The January Jobs Report Does Not Ensure a March Rate Hike

Fed, GDP, jobs report, Oh My!The January Jobs Report Does Not Ensure a March Rate Hike

Investors should be alarmed by what the Fed will miss in the most recent slew of data on the state of the U.S. labor market. By the same token, they should be reassured that there’s is another payroll report ahead of the March Federal Open Market Committee meeting.

What messages will the Fed glean? Their in-house economists’ metrics will tell them that consumer spending will pick up in the months to come care of full-time job creation and accelerating wage gains. Indeed, wage growth last year was the briskest since July 2009 and January’s outsized 0.5-percent gain gives credence to those who’ve been warning about growing paychecks.

Expect the Fed to disregard the slide in job creation and conclude that a one-month aberration can be dismissed, as one month never makes a trend. In fact, when you average the gains, the trend in payroll growth is accelerating: the three-month average is 222,000, which outpaces the six-month average of 212,000, which in turn bests the 12-month average of 214,000.

The most encouraging aspect of the report, bar none, was the age cohort responsible for the decline in the unemployment rate to an eight-year low of 4.9 percent. The Lindsey Group’s Peter Boockvar points out that the bulk of the gains in the household report came from those ages 25-54 years old.

“In this ripe-age-for-working category, 607,000 more got jobs while there was little change for those aged 16-24 and over the age of 55, in sharp contrast to the prior month and in this cycle,” Boockvar noted.

So the increase in the labor force participation rate and wages, coupled with the decline in the unemployment rate and no disaster in average gains will probably be where the narrative ends for Fed policymakers. Janet Yellen is sure to applaud the improvement in the jobs market when she testifies to Congress next week. Expect speech after speech to echo this merry sentiment in the weeks to come, putting investors further on edge.

What should the Fed incorporate into its analysis?

The first fly in the ointment is that all of the recent averages represent a marked deceleration from 2014’s average monthly gains of 260,000. The second is that December’s gains were revised downwards bringing the last two-month average to 206,500.

More to the point is the havoc wreaked over the last two months by seasonal adjustments that have been whipsawed due to weather-related quirks. ITG’s Steve Blitz is astute in recognizing that January’s data are more a portrayal of “a working out of fourth quarter payroll additions which were, in our view, more a product of statistical methods than actual hiring.” In his estimation, statistical offsets are responsible for 91 percent of January private sector gains being at retailers, restaurants and health care providers.

The 58,000 gain in retail jobs looks particularly suspect given the most recent layoff announcement data from Challenger, Gray & Christmas. In January, retailers announced 22,246 job cuts, the highest January total since 2009. Maybe those commitments to front run any increase in the minimum wage aren’t all they’re stacked up to be when households’ budgets continue to be squeezed by rising rents and healthcare costs.

In all, some 75,114 job cuts were announced across all industries last month, a 218-percent jump from December and a 42-percent increase from the same month last year.

As for Chair Yellen’s best laid plans that the damage from the energy industry downturn will be “transitory,” January also marked the return of heavy jobs cuts in the energy industry. Firms announced 20,246 layoffs – the highest month on record since oil prices began to decline in mid-2014.

Looking ahead, default scares will morph to actual bankruptcies in the months to come. In other words, there are more high-paying job losses building in the oil pipeline, not fewer. Is it any wonder households’ expectations for a higher unemployment rate in one year’s time is at the highest level since September 2014 according to the January University of Michigan survey?

The biggest elephant in the room, though, the one that Fed officials are the most likely to ignore, is how skittish the average C-suite occupant has become since ringing in the New Year. Market volatility and signs that black swan events such as a major European banking scare or a South American sovereign debt default are very much in their sights.

One of the least appreciated and best data sets around, though, are usually buried in the bottom of the Challenger report, that of announced hiring plans. Last year, companies announced 690,751 planned openings, down materially 821,506 in 2014.

All things considered, the trend toward less hiring and more firing should continue on its downward path. Sufficient time should have passed for evidence of this to be apparent in the February jobs report just in time to place Fed officials on hold. Until then, expect the volatility in the markets to continue and be further exacerbated every time a Fed official opens their mouth.


Creative Indestruction

Night of the Living Dead movie posterGeorge A. Romero knew how to make an entrance onto the Hollywood stage.

Night of the Living Dead, his 1968 directorial debut, set the ‘A’ standard for horror flicks. Though the special effects may seem unsophisticated to today’s moviegoers, the movie still terrifies modern day audiences.

The premise of the film has stood the test of time and been the subject of numerous sequels: The recently deceased find no peace in their graveyard slumber; they rise from the dead hungry to feast upon living human flesh. The film, produced on a shoestring budget of $114,000, follows a group of seven unlucky souls trapped in a rural Pennsylvania farmhouse, desperate to escape the fate that has befallen others who’ve succumbed to the grasp of the ravenous zombies.

It’s plausible that Romero had come across the work of Joseph Schumpeter before entering filmmaking. The phrase ‘creative destruction’ was coined by the Austrian American economist in 1942 and refers to what W. Michael Cox describes as “free market’s messy way of delivering progress.” Something new and innovative necessarily kills off the methodology it replaces, freeing an economic pathway to advancement. The absence of creative destruction, therefore, invites zombie industries to languish, feeding off healthy and more efficient new entrants and dragging down economic growth.

Think Eli Whitney’s cotton gin, which removed seeds from cotton in a fraction of the time it had taken to do so by hand. Imagine a world before the rise of railroads, in which horse drawn wagons were primarily responsible for transporting goods. Dare we go there? Close your eyes and picture what it would take to get through any given day with a rotary phone.

Feeling immeasurably more productive with that iPhone in hand? Then you understand creative destruction, what Schumpeter himself called, “The essential fact about capitalism.”

I suppose that makes quantitative easing and other central banking magic tricks like negative interest rates the essential executioner of capitalism. Look no further than the amount of U.S. industrial capacity that is up and running, or better put, fallow. At 76.5 percent, the rate of capacity utilization remains 3.6 percentage points below its average dating back to 1972.

A friendly reminder – the U.S. economy is technically 80 months into ‘recovery.’ Imagine how much better off we’d be if a little creative destruction would have been allowed to take hold.

It could be worse. We could be as overcapacitized as China’s industrial sector. Consider that cutbacks to production in the Chinese steel industry alone will result in some 400,000 layoffs. Tack on planned capacity reductions in China’s coal, aluminum and copper industries and you’re talking about reducing the Chinese workforce by the equivalent of Wyoming’s or Vermont’s entire population. Debt-fueled growth stories all tend to end the same, though China’s case is arguably one for the history books.

