Honne And Tatemae

There are many financial conditions indexes, but in general terms they represent the cost and availability of credit and equity financing, interpreted as relatively “tighter” or “loose, easy”. Markets were surprised that Powell appeared unconcerned that these indexes showed that financial conditions were more or less unchanged by the Fed’s rate and QT actions. His unconcern was interpreted as conceding that the bulls were right in believing that rates would soon come down.

My interpretation was that he simply didn’t think it was a problem. One of the Fed’s primary concerns is to keep financial markets functioning normally, and the indexes show that they are. However, it is important to remember that the Fed is very well informed. The Japanese have words for this, “honne” and “tatemae”. “Tatemae” is the outward appearance of conformance to society’s norms and rituals, while “Honne” is what is really going on behind the scenes. In this case, the “Tatemae” is the traditional information bureaucracy – the BLS, BEA, and even the Fed itself – and the ritual announcements of  lagged and often politicized estimates of economic data. The “Honne” is that the Fed uses all kinds of information services and is very much in touch with the high-frequency data that is gathered by state governments, industry associations and many other private services. The recent callout of the BLS by the Philly Fed shows that the Fed has little faith in the BLS. Powell knows that the economy is either on the verge of recession or already in one regardless of the NBER’s view. He knows that deflationary collapses are underway in markets like housing and used cars. He probably also expects that taking down inflation, as happened in the GFC, will likely require a severe correction in financial markets, probably worse than the GFC. But I am of the opinion that  he is willing to be wrong about that, so if markets are right to “look through” the recession to a return to low inflation he would be perfectly OK with that. He did warn that no rate reductions should be expected in 2023, nor would he back off prematurely, but this was widely ignored.

Edit: This morning’s employment report demonstrates the useless, erratic nature of the BLS data.

Kumquat

Recession is here. The official dating will come later, much later. But the economy is slowing quickly. Commodity prices are falling due to lack of demand. Property – real estate – is slowing. China is struggling with Covid – and trying to infect the rest of the world with whatever variants they have incubated over the last couple of years. Europe is struggling with the Ukraine war and self-inflicted wounds from sanctions and immigration.

But equity markets don’t care. The S&P 500 looks to be making a bottom at a level that was the May bottom. The Dow seems to be heading for all time highs. Only the NDX seems to be close to a new low as some hypervalued “tech” stocks have been clobbered.

What Happens Next

Well 2022 is just about over. I traded badly this year but that is behind me, I hope. Especially annoying since I have been expecting this bubble to burst for a long time. The big question is, where do we go from here. Some thoughts:

• Housing. Sales volumes are falling very rapidly because affordability is poor, but prices are holding as sellers are reluctant to drop their expectations. In the last housing bubble pop, it took a year and a half for this process to work through so that sellers finally acknowledged that prices could actually fall. This means that housing costs, which make up a disproportionate share of CPI, will be sticky.
• Employment. The pandemic significantly reduced the labor pool as many people retired or just dropped out. In China, the pandemic and measures to suppress it have badly damaged the economy and look to continue to do so. It seems likely that the offshoring that reduced labor demand in the US is over, and will be replaced by onshoring and relocation of production. Either way, labor demand is likely to remain relatively strong well after consumption growth falls. Labor looks to reclaim at least part of the loss of its share of economic output, at the expense of capital, i.e. profits.
• Energy. The idiocy of belief that minor reductions in CO2 output will have a material affect on the climate is hampering investment in energy sources. Of course this will throttle growth in energy production and keep prices high, even as a slowing economy will reduce demand for other commodities. I was amused to find that DNA recovered from northern Greenland revealed that during the region’s warm period, when average temperatures were 20 to 34 degrees Fahrenheit (11 to 19 degrees Celsius) higher than today, the area was filled with an unusual array of plant and animal life, including aurochs and mastodons. Then of course there are the (hopefully temporary) supply constraints that have been caused by the sanctions on Russian production.
• Food. The good news is that more CO2 in the atmosphere helps food production. But modern farming depends heavily on diesel fuel for big equipment and natural gas for fertilizer production. Fossil fuel prices directly affect food prices, because even though yields may be good, farmers will not plant crops on which they cannot make a profit. In addition to high prices, shortages of some crops will develop as farmers pivot to crops which require less of these costly inputs.
• Interest Rates. It seems that no-one believes that Fed Chair Powell will actually carry out the attack on inflation that he has outlined. Some argue that a recession will “force” him to abandon his current goals and resume ZIRP and QE, redefining his goals in the process to accept a higher level of inflation on an ongoing basis. Others believe that the recession will cause inflation to fall quickly and make the question moot as his goals, such as positive real rates across all maturities, will be automatically met.It is certainly true that this long-suppressed business cycle is moving fast, but there is a long way to go to normal. My personal view is that his vision for his legacy is an economy that does not depend on massive growth of debt relative to GDP as has been the case in recent years, and he will do “whatever it takes” to get there

