The US Fed as political animal

 

Today marks a potentially watershed moment in global finance as the US Federal Reserve under chair Janet Yellen makes a policy announcement concerning the Federal Funds rate. The punditry and trading data points to an expectation of a rate hike, widely expected to be 0.25%, and the first hike since 2006. (The rate was lowered to zero in 2008 in the wake of the financial crisis.) In my opinion, it’s also the day the Fed has been most dreading because it has finally been backed into a corner it knew was coming but could do little about. The fact is, the Fed doesn’t want to raise rates because the economic recovery it and wide swathes of the financial press have been touting for years hasn’t actually happened and the data on which the Fed never tires of telling everyone it is dependent shows that fairly clearly. So, like typical politicians, the Fed has for years been engaged in an exercise of saying one thing while doing another.

What it has been saying is that the US economy is improving. But what it has been doing is holding rates at zero, which would only be done if the economy was not improving. Merely moving from the so-called “zero bound” has been an operation fraught with tension, drama and, ultimately, backtracking, as the Fed did in September the last time the market was confident of a rate hike but then saw the Fed pull back on concerns about “China and global growth.” If the US was as strong as pundits and the Fed say it is, then such a tiny hike (and this is from zero, not 3% or 4%!) should be an inconsequential event. But here’s what some of the specific data is saying about how the US economy is doing.

As pointed out by Alhambra Investment Partners, the historical average for retail sales growth outside of recession is 6%. But growth has actually been on a downward trend for the last four years and has hovered around 2% for 2015. Ex-autos (which is another worrying data point on its own), the number is well below that at about 1.5%. For reference, the recession officially ended in the summer of 2009. This number isn’t consistent with a recovering consumer or economy.

The problem with auto sales is this: data currently reports an annual run-rate of about 18 million, a record. But what the data doesn’t show is the makeup of those sales and, as always, context is everything. To wit, in a May 19, 2015 appearance on BNN, Jack Ablin, CIO at BMO Private Bank, asserted that one-third of all US auto loans were sub-prime. So if we conservatively remove one-third from the 18 million run rate, we’re left with about 12 million–definitely not a record. And there has been a fair bit of media reporting on the surge in a subprime lending and unheard of loan terms (72 months or more) that have almost certainly ballooned car sales far above where they would be otherwise (even accounting for the effect of cheaper gas prices). See, for example, “Subprime Loans Are Boosting Car Sales,” and “Another Sign That the Subprime Auto Market Is Getting Hot.” So it seems premature, to say the least, to characterize the auto market as having recovered when that recovery is being carried aloft on the same basis as the housing market “boom” pre-2008.

Speaking of housing, that’s another sector dominated by wishful thinking, data cherry picking and confirmation bias. Hardly a positive housing starts report passes that doesn’t cause Bloomberg to announce that the housing recovery is complete, only to have to walk it back a month later when the next batch of data comes in decidedly softer. Again, the fact is the data on housing starts, new home sales, etc., has been lumpy and just limping along for years now. Sometimes there’s a particularly good print and then other times the gains are completely reversed and then some by poor prints. But what is definite is that first-time homebuyers, who ultimately propel the market, continue to be absent. In a normal market, first-timers comprise about 40% of all purchases according to the National Association of Realtors. In 2014–in the middle of “recovery”–that number fell to 33%, a three-decade low. How has that figure changed since? Down again for November, now at 32%. From where is the price support coming that is reported by Case-Shiller and then eagerly reported by the financial press? Maybe from foreign buyers such as the Chinese (“Chinese Lead Foreign U.S. Home Purchases for First Time“). But even that is almost a sideline compared to the real story which is that even as price appreciation continues, it runs into the problem of affordability–namely, how can first-timers afford these homes if they don’t have jobs or rising incomes? Apparently, they can’t and that might explain the 33% number, which is the complete opposite of economic strength.

How about those jobs, then? The official unemployment statistics have shown steady improvement for several years now and currently stands at 5%, very close to what technically constitutes “full employment” which is 3%-4%. The Fed’s Yellen has been consistent in saying improving employment and wage inflation is the key data she’s looking for in determining when to hike interest rates. The punditry regularly cites the unemployment rate as the central evidence that the economy is recovering. But none of this tells the whole story. Context matters. And by that I mean that if employment was indeed as robust as the headline figure says it is, why are retail sales so poor? Why is there no wage inflation (a point Yellen continues to make as she looks for ways to avoid hiking)? The answer, much like that of autos and housing, is in the makeup of that employment. That means looking at the labor force participation rate, wage inflation and the composition of the jobs that have actually been created. In both cases, the data is disappointing, to put it mildly. In the case of the former, the rate now stands at 62.5%, very near the record low of 62.4% not seen since 1977. I won’t bother detailing wage inflation since it hasn’t been statistically meaningful for years, although it’s always “just around the corner.” The third issue, job composition, completes the picture. Frankly, too many of the jobs created have been of the low-paying service-sector kind–essentially bartenders and waitresses. A look at the tables put out by the Bureau of Labor Statistics corroborates this, where the “food services and drinking places” category shows a 32.9% year-over-year increase from October to November. That comfortably leads all other categories (only health services are close and that can likely be attributed to Obamacare and an aging population) and is typical of monthly changes going back years now. Do these jobs count as employment? Sure. Are they the kind of jobs that can power robust consumer spending and home buying? Nope. (And with unions now a spent and defeated force, one more critical lever in the push for wage inflation simply doesn’t exist.)

Other data is similarly poor or trending poorer. Purchasing Managers’ Index data from Markit shows services merely treading water and manufacturing hitting new lows. The commodities complex has collapsed, taking the US shale industry with it. A rate hike will actually make it even worse, since all these commodities are priced in US dollars. Spreads in high yield bonds are reaching new highs while their prices reach lows not seen since the financial crisis of 2008. Corporate earnings are set to come under additional pressure (on top of that generated by the already high dollar and a slow global economy) with rate hikes because the bar they need to clear to generate profits will become that much higher. With higher rates, buying back stock will become less and less of a practical way to goose earnings. With higher rates, the emerging markets will have that much more trouble servicing their $4.5 trillion in US-dollar-denominated debt–with economies whose export markets are shrinking due to global slowdown and from where capital will flee to the higher-paying, “safe haven” US. There goes the emerging market customers from which the S&P 500 derives 40% of its earnings.

And this is the environment into which the Fed is hiking? Unfortunately for the Fed, yes. But it’s a scenario of its own making. By consistently talking up the markets and the economy–by playing politics rather than being the “neutral actor” it’s supposed to be–the Fed has no choice but to hike. If it doesn’t it will throw its credibility out the window and possibly lose de facto control of its interest rate setting power (the so-called yield curve). The market will likely interpret a refusal to hike as an admission by the Fed that the economy is in fact not as strong as it says and in fact may not be in recovery at all (again, this is zero interest rates, not 2% or 4%). Then a selling panic might ensure as investors value their investments as overvalued and look to cash out before the “other guy” does.

I expect the Fed to go to a containment strategy where it will hike a symbolic 0.25% and then stress–repeatedly–that it will hold there indefinitely, as if to say to the markets with a nudge and wink, “This is just for show. We’re not really going to raise rates. So don’t worry.” Portfolio and hedge fund managers, and important financial commentators, will then proceed to pat themselves on the back that normalcy has returned as if to say, “See, the system works!”

And that’s the rub: allowing the system to work will reveal that it doesn’t in fact work because nothing about the 2008 crisis led to fundamental change. So the very last thing the Fed can allow is honesty. Like a politician.

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