Many years ago, when my friend Oleg Melentyev was still at Bank of America Merrill Lynch, he wrote a report that haunts me to this day. In what I now realize was a channeling of Romero’s spirit, Melentyev warned that there would be repercussions for the default rate cycle of the Great Financial Crisis being cut short by the Fed’s extraordinary measures.

You will recall that step one on the road to ‘extraordinary’ entailed reducing interest rates to the zero bound, which the Fed did in December 2008. By then, there were multiple horror shows playing out in the financial markets. While the stock market bottomed in March 2009, with the Standard & Poor’s 500 hitting a devilish 666-level before rebounding, the bloodbath in the bond market continued through year end.

Companies were meeting their makers right and left. The default rate, which tracks the percentage of issuers reneging on their promised interest payments, was careening skywards and would eventually top out at 13.1 percent, according to Moody’s Investors Service. The rate was a barely discernible one percent two years earlier. Looked at through a slightly different prism, the dollar volume of defaults ended 2009 at 16.8 percent.

The what-happens-next is what so troubled Melentyev at the time. The default rate tumbled 10 percentage points, ending 2010 at 3.2 percent, while the dollar-volume rate crashed to 1.6 percent. (No, Virginia, that is NOT normal.)

For all of the analyst communities’ concerns about the inability to refinance all of this junky debt over the past few years, cheap money has managed to tear down each and every so-called ‘wall of maturity.’ Such is the reality of a world without yield in safe places.

A glance at issuance volumes doesn’t begin to suggest there was a recession underway, much less one that was ‘Great.’ Though growth slowed for a moment between 2007 and 2008, the siren call of zero interest rates that led off 2009 all but commanded investors back into the bond market.

The high yield bond market has doubled in size not once, but twice, since the start of this young century, hence the tendency for it to implode under its own weight. Outstandings doubled from 2000’s $334 billion to end 2007 at $674 billion. Then came the pause. The high yield market ended 2008 at $675 billion, up a mere billion over the prior 12 months.

Then it was off to the races. Issuance has since redoubled the size of the junk bond market to $1.5 trillion, with a capital ‘T.’ If you include all of the debt on high risk borrower balance sheets, including institutional facilities, term loans and credit lines outstanding, you’re talking about an additional $2 trillion.

“The high yield market and leveraged loan market has continued to grow,” worries Moody’s Tiina Siilaberg, “and the covenants are much looser now than they were in 2007. The default cycle this time around will be much different.”

As things stand, investors are being reminded in rude form how closely linked the behavior of risky debt and the stock market are. According to Melentyev’s latest tally, the spread, or the extra compensation investors receive for holding junk bonds vis-à-vis Treasury bonds, is nearly eight percentage points, the most since the fall of 2011.

“All-in high yield spreads today…are at their widest point since the depths of the Great Financial Crisis in 2009,” Melentyev cautions.

To his credit, Melentyev has never been one to buy into the dire need to net out energy borrowers to get the true underlying health of the bond market. After all, no analyst was doing this when oil issuance was going haywire and benefitting investors. If you must, junk spreads ex-energy have another percentage point to go in terms of widening and worsening before reaching their 2011 wides.

By the looks of things, investors won’t have to wait too long. Six of the ten issuers Moody’s downgraded in January to the category least-likely-to-be-able-to-refinance-their-debts were companies outside the atrophied energy sector. Overall stress, as gauged by the credit rating agency’s Liquidity Stress Index, spiked to 7.9 percent from 6.8 percent in December, the highest since December 2009 and the biggest one-month leap since March 2009.

Where’s the real worry? If you do play the neat netting game, but in a fair manner, removing financial issuers, which were a massive drag on the market, AND energy borrowers, which flattered the figures, investment grade is trading at its widest since 2011.

In other words, on a relative basis, junk is actually outperforming its hoity-toity investment grade big brother. It’s tomorrow’s fallen angels, or downgrades to junkland, that should give investors fright. At $5.3 trillion, it’s over three times the size of the high yield market. But that’s such a big story on its own, it merits its own sequel.

Of course, the Fed could truly be on the path to normalizing interest rates, which would give investors license to pull the plug on zombie companies once and for all, and allow Schumpeter to finally slumber peacefully in his ***own*** grave. What are the odds of that happening?

Investors would do well to listen to one of Wall Street’s most experienced voices, UBS’ Art Cashin, on those prospects. Cashin is sticking by his call that we’ll see zero before we see one percent interest rates care of a frightened Fed that backtracks on its ill-fated and two-years-overdue initial interest rate hike.

The next stop? That would be negative interest rates according to the dangerous theorists running the world economy.

Japan certainly seems to have bought into the notion that negative interest rates will prove to be the palliative they’re in desperate need of after 25 years of failed monetary policy. Japan’s inauguration to this sad group brings the total amount of global sovereign debt trading at negative yields to $5.5 trillion. Punctuating the implications for future countries dragged down the same path to negativity: The Japanese government has just canceled its next 10-year sovereign debt auction.

Can you imagine Uncle Sam going that same route – cancelling a Treasury auction because the 10-year was trading with a negative yield? If you answered ‘yes,’ you’re clearly comfortable co-existing with the corporate zombies in our collective midst.


Note to the FOMC: Google ‘Nuance’

FOMC-Meeting, @dimartinoboothNuance’ is defined as a subtle difference in or shade of meaning, expression or sound. It’s safe to say a copy of the definition of ‘nuance’ was not distributed to members of the Federal Open Market Committee (FOMC) in advance of today’s statement release.

Yellen et al knew going into this meeting that skittish financial markets and a weakening dollar dictated that they be more careful than they’ve ever been in choosing their words carefully. And yet they opted for the verbal bull in a China shop route knowing they’re engaged in a full scale stealth currency war with the People’s Bank of China (PBOC).

Despite oil closing up on the day, stocks raced off script with the Standard & Poor’s 500 closing down 1.1 percent, giving back the bulk of yesterday’s gains. So much for that ‘stocks and oil move in perfect lockstep’ relationship that’s been firmly in place since the start of the year.

What spooked the markets is both what the Fed did and did not change in the statement’s language.

Yes, they nodded to global financial strains. Yes, the applauded the recent strong headline gains in nonfarm payrolls (though they clearly were not provided a copy of the household report which showed a whopping three percent of job gains went to those ages 25-55). The FOMC even expanded its verbiage to recognize a fresh source of weakness in the economy, as in the inventory businesses no longer see fit to build.

But we were all expecting an acknowledgment of the obvious.

Less anticipated was the adamancy of Committee members that inflation would hit their stated goal of “two percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.”

‘Strengthens further?’ Anyone bother to share the last few weekly jobless claims reports with monetary policymakers?

As for inflation’s prospects, a year and a half into crashing oil prices, the FOMC’s use of the word ‘transitory’ leads one to wonder if they are stuck in some space age time warp. Or maybe they declared it Opposite Day but failed to share that with the rest of us.

