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Dysfunctional Credit Markets – Still Waiting on the Fed

As the week ended, U.S. credit markets appeared confused, if not outright dysfunctional.  The 10-Year Treasury yield began February at 1.09% and reached an interim peak of 1.54% on February 25.  Then it retreated to 1.42% as markets thought the rise had simply been overdone.  But Fed Chair Powell’s refusal to assure financial markets regarding the Fed’s intentions at the Wall Street Journal’s Jobs Summit (as detailed in last week’s blog) caused the 10-Year to spike again to 1.56% on Friday, March 5.  Markets were steady most of last week as the RBA (Reserve Bank of Australia) and ECB (European Central Bank) announced new easing programs.  But, on Friday (March 12), the 10-Year yield spiked again, this time by nearly 10 basis points (0.1 percentage points) to 1.625%.  And, once again, the Fed was MIA.

It could be that the Fed is simply in its quiet period as the Federal Open Market Committee (FOMC) is scheduled to meet Tuesday and Wednesday (March 16-17).  Surely, they can’t continue to allow the financial markets to continue to assume a tightening phase is approaching.  Because Chair Powell doesn’t have the best track record for consistency, despite his having indicated several times that tightening is nowhere in sight, today’s financial markets need constant assurance.  Hopefully, that comes in Wednesday’s FOMC statement and the follow-on press conference.

Dysfunctionality

As indicated above, markets appear to be dysfunctional.  Last week, the repo rate (the interest rate paid in the interbank market for reserves) had episodes where it was negative, i.e., the borrowing institution got paid to borrow instead of paying for funds!  Fed silence on expiring capital rules was likely responsible for most of Friday’s 10 basis point rate spike.

When the pandemic began last April, to ease liquidity strains, the Fed exempted the banks from having to hold capital against their portfolios of Treasury securities.  That exemption expires on March 31, and the Fed has been silent on whether-or-not it would extend the exemption.  In-all-likelihood, it will.  But, don’t forget that March 31 is also quarter end where these institutions must report their capital ratios both to the regulators and to the public (if publicly traded). 

As a result, as a hedge against the worst outcome, the primary bond dealers dumped more than $65 billion, or 25% of their Treasury holdings and banks sold an additional $38 billion.  This, together with last week’s Treasury auctions and the signing of the $1.9 trillion “stimulus” bill (i.e., significantly more future borrowing) all came together at week’s end. 

The confluence of these events seems to be the immediate cause of the rate spike.  Can rates rise further from here?  That depends on the Fed.  There may be some nervousness between now and Wednesday, but markets will know for sure when the FOMC statement is released and the follow-on press conference concludes.

Long-Term Demographics

The post-Great Recession up-cycle in terms of real aggregate economic growth was the weakest in the post-WWII era.  This occurred despite massive monetary stimulus and unprecedented fiscal deficits during an economic expansion.  We scratch our heads about this, but every single developed world central bank sees falling aggregate GDP as unacceptable despite their demographics.  In the developed world, including the U.S., the ratio of the working aged population to retirees has been falling and is expected to continue to do so.  This also includes China, where the now defunct “one-child policy” will play havoc with their ability to grow, at least for the next generation.  Japan, of course, is the poster-child for this phenomenon, having entered negative population growth and an aging population in the 1990s.  There we see a stable and thriving country from a micro point of view where unemployment is low and the populous is generally thriving.   This is a developed economy with all the social advantages that come with such status.  But, because of its demographic structures, including aging and fertility, its GDP doesn’t grow.  Yet, its central bank continues to push for such growth to such an extent that it owns much of the government bond market and nearly 10% of Japanese equities.  As most readers of this blog know, their sovereign bonds yield at or below 0% and have done so for decades.  A good primer on these demographic issues can be found on the ZeroHedge site: (https://www.zerohedge.com/economics/narrative-inflation-amid-depopulation)The Narrative of Inflation Amid Depopulation.

Current Economic Conditions

This blog is mainly about current economic conditions, as they generally determine trends in the financial markets.  And, here, too, while the sell-side of Wall Street continues to predict a “V”-shaped recovery and a return of 1970’s style inflation, we have a hard time reconciling these views with what we observe in the data.  The health of the labor market is a case in point, and key to the economy’s health. 

On Thursday, March 11, the Department of Labor’s weekly missive on new and continuing unemployment caused a stir on Wall Street.  The aggregated state weekly Initial Unemployment Claims (ICs) fell more than -47K.  Wall Street celebrated this as a confirmation that the “V”-shaped recovery was alive and well.  Digging deeper, we find:

  • The latest (March 6) IC number (+709K) was still higher than the worst pre-pandemic number ever recorded (about +650K during the Great Recession).
  • ICs are a proxy for new layoffs; so, a year into the pandemic, businesses that pay into the state unemployment systems are still laying off hundreds of thousands of employees per week.
  • The Wall Street crew ignored the +42K surge in the Pandemic Unemployment Assistance programs (PUA) which are for small businesses, gig workers and independent contractors that aren’t covered by state unemployment programs.
  • Taken together, and as shown in the chart and table, there was no real difference in the week to week ICs; so, nothing to celebrate regarding economic improvement, and really no progress here since October.
  • Worse, Continuing Claims (those on some unemployment program for more than a week) jumped more than +2.0 million to 20.1 million the week of February 20 (latest data).  Re-openings are sure to help, and perhaps the March data won’t be so dire.  But they certainly are dire enough to conclude that the “V”-shaped recovery has yet to begin.
  • The latest JOLTS (Job Openings and Labor Turnover Survey, a monthly survey from the BLS) was another headline touted by the media, as job openings rose +165K to 6.917 million.  What was left out was that hiring fell -110K, and that hiring has been down for three months in a row and in four of the last five.  Openings up; Hiring down!  One would think that with all the unemployment, there would be applicants galore.  Could it be that current unemployment benefits are a disincentive?  Because Biden signed the new $1.9 billion bill, it appears that this phenomenon (high unemployment, job openings, but no takers) will be with us most of the rest of this year.

