We All Know it
“Well, I think he is pretty accurate when he opines on Europe, but…like all of us in the business these days… he just keeps saying the same thing. There are only 3 or 4 big themes and everybody knows them.”
The above comment came from a friend; I had mentioned that I didn’t think a particular analyst was all that insightful. My friend’s reply is distressingly true. We all know how the growth of central bank balance sheets has exploded and supported financial assets. We know that volatility has been smothered across products. We know that CBs are struggling (for some reason) to bring inflation up to the magical 2% target. And we know it’s all tied up in the same animal, the government. This analogy is best represented by Homer Simpson, addressing his daughter Lisa’s switch to becoming a vegetarian:
“Now wait a minute honey, are you saying you’re never going to eat another animal again? What about bacon?” “No.” “Ham?” “No!” “Pork chops?” “Dad, those all come from the SAME animal!” Homer (chuckling and mystically waving his hands in the air) “Oh yeah right Lisa…a wonderful, MAGICAL animal!”
Now wait a minute Janet, are you saying the Fed created all this economic support, but now no more buying AND a cutback in reinvestment? What about Treasuries? What about mortgages? What about (*waves hands in air*) the plunge protection team?
So the Fed announced the onset of balance sheet reduction, and signaled a hike in December while lowering the long term dots in acknowledgment of a lower neutral rate than previously thought (except that the market has been below the dots the entire time). On the week, rates rose mechanistically, and the curve flattened. Tens were up another 6 bps to 2.26%. In terms of the curve, 2/10 at 82 and 5/30 at 92, are on top of the lows of 2016, which were in turn the lowest since 2007. The back end of the Eurodollar curve is extremely flat with reds (2nd year forward) to golds (5th year) at only 44.5 bps. By the way, at 2.26%, the ten year yield is exactly where it was in early December of 2015, just before this Fed’s ‘tightening cycle’ began. Sorry. We all know it.
The chart below shows the history for the last 20 years of Fed Funds and the red/gold pack spread. The curve is now nearly as flat as it was after the last hiking campaign in 2004 to 2006. Except in this particular episode, the current Fed effective of 1.16% is just a few bps above the STARTING point of the last hike cycle, which began at 1%, was 1.5% two meetings later, and topped at 5.25%. We all know it. To paraphrase Irving Fisher, we’re in a permanently safe valley of low rates and low volatility.
Taken with the notion that yields will forever remain low, I am adding the next chart, just as a curiosity. It shows the explosion of share price in the Swiss National Bank. I overlaid the price of bitcoin just for fun. From an article in the FT [link below] “A share in the SNB is like a perpetual bond with a fixed coupon. At a price of SFr 3000 the yield is only about 0.5%, but that still compares favorably with the yield on a 10 yr Swiss gov’t bond, currently about minus 0.15%. “If you treat them as bond substitutes, then there is quite some premium.” Hmmm. I think there’s more to it than that… Is this a case of fitting the narrative into the framework of themes that we all know?
Sometimes, our policy issues can be addressed with a bit of tweaking. For example, the NY Fed finally released its new Underlying Inflation Gauge (UIG), which “provides a measure of … the long-run (or persistent) component of aggregate inflation.” Now, according to UIG [link attached] the ‘full data set’ rose from 2.64% in July to 2.74% in August, and the ‘prices only’ measure from 2.09% in July to 2.17% in August. Both UIG measures “displayed a rise in trend inflation.” So, the Fed needs 2% inflation? Problem SOLVED.
We’ll get a new Fed board next year, and believe me, the neutral level will also find its way higher. Through “research.”
Continuing with the theme of government data, I created the following table from last week’s Fed release Z.1. The typical headline coming from this report (and this time was no different) is YAY! US Household Net Worth was up again! (In Q2 2017, +$1.7T, due to stocks and real estate). However, the table below shows outstanding debt levels of the three sectors of the economy, Households (top), Business including Corporate (middle), and Gov’t (third down) with the sum at the bottom.