In the event interpreters harbored any doubts that a March rate hike was still on the table, this language was kept in the statement: “The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.”

While the Fed clearly remains giddily detached from reality, the bond market communicated unequivocally what it thinks about the economy’s prospects: the 10-year Treasury closed below the two percent line in the sand that’s been drawn since the start of the year.

We’ll all see on Friday how close Morgan Stanley’s dour forecast is to what’s actually reported for fourth quarter gross domestic product. The latest economic reports have led the big bank to predict economic growth slowed to a barely discernible 0.1 percent in the last three months of the year.

Clearly the folks at Morgan Stanley are looking at different data sets than the FOMC.

Of course, there are two opportunities to reshape the intent and meaning of the statement right around the corner. The first arrives February 10th when Chair Yellen will offer up her semiannual testimony to Congress. Set your DVRs now.

The second chance to massage the message comes in three weeks when the minutes of today’s meeting are released. Five years ago, as revealed in the 2008 FOMC transcripts, Yellen advised her fellow committee members to “consider using the minutes to provide quantitative information of our expectations.”

How convenient, For the FOMC, that is.

In the meantime, the Chinese will retain license to devalue the yuan to defend their economy, which whether they like it or not, still depends heavily on exports. Until the Fed makes way for the dollar to stand down, all will remain fair in word and currency wars.


Paying the Pied Piper of Passivity

The Pied Piper of Hamlin

“In the year of 1284, on the day of Saints John and Paul on June 26, by a piper, clothed in many kinds of colours, 130 children born in Hamelin were seduced, and lost at the place of execution near the koppen.”


We are all familiar with the tale of the brightly-clothed pied piper whose lovely tune was so enchanting as to lure a town’s entire population of children to their premature demise. Few may realize the legend was borne of true events. The Lower Saxony hamlet was battling a rat infestation and the pied piper originally labored to rid the scourge in exchange for payment. Rat-free, the townspeople reneged and paid dearly with their children’s lives, or so the story goes.

Listen to investing legend John Bogle and you too might be lulled. Not by music, but by a message that could have you believing that active investing should also have long ago met its own demise. The man is on top of his game with Vanguard, the firm he founded on September 24, 1974, raking in a record $236 billion last year. Total assets under management? A cool $3.1 trillion. (OK, you might should round down considering how this year has started.)

Nevertheless, Bogle makes beautifully salient points about passive investing. Active managers are too richly rewarded. Or in Bogle’s words from a Bloomberg interview last April, active mutual funds are “fat, dumb and happy,” soaking would-be retirees with excessive fees.

In many cases that assessment suits, especially when “closet indexing” is involved. Think handsomely rewarded “active” managers circa 2000 buying into the dotcom revolution’s poster children of profitless phantasmal prosperity. Or jump to present day and picture managers who veered blindly from concentrated to the core in Apple to a deep dive into the FANG stocks that we can all name.

What should be most important to investors is that index investing has proven its merit, outperforming its actively-managed peers. Morningstar tracked 562 actively managed large-cap growth stock mutual funds and 25 passively managed funds in the same asset class. In the decade through yearend 2014, passive outperformed by a significant margin, with average returns of 9.27 percent compared to managed funds’ 8.05 percent.

Bogle’s prediction: “In 25 to 30 years, they’ll be gone. That seems like an extreme statement, but I think it isn’t without possibility.”

Spend nearly a decade as an outsider inside the Federal Reserve and you realize the perilous nature of Bogle’s arguably logical conclusion. Data, one comes to understand, is akin to an artist’s canvas, clay or marble; it can be painted, molded and sculpted, conforming to the artist’s strokes. Framing timeframes is by far the most convenient method to help the data assume the shape of your intended outcome.

Don’t like the way inflation trends behave going back to the 1800s when deflation was a much more common occurrence? Slice right through history and begin in a postwar world. And voila. The results pan out just as you’d hypothesized. It bears mentioning that this line of thought has infected the collective mindset of the current generation of economists at the Fed and gone a long way towards perfecting models that justify the stifling of the business cycle.

Be mindful, in other words, that Morningstar examined ten years in which easy monetary policy ruled the financial markets’ roost. It should be no wonder that stock picking can be placed right up there beside bungee jumping with a broken cord.

In the event the little hairs on the back of your neck are standing up, that’s your subconscious asking a pertinent question: Are central bankers omnipotent? Do they have the ability to keep Mother Nature at bay indefinitely?

If you believe that to be the case, then double down in index investing. But if you’re a wee bit skeptical, consider the following less discussed index fund investing attributes care of Schroders’ Alistair Jones.

Equity index funds weight their stocks by their market capitalization. That means the go-go stocks with the most inflated prices drive the train. In a report, Jones warned “The problem is that market cap weighted indices can force investors to buy stocks with expensive valuations and sell cheap ones.” He goes on, “In other words, buy high and sell low.”

For those keeping track, the broad index is off by one percent since December 2014 but has suffered a decline of five percent if you net out the top 10. That tony top cohort is up by 17 percent over the same time frame. But the parallel with 1999 should stand as warning enough to passive investors comforted by how well their portfolios have performed. What spikes upwards will crash just as violently when the air rushes out of these bubbling stocks.

Jones’ second reservation has to do with this concept we used to be familiar with called ‘price discovery.’ Value, we learned in portfolio management 101, is what you buy at a fair price. The implication is that good companies can be bad values. “Passive managers,” Jones explains, “are not able to distinguish between good and bad, wheat or chaff. They are forced to invest in all the stocks in an index, irrespective of any views about their value or quality.”

Jones’ last concern drives at why investors have piled into passive funds care of the Fed’s enticing investors into risky assets with their own special strain to which worryingly few are impervious. Rather than disappear and never be seen by their parents again, as was the case with the town’s children and the 11th century piper, investors must reckon with the systemic risk that permeates the markets when boom turn to bust.

The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the ‘miracle’ of China’s emergence onto the global economic stage that ignited the engine to begin with.

Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher’s stone.

Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these last few years.

Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.

Last Friday, Mario Draghi sang acapella to the roaring applause of financial markets, which rallied to close in positive territory for the first time in a month.

It’s likely that the Wall Street Journal’s Greg Ip answered the mother of all questions posed by passive investors. Their query: Why bother with the nitty gritty of identifying value in individual securities in a world in which macro is all that matters?

Ip’s answer: “Just as the Fed doesn’t determine the breadth of the boom, it can’t dictate the scale of the bust.”

The conventional wisdom is that a rising interest rate environment will lay the groundwork for active managers to finally outshine their passive brethren. A recession ensues outing the passive managers as sheep in wolves’ clothing – all good on the upside, brutal on the downside. But what if recession emerges without being triggered by a textbook tightening cycle?

