U.S. bank–remaining in its deposit insurance fund for future failed-bank resolutions.

There are valid reasons to rethink the current FDIC insurance cap. First, it is outdated. The cap of $250,000 had in 2008 the purchasing power of what is now $350,000. Second, proponents of a blanket deposit guarantee say that regional-bank bleeding won’t stop if depositors perceive a two-tier system where deposits at the biggest banks are implicitly guaranteed by the government while deposits at smaller banks aren’t. The point isn’t insignificant; small banks account for about a third of all banking-sector deposits.

But a decision to fully backstop deposits isn’t a simple choice between preventing or inviting bank runs. The issue is at the center of an increasingly dysfunctional relationship between government spending and Fed policy, where burgeoning budget deficits rely on easy money and then constrain the central bank’s ability to navigate business cycles. Scant conversation around the gap between trillions in bank deposits and the FDIC’s insurance-fund balance highlights how entrenched deficit spending and money printing have become in the U.S., desensitizing some policymakers, economists and investors to the costs of a full-deposit backstop.

Consider how economists Asli Demirgüç-Kunt and Edward Kane outlined the consequences in a 2002 paper examining the proliferation of deposit insurance worldwide. Explicit deposit-insurance schemes can, in the short run, seem like a costless way to avert bank runs. But deposit insurance puts institutions at greater risk of failure because depositors are less incentivized to monitor their banks and proactively manage their deposits, they warn. Bankers in turn take on greater risk because they know their principal is protected even if risky borrowers default. The economic costs of compromised market discipline and financial fragility are far greater than the direct costs associated with the government running an insurance enterprise, Demirgüç-Kunt and Kane say.

The deposit debate in the U.S. isn’t a new story, and Japan offers a cautionary tale. When the Japanese government backstopped all deposits in 1996 after multiple bank failures, depositors’ confidence quickly improved, says Masami Imai, an economics professor at Wesleyan University. But because the move reduced the urgency among banks, regulators and politicians to address root problems, it set up a full-fledged banking crisis two years later. Imai says it wasn’t until 2001-2002 that the government finally cleaned up a large number of weak, small banks that wouldn’t survive the expiration of the blanket deposit guarantee.

Economists Luc Laeven and Fabian Valencia say that of public funds deployed to address Japan’s banking crisis, only about half of the money was recovered. That isn’t to mention the pair’s estimate that Japan lost output equivalent to about 18% of GDP in the three years after the crisis started. the outbreak of Japan’s banking crisis.

Quantitative easing, first introduced by the Bank of Japan in 2001, has complicated the interplay between fiscal policy and monetary policy. Massive bond buying with rates on the floor enabled excessive fiscal spending, with the ballooning deficit underpinning inflation and inflation diminishing the government’s debt burden. As the government, and the overall economy, became hooked on easy money, higher interest rates became a bigger threat. The dynamic was easy to ignore until inflation surged in recent years.

Thomas Cargill, an economist who spent years working at the Bank of Japan and Japan’s Ministry of Finance, blames full deposit backstops for decades of economic and political instability in Japan. He says the intervention fueled irresponsible fiscal and monetary policy that exacerbated the problems politicians and policy makers said they would fix.

“When you extend government guarantees, only bad things happen,” Cargill warns, adding that you eventually get to a point where the center won’t hold. “It doesn't mean you shouldn’t intervene, but you have to be very, very careful.”

The idea that U.S. fiscal policy is undermining monetary policy is more than theoretical. Solomon Tadesse, head of quantitative equities strategies North America at Société Générale, has quantified the impact of growing fiscal deficits on the Fed’s ability to affect the economy through monetary policy.

Apart from the fact that fiscal spending undermines Fed tightening by replenishing liquidity and reinforcing inflation, Tadesse says there is a falling ceiling before policy tightening induces a recession. That means ever-larger Fed asset-buying programs are inevitable as rates hit the zero bound more quickly and stay there longer. And as the central bank’s balance sheet grows, it gets harder to unwind it–effectively leading to indirect monetization of government debt.

Tadesse uses several measures to quantify the impact of fiscal policy on monetary policy. First, he measures the potential degree of fiscal debt monetization through the ratio of federal debt held in the Federal Reserve system as a percentage of GDP. He says the measure has historically ranged from 3-5%. At the end of 2021, it stood at 25.1%. He meanwhile defines the monetary policy space as the maximum fed funds rate at a tightening peak during a monetary policy cycle.

Together, those measures create Tadesse’s monetary tightening to fiscal monetisation ratio (MTFM), which he uses to project the path of monetary policy. His conclusion: Overall monetary tightening (rate increases plus balance-sheet shrinkage) in the current cycle can’t have gone beyond a total of about 300 basis points without inducing recession.

The policy rate alone is already in a range of 4.75-5%, with the lagged effects of monetary policy just starting to bite. One way to square that reality with Tadesse’s findings is that a hard economic landing will be harder than many anticipate–creating the need for more Fed intervention that supports the very deficit spending that fans inflation and undermines the Fed’s ability to fight it.

And thus the full deposit backstop debate should be put in appropriate context. The desire to prevent bank runs is sensible, but the cost of the government backstopping trillions in deposits is higher and more complicated than many investors, taxpayers and government officials may appreciate.