Powell On QE

Extract from the FOMC minutes 10/24/2012. Emphasis is mine:

MR. POWELL. Thank you, Mr. Chairman. So we have had Gary Cooper, the Most Interesting Man in the World, Bill Belichick, Woody Allen, and now Hamlet. [Laughter]

I support alternative B, to relieve the suspense. And as far as what is to be decided at the next meeting, it seems to me we should let it be decided at the next meeting. But I will say that if we have another good run of data, I think there would be a strong case to defer action. And I don’t see us as committed to act unless conditions warrant.

I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.

First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?

Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.

Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market. And I would just say I want to understand that a lot better in the intermeeting period and leave it at that. Thank you very much, Mr. Chairman

After you’ve read this, do you think that Powell is in the least surprised by the consequences of raising rates? I don’t know what he will do, but I doubt that he will be deterred from whatever his strategy may be.

Something’s Going To Break

From past experience, we can be pretty sure that the bear market doesn’t begin until the inverted yield curve returns to a positive slope. Usually this happens because of a major disruption in the financial markets. Here are some of the opportunities for breakage.

• The average 30-year mortgage rate, as of today, is 7.13% according to Bankrate.com. Housing affordability has dropped to what Redfin deputy chief economist Taylor Marr calls the “lowest level in history.”
• Office occupancy in major city centers is ranging from 40-60% as a result of WFH practices. Pressure on bricks-and-mortar retailers from online shopping continues to build. The overall US CMBS delinquency rate jumped 18 basis points in February to 3.12%. (The all-time high on this basis was 10.34% registered in July 2012. The COVID-19 high was 10.32% in June 2020.) . Giga-investor Blackstone just defaulted on $562 million of CMBS.
• CPI/PCE inflation continues. While energy prices continue to be contained by withdrawals from the SPR, labor prices continue to increase. Fed chair Powell says that his primary measure of inflation is core PCE less housing, which implies a heavy weight on labor costs when evaluating inflation.
• The Fed continues to raise short-term interest rates to reduce business activity and therefore reduce inflation. So far with little success. Financial markets are busily fighting the Fed’s attempts to tighten financial conditions. History says this does not end well.
• There’s a war on, into which black hole the US continues to pump money and armaments. These will need to be replaced at great cost. Defense spending will be increased. The big risk is of further escalation, which could include the use of nuclear weapons.
• The primary source of inflation is deficit spending by government. Half of the government’s debt has a maturity of less than five years. The Fed’s rate increases are quickly running up the government’s interest bill, which of course will increase the deficit – that’s how the black hole works. Interest is already nearly as large a budget item as defense spending.
• China’s recovery from its draconian COVID policies is limping badly after a small initial surge. In addition, the US is actively hampering the development of technology in China and relations are a historic lows. There is a significant risk of another war, this time over Taiwan, where TSMC is the crown jewel of semiconductor manufacturing. All this means that China is unlikely to be the source of cheap manufactures goods that have helped quell inflation for the last twenty years or so.
• The US stock markets remain highly overvalued and not investable as the flood of liquidity during the COVID era has supported speculation. The options market has grown to be larger than the equity market of which it is supposedly a derivative, leading to extreme gambling activities such as 0DTE options..

Get the idea?

Neutron Elon

Elon Musk has now dismissed 75% of the 7,500 staff that Twitter employed when he took over. The service is better than ever and new features are being rolled out. One wonders what, if anything, all those people were doing all day. One also wonders how this reflects on other companies in the space.

Happy Days Are Here Again

Markets continue to behave as if 2022 never happened, inflation is dead, growth is strong, the Fed is impotent, we’ve had a soft landing and caution can be thrown to the winds. Stock prices have resumed their uptrend and new highs are soon to be seen. After all, the Dow is only down 7.5% from its all-time high close, and the S&P only 15%, dragged down by the big tech stocks, which are recovering fast from irrational selling, thanks to cost reductions from layoffs. VIX, the volatility index, is at levels last seen in early January last year, close to the December 2021 all-time stock market highs (18.06 as I write). Perhaps that is not a coincidence.

To me, this looks like an opportunity. Far be it for me to rain on a parade, but this looks like a bull trap.

What If?

The stock and bond markets are depending on the recession to “force” the Fed to “pivot” back to money printing and ZIRP. The economy is addicted to free money and is slowing rapidly now that it has been withdrawn. The bond market has already priced in disinflation and Fed easing, and the stock market has been buoyed accordingly, proceeding from short squeeze to short squeeze since June of 2022.

But what if Powell has decided that the QE policies that have yielded only $1 of GDP growth for every $10 of fresh debt are toxic and the addiction must be broken, no matter what the symptoms of withdrawal might be? That his legacy will be having returned the economy from dependence on continuous stimulus to sustainable growth? To say nothing of reducing the Fed-induced income inequality that is being exacerbated by inflation? That would certainly earn him a niche in the financial Hall of Fame, perhaps next to Paul Volcker.

Labor Pains

The Bureau of Labor Statistics produces a monthly report which is largely based on two telephone surveys, the establishment survey and the household survey. The establishment survey covers businesses and produces an estimate of the number of jobs, which makes the headlines. The household survey produces estimates of the number of employed persons and the unemployment rate. 2022 to date has featured a record and growing discrepancy between the two reports. Of course, a discrepancy is normal as a result of individuals holding multiple jobs, but this year has been exceptional.

However, the Philly Fed produces a quarterly revision of the employment estimates based on the QCEW, the Quarterly Census of Employment and Wages which covers more than 95% of employers. The most recent revisions, for 2Q2022, revealed that headline job growth was 10,500, consistent with the household survey, rather than the 1,047,000 reported by the BLS, The discrepancy between the BLS estimates continues in the rest of the year to date so it is reasonable to assume that the job growth during that period was also a mirage.

Bullish analysts have seized upon this report to justify an early “pivot” by the Fed. This fails to be convincing because the unemployment rate and average hourly wages continue to show a very tight labor market, reported layoffs notwithstanding. What is does show is that Biden’s boast of job creation was BS, just like pretty much everything he boasts about.

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.

Recession

Albert Edwards observes that history implies that recession is starting now:

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.

Where The Fugawi?

The flightless Fugawi bird lives in the tall grass of the African savannahs. Unfortunately, this bird is not as tall as the grass that surrounds it, hence its mournful call. The mavens of Wall Street seem to share the bird’s frustration as they focus on fractional changes in economic data, in the hope that they will foreshadow a return to the peaceful, sunlit uplands of free and flowing money.

Alas, it is not to be. We are fated to do battle with the multi-headed Scylla of inflation and, if we win, it is only to be sucked into Charybdis’ whirlpool of depression. Massive increases in government debt have, inevitably, increased private sector savings and pulled consumption forward in time. If these increases continue, Scylla will dine well as hyperinflation ruins the dollar. If they do not, consumption will, of necessity, fall as the credit impulse reverses. Charybdis’ whirlpool is a fine metaphor for the negative feedback cycle that will result from bankruptcies and defaults. If I do say so myself.