The world as we know it has become dangerously interconnected. We read about the trillions of dollars of dollar-denominated emerging markets bonds that have been issued in recent years to say nothing of the explosion in supposedly safe developed-market debt and pretend that rationality has played a part.

We delude ourselves into believing that events halfway around the world can be contained. Recall the last time we bought into the notion of events being contained and consider yourself forewarned.

In the fabled fable of the Pied Piper, there was only one lucky child who was spared. The lucky child depends on the version of the story being told. In one version it was a lame child who could not keep up with the mass exodus, another version spares a deaf child, perfectly immune to the fatal melody, and still another version saves a blind child who could not make his way.

Are there modern day parallels to the survivors, ardent disciples of Graham & Dodd and idealistic short sellers standing sentry against corporate malfeasance’s entry? We can only hope.


The Sweathogs of Sovereigns?

Welcome Back Kotter, The Sweathogs of Sovereigns? Dimartinobooth.comBefore there was Tony Moreno, there was Vinnie Barbarino.

The 1970s TV sitcom Welcome Back Kotter would make a star of John Travolta and leave the others in the cast behind. For some though, despite the show’s own short-lived success, the Sweathogs will live on in infamy. The “Kotter” in the show title referred to Gabe Kotter, a former remedial student himself tasked with corralling the rag-tag group of slackers affectionately called the “Sweathogs.” Heartthrob Barbarino was the self-assured Italian who led the fictional Brooklyn high school class. Freddie “Boom Boom” Washington was the resident wisecracking jock. Not to be forgotten easily was Juan Luis Pedro Felipo de Huevos Epstein, a self-described Puerto Rican Jew voted “Most Likely to Take a Life.” And finally, there was the venerable Arnold Horshack, whose hyena-like laugh masked that he was the brains of the bunch.

The only serious aspect of the show involved the assumption that the Sweathogs would never amount to anything in life. The hoodlums’ scripted on-air antics certainly backed the perception they were witless wonders. But as predictable plots would have it, Kotter’s faith and dedication ultimately reveal his problematic pupils’ promise and potential.

Judging by the past two weeks, the Wall Street Journal’s headline writers must think that Chinese officials are sovereigns’ answer to the Sweathogs. Here’s a smattering of the smack-down teasers:

‘China’s Currency Communication Suffers a Breakdown’

‘Did China Change the Way it Fixes the Yuan?’

‘China Central Bank Puzzles Investors’

‘China’s Shift in Yuan Strategy Backfires’

‘China’s War on Yuan Speculators Targets Wrong Problem’

By last Friday, readers wouldn’t have been surprised to open their Journal to ‘Currency Controls for Dummies.’ Instead, they got the following: ‘Beijing’s Yuan Policy is Meant to Baffle.’ Chinese policymakers weren’t, after all, bumbling bureaucratic buffoons. Rather, they had planned to manufacture uncertainty all along, kind of like they’d carefully planned to over-manufacture steel rebar and other commodities suffocating the global economy.

The Journal cited people close to the People’s Bank of China (PBOC), a.k.a. China’s Fed, in its reporting. The PBOC had purposefully changed up the way it sets the yuan’s price by “interspersing periods of depreciation with surprise bouts of strengthening through market guidance or intervention.”

The end game: by illustrating that the currency can gyrate like any other that floats freely, demonstrable evidence can be entered into the public record that opens the pathway to an eventual free float and independence from the dollar peg to which it ostensibly remains tethered.

Now who was the wiser, who made the rest of the world work up a sweat?

My good friend and China expert Worth Wray opened a recent report with the following timely quote from President John F. Kennedy: “When written in Chinese, the word crisis is comprised of two characters. One represents danger and the other represents opportunity.”

Any cold war thinkers out there could certainly connect the dots. How brilliant would it be if the Chinese were meticulously orchestrating a free floating currency knowing full well the financial markets are so fragile as to throw the entire global economy into recession? A crisis begets an opportunity to take one more step closer to reserve currency status.

It’s doubtful though that even the Chinese are that adept, though there is a very real and recent precedent to suggest connivery at the highest levels. Recall that the world was poised to absorb the first Fed rate hike on September 17th. What stopped the Fed from pulling the trigger then? That would be the surprise devaluation of the yuan in August. Of course, Chinese policymakers were simply reacting to the reality of the strengthening dollar to which their currency is pegged.

First, a soupcon of background. According to a report by Elvis Picardo, the Chinese economy quintupled in size in dollar terms in the decade to 2013 catapulting it to unseat Japan as the world’s second largest economy. This growth was generated by an export machine: trade between the U.S. and China swelled from $559 billion in 2013 from $4 billion in 1981.

The critical underpinning was a currency that Chinese policymakers held at artificially weak levels thus rendering their goods more competitive in the global marketplace. The dollar first entered the picture in 1994 when the yuan was pegged to the U.S. currency at a level of 8.28 to the dollar. Over a decade later, pressure from its trading partners forced China’s hand. By 2013, the yuan had appreciated to about 6 to the dollar ($1 bought only 6 yuan whereas it had purchased over 8 yuan in 1994).

Yuan appreciation is not all bad if you consider the ultimate goal of the Chinese powers that be, which is to transform the Chinese economy into one that resembles more closely that of the United States. The goal: Consumption and services self-sustain economic growth freeing China of its modern-day manufacturing shackles. Chinese domestic households must have a strong currency if they ever hope to consume their way to economic nirvana.

The problem is reality often collides with even the best laid plans. Transitioning the Chinese economy could not be accomplished in a Shanghai minute. To that end, it was mandated that manufacturing continued to carry its economic weight to ensure a smooth evolution.

Flash forward to last year and it’s easy enough to imagine Chinese central bankers’ increasing discomfort. The dollar was a runaway train of strength as the world prepared for the Fed to go in one direction while the rest of the world, with their faltering economies, pulled in the opposite direction.

It was thus perfectly plausible and no fault of the Chinese, the explanation goes, that the yuan was taken down a peg in August. Financial market panic ensued and sure enough, the Fed stood down.

But as we all know, that was but a momentary stay of execution. The Fed dropped the gauntlet on December 16th pushing the dollar to fresh heights. That’s when things started to get hairy. Chinese policymakers had vowed to ensure that any future devaluation subsequent to August’s initial move would be gradual.

The market had its own ideas.

China’s “reported” economic growth has slowed from the boom-boom days’ rate of 10 percent to this week’s 6.9 percent for all of 2015. The market for its part has rationally begun to price in the need for further yuan depreciation to prop up the slowing economy.

That’s all well and good except for one little thing. The rest of the world is also falling apart as oil prices collapse, which could easily be perceived to be a reflection of the global growth slowdown resulting from the end of the commodity supercycle, which itself was triggered by the Chinese hitting the outer limits of building empty cities and thus being forced to move to a consumption-driven economy.