In summary, inflation will prove sticky although not runaway, and Powell will accept a recession. But as the recession gains hold, it will accelerate as defaults reduce credit availability regardless of Powell.

Disintegration

The world is disintegrating. Trust has been lost, both within countries and between countries. Without trust, economic relationships cannot operate.

China

China is a poor country, despite the glitz and glamor of its big cities and its showpiece infrastructure, with a per-capita annual GDP of about USD 11,000.

Chairman Xi presented his plan for world domination at the opening of the party congress. Not going to happen, sir. Your country is an economic and social house of cards that is in the process of collapsing. The housing market, investment of choice for the masses, is a bubble bursting and desperate local governments are even buying their own land use rights from themselves or one another because retail buyers have left the building. So to speak. Your Covid-zero policy has shaken the people’s faith in the benign CCP, while wreaking destruction on millions of small businesses. Unemployment is high and rising, college graduates cannot find jobs. Biden’s withdrawal of support for your semiconductor industry has condemned it to a bleak future without the production technology that your people cannot build. Export demand from the rest of the world is shrinking fast. Sir, your country is likely heading for a deep economic depression and social turmoil. This will further weaken China’s positioning for the world hegemony which you desire.

United States

In the USA, we live in a world now that George Orwell and Aldous Huxley would readily recognize. The state has commandeered the legacy media, as well as the new social media, to not only put out the “progressive” state’s version of reality but to identify, spy on, ostracize and  punish critics and dissenters.

President Biden, your “progressive” policies are not working. Democrat-run inner cities are being abandoned to crime and homelessness. Illegal immigrants are flooding in without any prospects for employment or training. You are continuing to feed the inflation which is mostly damaging the people you claim to represent. Your support for expansion of NATO triggered the invasion of Ukraine, with severe economic and social consequences.

You and your Democratic predecessors, notably Hillary Clinton, have created a deeply divided society, with those who have drunk the purple Kool-Aid and accept the state’s lies and propaganda on one side, and those with a more traditional view of reality on the other. Neither side trusts the other, respects the other’s views, or is willing to compromise. Both sides are preparing for more direct conflict as the sporadic clashes increase in frequency and severity. This is a recipe for a failing state with extremism on both sides. Negative economic consequences are to be expected.

Europe

Neither China nor Europe are democracies – by design. The architects of the European Union claimed that, since democracy had enabled Hitler, it could not be a part of the EU’s structure. As a result, bureaucrats who suffer no consequences for their failures and care little for the fate of the citizenry run the EU. Ursula van der Leyen is no less of an autocrat than Xi. Deep rifts have emerged as democratically elected governments have resisted the orders of the bureaucrats. These rifts are between rich north and poor south as well as conservative east and “progressive” west. It is only a matter of time before a second country leaves the EU, and that will spark a rush for the exits.

The coming winter is going to be hard, as the bureaucrats’ energy policy has been disastrous. Immigration policies have resulted in shocking increases in crime, with many countries reporting zones where the police dare not go in fear for their lives. Mario Draghi’s “whatever it takes” has left a legacy of irresponsible debt, as in the USA. As  interest rates increase, this is going to be a huge problem

Russia and Ukraine

Russia’s invasion of Ukraine has no winners. Regardless of the outcome, the invasion is an economic disaster for both of them. Their economies depend heavily on the export of commodities, such as food, energy and metals. The volumes of these commodities are large, and their absence are also a problem for the countries that have come to depend on them.