I don’t think I have quite seen the data presented in this way. It shows the debt of the Federal Gov’t at $16.05 trillion. But wait, we’ve heard that gov’t debt is just over $20T. (I think they net out the balance sheet of the Fed). In any event, this table indicates just how much the Fed’l Gov’t has grown as a percent of total debt. As we were all told, the gov’t shifted private debts onto its own balance sheet in the aftermath of the crisis. This table is a reflection of that. From 2002 to now, HH debt has grown 1.74x, from 40% of the total debt to just 31%. (We euphemistically call that deleveraging). Business has grown 1.98x from 32.7% of the total to 29%. But the Federal Gov’t has grown 3.63x from 20.6% of total debt to 33.5%! Federal gov’t outlays as a % of GDP are just over 20%. This is, as we and everyone else likes to say, unsustainable.
| TOTAL DEBT | Dom Households | HH Home Mortgage | HH Consume Credit | |||
| BY SECTOR | Total | % | % | % | ||
| 2002 | 8581.6 | 39.9% | 6028.3 | 28.0% | 1997.0 | 9.3% |
| 2007 | 14175.5 | 42.6% | 10638.4 | 32.0% | 2609.5 | 7.8% |
| 2012 | 13445.5 | 33.5% | 9557.9 | 23.8% | 2919.7 | 7.3% |
| 2017 | 14912.5 | 31.1% | 9923.3 | 20.7% | 3735.4 | 7.8% |
| Change x 2002 to 2017 | 1.74 | 1.65 | 1.87 | |||
| Dom NonFin Business | Corporate | |||||
| Total | ||||||
| 2002 | 7037.8 | 32.7% | 4810.2 | 22.4% | ||
| 2007 | 10106.2 | 30.4% | 6331.1 | 19.0% | ||
| 2012 | 10766.5 | 26.8% | 6709.0 | 16.7% | ||
| 2017 | 13905.5 | 29.0% | 8717.8 | 18.2% | ||
| Change x 2002 to 2017 | 1.98 | 1.81 | ||||
| Federal Gov’t | State and Local | |||||
| % | ||||||
| 2002 | 4427.3 | 20.6% | 1447.90 | 6.7% | ||
| 2007 | 6074.3 | 18.2% | 2931.50 | 8.8% | ||
| 2012 | 12847.8 | 32.0% | 3132.50 | 7.8% | ||
| 2017 | 16049.3 | 33.5% | 3049.00 | 6.4% | ||
| Change x 2002 to 2017 | 3.63 | 2.11 | ||||
| Domestic Nonfinancial | ||||||
| Total | ||||||
| 2002 | 21494.6 | 100.0% | ||||
| 2007 | 33287.6 | 100.0% | ||||
| 2012 | 40192.3 | 100.0% | ||||
| 2017 | 47916.3 | 100.0% | ||||
| Change x 2002 to 2017 | 2.23 |
We used to hear about the government “crowding out” the private sector for scarce capital. Now capital doesn’t seem to be scarce at all. In a way, this table is supportive of the idea of corporates being tight to treasuries; it’s the Federal Gov’t that is over leveraged. So in a way, corporate assets, stocks included, are relatively better. As the economist in the FT might say, “there is quite some premium.”
We’re likely to get a blow up of the federal deficit, and with it of course, more bond issuance. Partially related to storm rebuilding. Partially related to the idea that any tax deal is NOT going to be revenue neutral, because the savings from healthcare reform have gone up like a puff of smoke. So who’s going to buy this stuff? Not the Chinese. With trade tensions increasing they’re out of the vendor financing business. Not the Fed. They are on a diet. Maybe Japan. They don’t care what they own as long as it doesn’t move their currency higher.
Eventually, it’s going to be the Fed again. But before that, I suspect Mnuchin’s treasury is going to find out sometime in 2018 that capital is sort of scarce again. And the administration’s natural response is going to be to go where the money is. Big tech. We can squeeze it out of them. It’s not going to be pretty and it’s going to make the composition of the next Federal Reserve Board very important.
(Rtrs) The CBOE Volatility Index .VIX, a gauge of the degree to which investors expect share prices to fluctuate, has averaged 11.4 this year. That is lower than for any comparable period over its nearly three-decade history.
We all know it. And we know it’s going to change.
Note: Yellen speaks again Tuesday. “Prospects for Growth: Reassessing the Fundamentals” 59th National Association for Business Economics Meeting in Cleveland, Ohio.