In economics this vicious cycle that spirals out of control is delicately referred to as a negative feedback loop. Its much more attractive twin sister is the positive feedback loop. In the case of the current boom which is coming to a violent end, the positive feedback loop was catalyzed by the Chinese consuming more concrete in the three years ending 2013 than the U.S. did in the entire 20th century.

Who is delusional enough to believe this set of circumstances could be replicated today given that the global economy is dangling by an unravelling thread spun by central bank stimulus? And why would anyone believe an orderly unwind of this magnitude to be an even remote possibility?

Of course, the conventional wisdom is sanguine. After all, we are assured, China has $3.3 trillion in foreign reserves to guarantee against any sort of disruptive depreciation. As one Chinese official said last week, bets against the yuan are ‘ridiculous.’

Let’s just say my buddy Wray didn’t get to be Evergreen Gavekal’s chief economist by toeing the conventional wisdom line. By Wray’s reckoning, the starting point is a heck of a lot closer to $3 trillion given the enormous sums they’ve had to throw at stopping the currency’s most run from veering out of control.

But it’s not just what they’ve already spent. A third of their reserves are illiquid and cannot be readily deployed in the business of defending said currency.

And then there’s that thorny issue of prior commitments. President Xi Jinping has earmarked $1 trillion to underwrite the “One Belt, One Road” initiative to lift their economy to new heights. The plan’s anchor entails constructing a new Silk Road that builds infrastructure links from China to Europe and the rest of Asia.

We’re talking about what the Financial Times described as “the largest programme of economic diplomacy since the US-led Marshall Plan for postwar reconstruction in Europe, covering dozens of countries with a total population of over 3 billion people.”

If that doesn’t unseat the dollar, what will? (Pardon the digression.)

The bottom line is that bottom line is skinnier than most people are assuming. We’re talking $1 to $1.5 trillion which covers only five to seven percent of China’s $21 trillion money supply.

Exacerbating matters is the fact that it is not purely speculators driving the yuan’s moves. Domestic depositors are moving their money out of the country for fear that the economic slowdown could morph into something far worse. It’s conceivable that outflows could deplete the reserve cushion by the time we’re ringing in the next new year.

That leaves China’s leadership with three options according to Wray’s wisdom:

  1. Attempt to strengthen China’s capital controls to stop the bloodletting of outflows and thereby stabilize the yuan.
  2. China can burn through their reserves trying to buy time. But this ends in tears as they are forced to float the currency from a position of weakness.
  3. OR, China can preserve its reserve stash and float the currency in the next few months from a position of relative strength

“Yes, there’s a lot of risk involved with free floating the aspiring reserve currency earlier than planned, but waiting around for a major yuan buyer to suddenly emerge is downright reckless,” Wray warns.

Gabe Kaplan, who played the Sweathogs’ Mr. Kotter once cited The Marx Brothers as inspiration for the sitcom’s plot lines and character behaviors. Classic slapstick made the show’s first few seasons magical. But the show died an early death as casting challenges set in and stardom beckoned a young Travolta to light up a disco dance floor in Saturday Night Fever.

Will China’s financial miracle meet its own demise thanks to what appear to be increasingly uncontrolled Sweathog-like shenanigans? Or will they graduate to a rational, well-run economic superpower thanks to taking the higher Silk Road home? For the time being, we will all have to put our seatbelts on and be satisfied with staying tuned until their next season’s episodes air.


Locked and Not Loaded


John Wayne had a way with words.

His delivery and performance as Marine Sargent John Stryker in the Sands of Iwo Jima were so convincing as to garner him an Academy Award nomination for Best Actor in a Leading Role. Though the marines Sargent Stryker led into battle might have begrudged his demanding training standards, the reality of life and death depicted on the battlefield quickly quashed resentment and replaced it with respect. It’s fitting that one of Hollywood’s toughest guys was the first in recorded history to command his onscreen troops into battle with the rally cry, “Lock and Load!”

It seems conceivable that Richard Fisher might have just seen Wayne’s World War II classic the night before his January 5th CNBC interview. Like Wayne, the former Dallas Federal Reserve President who went by the simpler term “boss” to yours truly for the better part of the last decade also happens to have a way with words. To wit is the following witticism: “The Federal Reserve is a giant weapon that has no ammunition left.”

Talk about fighting words.

If only policymakers understood that their collective mouthpiece was a weapon in and of itself. But they cannot seem to contain their commentary to the detriment of their ostensible lofty goal of stabilizing the financial system.

Take the other Fischer, as in Stanley Fischer, the Godfather of central banking. Was it not borderline reckless to insist that the Fed would hike interest rates four times this year in the face of market turmoil that made last August look like a walk in the park? It’s not so much that stock and bond market gyrations should be the driving force behind monetary policymaking. But prudence ought to at least dictate that public remarks not exacerbate the panic inciting investment behavior.

Going back to Richard Fisher for a moment, he rightly pointed out the direct source of market instability when he said, “We (the Fed) front-loaded an enormous rally to generate a wealth effect.”

Few former central bankers today have the gall to aver that the wealth effect performed as their models suggested they would. Turning the discussion into something political is a red herring; set that aside. Instead focus on research published by the International Monetary Fund (IMF) last summer. The conclusion of a study of 150 countries: the wealth effect is not only dead, unbalanced rewards of riches to the top earners actually slows aggregate economic growth.

Not that such math is infallible, but the IMF researchers determined that when the wealthiest 20 percent enjoy a one percent boost to their income, the annual growth rate of their respective country’s economy contracts by 0.1 percent within five years. The flipside: when the lowest 20 percent of earners see their incomes grow by that same one percent, economic growth rises by 0.4 percent over the same period.

Of course, lifting all boats requires true grit (if Mr. Wayne’s other boots fit…). In the case of the United States, it would require Congress first reform and then invest wisely in the nation’s education system so as to effect a lifelong wealth effect that benefits the economy in the long run.

But then, such actions require that adult comportment exist in DC to begin with. It has proven appreciably easier for politicians to lean on the Fed to keep interest rates at artificially low levels, which inevitably produces the illusion of wealth to low income earners via credit. No other sin of central banking has exacted such long-lasting damage on its country’s citizens (think subprime this or that).

As for what’s to come in the nearer term, veteran contrarians would suggest that a rally in the markets is building. Whether it’s investor sentiment surveys or Citigroup’s Panic/Euphoria gauge, which is deep in panic territory, history suggests that the rally stocks attempted earlier this week reflected what bulls were hoping was a deeply deeply oversold  market.