Conclusion

I could go on, but it is time to recognize that the future is not bright. Economies will get worse. Much worse. Be careful out there. Don’t focus on the narrative of the “Fed pivot.” The Fed is irrelevant.

Dummies?

When seeming professionals propose ideas that are internally contradictory I really start to question professionalism in the financial services industry.

The idea proposed was that since inflation was caused by limited supply, which the Fed cannot control, the Fed would simply raise its inflation target and resume easy money to resume growth, driving stocks to infinity and beyond.

Excuse me, but doesn’t limited supply itself limit growth?

Since when has the Fed ever been able to control supply? The money printers go b-r-r-r but there are no gas wells or potash mines at the Fed building. The Fed’s manipulations are intended to control demand.

And by the way, how is the economy to grow when businesses wanting to expand cannot hire the employees that they need?

The bubble is still with us.

The Price Of Moderation

From my last blog post of 2020:

William Greider, in his book, Secrets of the Temple: How the Federal Reserve Runs The Country, reports Nixon (’69-’74) as saying: “We’ll take inflation if necessary, but we can’t take unemployment.” The nation eventually had to take both. Note that Fed Chair Powell has indicated a willingness to let inflation “run hot” to encourage economic growth. That’s what they thought in the 1960s, too.

Well, inflation is running hot. Too hot for comfort. Discretionary spending is falling rapidly as the cost of essential goods and services takes more of people’s income. Fed Chair Powell is raising interest rates in baby steps, presumably in an attempt to quell inflation without slowing the economy significantly. People seem to think that raising rates to 2 1/2 percent will achieve this result, and are competing to time the “pivot” when the Fed returns to easy money. All I can say is good luck with that. History says that once inflation starts to surge – as it has – it is not easy to stop, as all kinds of feedback loops keep driving prices higher. Weakness now will only make the pain worse.

Perfect Storm Plus

The Perfect Storm began as an extratropical system, absorbed a tropical system (i.e., Hurricane Grace), and ended somewhat uneventfully as an unnamed hurricane. In the process it caused considerable damage on the US East Coast, and sank the fishing vessel Andrea Gail, with the loss of all hands.

We are now living through the early stages of the economic Perfect Storm Plus. The “Plus” is due to the near-simultaneous collapse of four great bubbles – China, Japan, North America and Europe. All are due to central bank monetization of government deficit spending, coupled with over-expansion of consumer and property credit. As Austrian economics teaches, there are only two paths out of these bubbles – stop the credit expansion and accept the resulting recession or depression, or continue to hyperinflation and the destruction of the currency.

The collapse of China began with the cascading failures of property developers, such as Evergrande, when President Xie’s “three red lines” reined in their ability to raise new debt. Then his idiotic “zero-Covid” policy drove a dagger into the beating heart of China’s economy, Shanghai. Then failures in a handful of smaller banks were mishandled by local governments which failed to honor deposit insurance guarantees, instead hiring toughs to beat up demonstrators. This has been followed by a wave of buyers refusing to continue mortgage payments on unfinished properties, especially where cash-starved developers have stopped working on them. A loss of confidence in the CCP government has resulted. It is attempting to stop the collapse with promises of more government funding, but so far success is elusive.

Japan is, so far, following the path of currency destruction. Even though Japan’s central bank now owns virtually all government debt and a very large chunk of the stock market, it continues its path of yield curve control – at zero. This has led to a downward slide in the yen as the US Fed has reacted to inflation, well a little bit anyway. Japan is short of natural resources and must import many commodities, especially energy as the Fukushima disaster has constrained the use of nuclear power. One could easily see a return of the yen to dollar valuations like the pre-1989 mid-200s, compared to 140 today and the 2012 high in the 70s. Needless to say, this would kick off serious inflation in Japan.