Other Observations

The “stimulus” is transitory, not “permanent.”  News reports indicating that the “income” of Americans grew 5% in the face of the pandemic are factually accurate but quite misleading.  The income “growth” was not “earned.”  It was a gift, and the recipients’ expected (“permanent”) income going forward has not been enhance.  In fact, given the unemployment levels discussed above, earned income is a lot lower than pre-pandemic.  Under such conditions, much of the “stimulus” will be saved.  This is in keeping with Milton Friedman’s “Permanent Income Hypothesis,” where changes in a consumer’s “permanent income, rather than changes in “temporary” income, drive changes in consumption.   In fact, studies by the NY Fed of spending of the first two “stimulus” payments confirm that very little of the new “stimulus” will be consumed. Most will be saved or used to pay down debt.  The chart shows that is exactly what has happened to credit card debt during the pandemic; now -11% lower Y/Y.

Pent-Up vs. Pent-Down

The “V”-shaped narrative has as its basic tenet that, when the economy fully re-opens, demand will explode.  No doubt restaurants, casinos, hotels, airlines etc. will see a gradual return toward pre-pandemic levels.  But, these sectors represent a small segment of GDP (<5%).  Meanwhile, during the pandemic, because the service sector was closed, there was a boom in household spending on durable goods ($16K per household according to Rosenberg Research).  It is likely that the upcoming resurgence in demand for the missed services will be offset, or maybe more than offset, by a reduction in the demand for durable goods, the demand for which looks to have been pulled forward by the pandemic.  As discussed in our last blog, buying intentions for autos and homes are down to levels last seen in ’08, and the rise in the 10-Year Treasury yield isn’t helping.  A similar story for major appliances. 

Given the demographic background, the level of unemployment, the precautionary rise in the savings rate, and the pent-down demand for durable goods, after the transitory impacts of the upcoming “stimulus” pass, it is hard for us to forecast a sustainable rapid economic growth path like the ones emanating from the large investment houses on Wall Street.

Inflation

The last topic here is the inflation narrative.  Some commodity prices have risen, but that is mainly due to transportation issues.   Cargo ships are lined up off the three main California ports as far as the eye can see.  But, just as demand for the services described earlier will return when the economy completely re-opens, so will supply.  It may take some time, but the ports will return to some semblance of “normal,” else alternative supply chains will develop.  And the commodity prices will fall back to more “normal” levels.

As indicated in earlier blogs, we do expect some temporary price spikes.  February’s headline CPI came in at +0.4% (vs. +0.3% in January).  But “core” CPI (ex-food and energy) only rose +0.1% (vs. 0.0% in both January and December).  It also rose 1.3% Y/Y.  Look at the Y/Y pattern here for the “core:” September: 1.7%; November: 1.6%; January: 1.4%, and now: 1.3%.  Yes, we could see Y/Y CPI spikes this spring (oil prices were negative a few days last April!), but those spikes will be temporary, mainly a catch up from the large negative price declines last spring.  Falling rents, which compose 30% of the CPI, have yet to show up there; but we do know they are falling (e.g., down 14% Y/Y in Manhattan).

For those who point to the rapid rise in the money supply as an inflationary worry, when that newly created money ends up sitting on bank balance sheets, like it has been, inflation doesn’t appear.  Referring to the Irving Fisher identity: MV=GDP, where M is Money and V is its Velocity of turnover, if money is created and it just sits on bank balance sheets, then V drops sufficiently to exactly offset the rise in M.  That is, if banks don’t lend it, GDP doesn’t rise.  The chart above shows what has recently been happening to consumer credit, and the one below shows that, after their initial line of credit (LOC) grab last spring (just to have the cash for precautionary reasons), corporate loan balances have been falling.  A rapid rise in corporate and consumer debt has always accompanied inflation.

Finally, if inflation was a real threat, wouldn’t gold’s price be rising, not languishing as it has been for the past few months?  The inflation narrative is just that, a narrative.

Conclusions

The rate spike is temporary, caused by market liquidity issues and faulty Fed communications.  Wednesday’s (March 17) post-FOMC meeting statement and press conference should assure markets that Fed tightening is not in sight.  (If this doesn’t occur, markets will continue tightening until the Fed steps up.)  As an aside, can you imagine today’s political blowback if the Fed said they were about to embark on a tightening cycle?  There has never been a long-term bear market in bonds without a Fed tightening regime. 

The economics are clear.  Both long-term and immediate economic indicators point to lower, not higher, interest rates.  Inflation is a non-starter.

Robert Barone, Ph.D.

Joshua Barone

Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU)

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