That said, these metrics say nothing about true valuations, which remain undetermined given the boost to the ‘E’ in the price/earnings (P/E) ratio care of the lowest debt-service costs in the history of mankind and share buybacks. These feel-good earnings boosters will prove as ephemeral to the stock market as they have every other time monetary policy has encouraged executive trickery.

If Fisher is right about the Fed’s lack of ammunition, further accommodation won’t be capable of riding to the rescue. Not that other policymakers are ceding even a hint at such a possibility.

Take the San Francisco Fed’s John Williams, who the Wall Street Journal recently ranked fifth in terms of influential Fed speakers (after Janet Yellen, Stanley Fischer, Bill Dudley and Jeffrey Lacker). The Journal attributed William’s former role as Yellen’s research director when she ran the SF Fed to his perceived role as one who “tends to signal the shifting consensus.” In other words, his comments are the next best thing to hearing it straight from Yellen’s mouth.

In a speech he gave the first week of January, he redefined understatement, conceding that the Fed had underestimated the negative economic ramifications of the decline in oil prices: “The world had changed; the U.S. has a lot of jobs connected to the oil industry.”

Not to worry, he continued, now that consumers finally trust that oil prices could remain low for a prolonged period of time, they will finally open their wallets and spend that windfall they’ve stingily been hoarding, which has in turn held back economic growth. His bottom line is that the Fed will hold to its plans to continue raising interest rates given that, “the U.S. economy still has a good head of steam.”

Isn’t it sublime when truth trumps fiction? Let’s hope William’s comments were:

A) not translated to other languages thus preventing the insulting of those devastated by the 250,000 and counting energy layoffs worldwide (to say nothing of metals and mining workers), and

B) for added good measure, not widely disseminated in Texas newspapers where 60,000 and counting high-paying energy jobs have been lost.

Perhaps Fedspeak, which purportedly has been raised to a Zen-like state in the era of unprecedented transparency, should follow Fed statements’ lead. Deutsche Bank’s Torsten Slok has been tracking the number of words in Fed statements for years. After peaking at 895 words in September, 2014, the number mercifully dwindled down to 556 as of December’s historic statement release.

Maybe even an election year moratorium on Fedspeak would do for now given how challenging it is to keep pace with all of the Candidate-speak clogging the airwaves. The investment community could put a motion to vote: replace confusing, contradictory and controversial Fedspeak with a press conference after every Federal Open Market Committee (FOMC) meeting.

Yellen pulling out the miracle of a unanimous vote at December’s meeting leaves little doubt the fair chair has gained control of her unruly underlings. That being the case, let her present a unified front in explaining the Committee’s decision-making methodology and determinations at the close of every FOMC meeting. If nothing else, the financial markets would be freed from what’s become a fresh source of violent volatility.

After all, it was Stanley Fischer himself who recently said of the Fed’s desire to normalize interest rates: “We want to get there and get there without creating big messes in the markets.”

If that’s truly the case, given the destructive toll inflicted by Fedspeak in recent years, less would indeed be more. It’s one thing to be locked and loaded. Try naming any war in history that’s been won firing off ineffectual blanks.


Grandma Got Run Over by a Rate Hike

Grandma got Run Over by a Rate Hike

Some songs don’t merit remakes.

And yet, a little over seven years ago, a variation on a southern Christmas ditty sprang onto the scene. The original remake, in the event you didn’t catch it on your radio, involved changing “Reindeer” to “Rate Cut.” Some seven years and over half a trillion in foregone savings later, most would agree that seniors were flattened in the era of zero interest rates.

Early last year, the insurer Swiss Re released findings of a study which found that in the five years through 2013, U.S. savers had lost some $470 billion in what they would otherwise have earned in interest income had rates not been held at artificially low levels.

Forget the shoulda, coulda, woulda nature of the matter – as if overwhelmed by a group epiphany, most economists now miraculously agree that the Federal Reserve was much too late in removing the punch bowl. The question for the here and now is what’s Grandma to do in the aftermath of the initiation of the long-feared tightening campaign?

As an aside, it’s beyond grating to hear every pundit on the financial news circuit brag about how they were all on board with the Fed hiking back in 2013. The term “taper tantrum” couldn’t have earned its name without most of Wall Street whining at the prospect of a mere reduction in the Fed’s quantitative easing campaign back in the summer of 2013.

Pardon the digression. Back to Grandma. What’s she to do when the recession does arrive? Take the best case scenario, that we’re talking 18 months from now and the re-writing of history books on lengthy economic expansions. Then what does she do?

By then, Baby Boomers will be endeavoring to retire en masse: according to a recent survey, two-thirds of boomers plan to retire by the time they turn 70. As it so happens, this year, the firstborn class of 1946 turns 70, meaning we are just at the outset of the trend.

Before continuing, the flipside of the above statistic is worth noting. If two-thirds of Boomers plan to retire by the age of 70, a solid one-third (think 25 million folks here) do not plan to leave the workforce. This goes a long way to explaining the relative strength of this cohort’s lofty labor force participation rate to say nothing of their propensity to be upsizing their homes.

According to a November Fannie Mae report, in 2013, the per capita rate of single-family home occupancy was unchanged with that of 2012 and in fact above 2006 levels. Far be it from downsizing, the average number of rooms per home increased from 2011 to 2013, the latest year for which data are available.

One interim observation:  While the explosion in apartment occupancy has been no mirage, it is entirely attributable to the Millennial generation. From 2011 to 2013, the number of Boomer apartment dwellers remained static while the number of Millennials living in apartments grew by a half million a year.

(Trivia – 2015 marked the year both generations numbered 75 million. From here on out, Millennials will increasingly outnumber Boomers, who’ve reigned supreme as the largest generation this country has known for what feels like a millennia.)

As for the Boomers who do want to retire, what exactly is it they’re willing to part with? For most, the answer is absolutely nothing. They want to keep their (large) home, their two cars and the lifestyle to which they’ve become accustomed. If only their desires matched up with their prospects. A survey released last spring by the Insured Retirement Institute found that Boomers’ “economic satisfaction” dropped to 48 percent last year from 65 percent in 2014 and 76 percent in 2011.

Delineating between retirees and those still working reveals a yawning gap: Retirees’ satisfaction caved to 45 percent from 72 percent in 2014 compared to 53 percent of working Boomers feeling satisfied vs. 60 percent the prior year.

In all, only six in 10 reported having saved adequately for retirement. This squares with a separate study that found those aged 55-64 had an average combined 401k and IRA balance of $111,000 in 2013.

So what’s a would-be retiree to do? Saving $10,000 a month to play catch-up would be a good start. That’s a steep order considering the median annual income in this country is somewhere in the neighborhood of $55,000.

Which brings us back to Grandma and that rate hike, which is sure to be blamed for the recession but in truth will be coincidental in nature. Whether she likes it or not, if that cruise she’s been planning is going to remain in her grand retirement plans, she might just have to sell off her beloved home sweet home.