North America’s asset bubble, in property and financial assets of all kinds has finally been joined by rapidly inflating prices of consumable goods and services. While Alan Greenspan started the Fed’s monetization addiction around the turn of the century, rapid growth in outsourcing to China, India and numerous other countries kept consumer prices and wages under pressure. Finally the combination of supply chains ruptured by Covid and government payments that put large sums directly in the hands of consumers started to drive up prices, and also allowed large numbers of people to withdraw from the labor force. The coup de grace was Biden’s decision to follow the urging of the climate fanatics and cut off investment in future fossil fuel supply. Anecdotally, a farmer of 1,800 acres in Canada reports that his annual diesel fuel bill has doubled from $40K to $80K, and nitrogen fertilizer (made from natural gas) has gone from $270/tonne to $900/tonne. The Fed’s reaction has been a minor increase in interest rates. A recession is either already underway or set to begin anytime now.

Europe (including the UK) is a basket case. It shares many of the same problems as North America, but in addition climate fanatics and the Russian attack on the Ukraine have conspired to leave it desperately short of energy. EU inflation is running high (8.8%) but the real problem is yet to come. Germany continues to shut down its remaining nuclear plants, while Russia has just notified Germany that it is terminating natural gas deliveries. Germany lacks the terminals needed to import LNG.

A key component of the coming confluence of these storms is the climate mania. This mania is based on bad science, but socialist politicians and activists see an opportunity to disrupt the status quo.

The Return Of Goldilocks

Everywhere I look in the financial press, I see predictions of a Fed “pivot”, by which is meant the abandonment of inflation-fighting and the return to the lowering of interest rates and printing of money.

This pivot is to occur sometime in the fall, apparently. The economy will be in recession, which will cause the Fed to panic and return to bubble-blowing. Inflation will have magically disappeared, because recession. The result will be the return of the bull market, “To infinity and beyond”, I guess. Biden will be carried on Powell’s shoulders to the mid-terms, supermarket shelves will be overflowing with foods, gas will be back to the $2s, unemployment will have taught the working classes the folly of asking for higher wages….

Too good to be true, I fear. But we’ll see.

Dr. Copper

It is generally held that the price of copper, otherwise known as Dr. Copper, has a PhD in economics. It is interesting to note that unlike, say, energy, the price of copper is slipping.

Historically this has implied a slowdown in economic activity.

Reality Check

Everywhere I read the pontifications of eager interpreters of yield inversions, and other signs and portents, predicting smooth sailing for the economy until a possible recession in 2023.

All I can say is you have to be kidding me. First of all, markets are still at unprecedented and artificial extremes. It seems to me to be a trifle naive to assume that scenarios from the past apply here. Markets have never been here before and hopefully will never return again. Secondly, there are major and poorly understood economic disruptions underway:

China: The world’s largest asset class, real estate in China, is in trouble. March sales of new homes are down 29% y-o-y. Lockdowns in Shanghai and other large cities in China are stalling production and shipments of many goods.

Ukraine: The Russian invasion and its corollary sanctions are negatively impacting agricultural and commodity exports. Restricted supply and high prices of fertilizer will reduce agricultural production around the world.

United States: Historically high consumer price increases have resulted from years of low interest rates and massive expansion of the money supply. Measures announced so far to deal with this issue are unlikely to have much effect. The 10-year Treasury yield has doubled since the beginning of 2022, with direct impact on mortgage rates and thence real estate prices. “Green” policies have driven up energy prices by restricting supply.

EU: “Green” policies have left the EU (and the UK) without reliable domestic sources of energy, leaving the group dependent on imports from the rest of the world, but without adequate LNG terminals to replace Russian pipelines. The EU is expected to announce an embargo on Russian oil immediately after the French election, which will drive prices higher.

Japan: The third most traded currency, JPY, the Japanese yen, is falling rapidly, now down more than 10% since the beginning of 2022 against the US dollar. The Bloomberg Commodity Spot Index rose 8.2% in JPY terms over just the past week. It’s up 29% since end of Feb., more than 48% ytd and 177% over the past two years (all in JPY terms). The possibility of intervention is being bruited about. Currency wars are the nuclear option for financial markets.

Look out below.