According to 2013 Census data, the 32 million single-family abodes Boomers call home account for over one-quarter of the nation’s housing stock. This cache of cottages has an estimated market value of $8 trillion which equates to 42 percent of the value of all owner-occupied homes out there (they don’t call them McMansions for nothing).

Aside from the observation that we’re talking about a whole heck of a lot of house, who exactly is going to buy them? Would you answer, “Why, the Millennials naturally”?

I’m personally going with AMC Lending’s Logan Mohtshami’s take on this one. He forecasts that demand for single-family homes won’t improve meaningfully until 2020 or so. “Until then, expect a slow and steady rise for (housing) starts and permits.” That, by the way, is just what we’ve had in recent years – slow and steady, as in new single-family home construction is a fraction of what is should be given population growth.

As for all that touted Millennial pent-up demand, even last year, the ranks of 25-34 year olds bunking up with mom and dad rose in number. The generation is effectively going in reverse vis-à-vis what the broad housing market needs, which is for this generation to fly the coop once and for all.

“We need the young to rent, hook up, date, find a steady relationship, pop the question, and have kids before we have any major boom in single family home sales,” Mohtshami wisely observes.

Of course, some of these choices are cultural as we’ve all learned. Why not live in your parent’s basement and drive a nicer set of wheels than you could otherwise? But surely that thinking is not representative of every member of this whole 75-million strong army?

On a more fundamental level, broad-based, higher paying job growth is what’s needed to solve this entrenched issue. That’s difficult to foresee given shrinking corporate profits and contracting manufacturing activity to say nothing of mounting evidence of a slowdown in the labor market, the most lagging of all indicators.

What transpires between now and 2020 is what really matters for the economy, and by extension for housing, which has yet to fully recover from the great housing crisis. Some 15 percent of U.S. homeowners still owe more on their home than it is worth. Many who borrowed against their home equity during the housing boom are just now having to start making good on that promise.

That said, mortgage applications have picked up over the past year and anecdotal evidence suggests more first time homebuyers are entering the market, albeit at inflated prices. But first timers are not what Boomers need. McMansions are sold to the generation that moves out of their first home, known as move-up buyers.

Will Grandma and her friends and neighbors with roofs over their heads be the only damage exacted by the coming recession, whenever that inevitably descends on the economy? We can only hope.

The starting point for the Baby Boomer generation is nothing to laugh about. The United States ranks 29th among 33 developed countries for seniors living in poverty – 21.5 percent of Americans ages 65 and older live in poverty vs. 12.6 percent for all developed countries.

It is hard to say when, and even if, monetary and fiscal policymakers will ever own up to the part they’ve played in encouraging debt in lieu of prudence. We can only hope they rue the day such darkly humorous lyrics sprang to mind (substitute “Hike” for 2015 version).

Grandma Got Run Over by a Rate Cut
Walking Home from D.C. Christmas Eve
You Can Say There’s No Such Thing as Free Lunch
But as for me and Grandpa, We Believed


Bottoms-Down Forecasting

Griswold, Bottoms-down forecasting

What do bad wiring, methane and non-chloric, silicon-based lubricant have in common?

Presumably a classic Christmas movie would not first come to mind. It’s a Wonderful Life and Miracle on 34th Street, those are true classic masterpieces. In more recent movie history, A Christmas Story and Home Alone have captured the rowdier spirit of the season.

That leaves National Lampoon’s Christmas Vacation a close fifth for some as a must watch, at least among the non-animated classics. Favorite scenes compete for top spot in this less-than-high-brow comedic tale; two of these star animals. In the first, a cat chewing Christmas tree light wires ends fatally for the feline. This side-splitting scene was almost cut by the PC police, which just goes to show you. In the second scene, an indoor squirrel chase also delights; the culmination of a hilarious series of events that features methane gas and Cousin Eddie, perhaps the best redneck character to ever grace, if such terms as redneck and grace can reside together, the big screen.

And then there’s the infamous downhill sled scene. In endeavoring to achieve a “new amateur, recreational, saucer-sled land-speed record,” Clark Griswold, played perfectly by Chevy Chase, waxes a steel sled with a kitchen lubricant. The fiery end in a Wal-Mart parking lot is truly one for the ages. With Christmas being over, it seems a shame to store these moments with everything else that comes out for the Holidays and won’t be seen for another long year.

But look ahead to the New Year we must. Wall Street has been doing just that for the better part of the last month. Barron’s recently characterized the Street’s 2016 outlook as, “Cautious, but Optimistic.” The group’s mean forecast places the benchmark Standard & Poor’s 500 stock index at 2220 by the end of next year, roughly six percent above current levels.

Of course, the optimistic predictions are on par with those being espoused at this time last year that have not panned out as prognosticated. But the optimism is to be expected. With rare exceptions, strategists are a sanguine lot, as they should be. After all, they’re tasked with keeping their firms’ clients’ money fully invested (and therefore fully fee-generating).

Given his constructive posture, Goldman Sachs’ David Kostin is this year’s standout among Barron’s ten cited strategists. His 2,100 yearend S&P 500 target is the lowest of the bunch. His outlook is weighed down by the view that the Fed will hike rates four times in 2016. This will in turn drag down what will otherwise be decent earnings against the backdrop of yet another year of tepid economic growth.

Citigroup’s Tobias Levkovich, a friend and investing legend in his own right, is characteristically optimistic. His Barron’s forecast lines right up with the consensus: The S&P will end next year at 2200. That upbeat take makes his downside risks all the more intriguing as they tap the contrarian in him. Tellingly, they begin with upside risk to the employment and wage picture which triggers a “chase towards higher bond yields.” This chase would catalyze what policymakers fear more than wage inflation; that is wide scale bond fund withdrawals which exacerbate illiquidity and trigger further financial market tightening.

Policymakers have good reason to be concerned: U.S. credit mutual funds have doubled since 2010 and now own a fifth of the market; retail investors have poured over $1.2 trillion into credit mutual and exchange-traded funds since then. The last thing portfolio managers need at this juncture is greater constriction on their ability to trade their holdings.

The real question is whether the long-anticipated rise in wage inflation is really around the corner. That would be a good problem to have for many Americans. While jobless claims would have many believing the arrival of higher paychecks is imminent, layoff announcements are poised to end the year up by nearly a third over 2014. In other words, the lowest commodity prices in 16 years will continue to exact a macroeconomic toll; the damage is unfolding with a lag as many companies (and countries) have banked on a rebound in energy prices.

The conventional wisdom heading into 2016 is that the economy is finally poised to reap the benefits of lower gasoline prices; oil prices have fallen so far they no longer have the ability to do incremental harm. Fresh data on home sales in energy dependent states, though, defies this conclusion as the fallout appears to be intensifying. Punctuating the latest stats on housing, the outlook in the just-released Dallas Fed manufacturing survey tumbled to its bleakest levels of the past year, matching lows last seen in 2009.

Meanwhile in the Midwest, the prognosis for the Chicago region refuses to break into positive territory. This can’t be comforting given the auto sector’s outsized positive influence on the current recovery. The dour outlook does, however, help explain the fact that the number of cars sitting in inventory vis-à-vis sales levels is at the highest since 2009.

The credit markets, for their part, are shooting first and presumably taking questions at a later date. What’s spooked them? In bond land, investors rely on the distress ratio to guide them, that is the number of high yield bonds trading at yields 10 percentage points or more above comparable-maturity Treasury bonds. As of November, one-in-five companies were in this leaky boat, the highest showing since 2009.

The distress ratio is seen as a precursor to the more definitive default rate, when companies actually renege on their interest payments. For now, the rate is just north of three percent, not high enough to set off any alarms. But forecasts are calling for it to push five percent next year fueled by energy company defaults, which are expected to spike to 11 percent.

A bit of context: Though the rate itself will remain historically low, the dollar amount of failing debt is expected to rise to $66 billion, close to 2001’s $78 billion but still a fraction of 2009’s record $119 billion. If only the credit markets existed in a vacuum. Roll the rest of the world’s debt markets into the equation and defaults have indeed risen to the highest level since 2009.

In the event the repeated mention of 2009 has given you a case of the jitters, fear not. At least that’s what New Albion Partner’s Brian Reynolds advises. Reynolds, who tracks public pensions’ penchant for risk taking, provides assurances to the leery in the form of a running tally of pension allocations to credit funds.

Reynolds’ figures grace these pages with frequency for good reason, namely that pensions have a lot more cash to throw around than most – as in $18 trillion. With the latest month’s count in hand, it’s official — pension allocations to credit funds hit monthly records in August, September, October, November and now December. In all, some $175 billion earmarked to fund current and future retirees’ income has flooded credit funds since August 2012. With the trend continuing apace, demand for all manner of credit promises to continue burying supply, propping up a market that should be toppling over.

As simple as the argument is, Reynolds could be on to something. If he’s right, recession may not greet the next president proving the cheery prognosticators at the Congressional Budget Office right. At the start of this year, the CBO predicted that the current recovery would last, at a minimum, through the end of 2017. Maybe the CBO has also been following pension behavior and knows that financial engineering in the New Year will remain alive and well.

If only this could end as well as a feel-good Christmas movie. For now, policymakers are looking the other way. What say could they possibly have in the matter, even if they did acknowledge that pensions are using neither a bottoms-up or top-down methodology to test the appropriateness of their portfolio allocations? Besides, party poopers have no place as New Year revelers gear up for one last hurrah.

But what if 2015 really is akin to 1998, and not 1999, for investors? What if this rally has legs and can keep recession at bay? Well then, we position our collective portfolios to profit at the expense of irresponsible pensions employing a bottoms-down approach, Griswold-style. The fact that they’re placing pensioners’ promised paychecks at grave risk of spontaneous ignition can be relegated to denial-ville as so many seemingly intractable issues are today.


A Texan in King Arthur’s Court


Diamonds are said to be a girl’s best friend, but for all their beauty, they can’t impart wisdom? This season as my gift to you, I would like to share the true wisdom of a gift I received years ago, one whose value cannot be measured in carats and nestled in robin’s egg blue. The gift is a story that can be taken as a parable, featuring that iconic little box and a legendary banker. You will soon agree that it is a priceless gift that truly keeps on giving.

It will come as no surprise to any who have met him that the giver of the gift was Arthur Cashin, one of the greatest storytellers of all time. Over the past decade, I’ve had the honor to call him friend. His infinite wisdom and consummate knowledge of the history of the financial markets were hugely helpful in fulfilling my role as advisor to Richard Fisher. Bringing those two gentlemen together several months before Fisher retired was bar none the highlight of my career at the Federal Reserve.

It’s impossible to describe Cashin’s breadth of knowledge of the most historic moments in modern day stock market history. It’s an understatement to say that he has earned his stripes. One year ago, King Arthur, as Fisher and I are apt to call him, celebrated his 50-year anniversary as a member of the New York Stock Exchange. The NYSE commemorated the occasion by having Cashin ring the opening bell; the moment befitted the occasion perfectly.

Readers of Cashin’s Comments, a daily missive that delights his followers the world round, would agree that it’s hard to pin down the very best story he has told over the years.

Cashin’s recollection of the day that followed the 1987 crash is among my favorites. Though the Dow initially opened up 200 points, trading quickly turned negative. Adding fuel to the panic, were banks in the process of cutting off lines of credit to the specialists on the floor. What would have followed, if this had proceeded, could have been catastrophic.

Few recall that Alan Greenspan was on an airplane headed back to Washington DC at the time. The freshly appointed Federal Reserve chairman had landed in Dallas on Black Monday just in time to learn that the Dow had fallen by 22 percent while he had been in flight. This shocking news prompted Greenspan’s cancelling his Dallas engagement and heading back to DC. Unfortunately, for the markets, he was once again in the air as yet another historic sell off ensued.

As Cashin wrote on the 25th anniversary of the crash, news that Greenspan couldn’t be reached was of little comfort to NYSE Chairman John Phelan: Desperate, Phelan called the President of the New York Fed, Gerry Corrigan. He sensed the danger immediately and began calling the banks to reopen the credit lines. They were reluctant but Corrigan ultimately cajoled them. The credit lines were reopened and the halted stocks were reopened. Best of all, the market started to rally and closed higher on the day.”

The story of the day the NYSE didn’t crash harder is a classic. But it doesn’t resonate as much as it once did. Since 1987, the stock market has operated in an increasingly contained vacuum thanks in large part to overly-easy monetary policy. That makes the following story, generously gifted to me in its entirety by King Arthur, the most relevant of the day. The two main characters of this timeless tale are Charles Lewis Tiffany and John Pierpont Morgan.

Being the astute jeweler that he was, Mr. Tiffany knew that Mr. Morgan had an acute affinity for diamond stickpins. One day, Tiffany came across a particularly unusual and extraordinarily beautiful pin. As was the custom of the day, he sent a man around to Morgan’s office with the stickpin elegantly wrapped in a robin’s egg blue gift box with the following note:

“My dear Mr. Morgan. Knowing your exceptional taste in stickpins, I have sent this rare and exquisite piece for your consideration. Due to its rarity, it is priced at $5,000. If you choose to accept it, please send a man to my offices tomorrow with your check for $5,000. If you choose not to accept, you may send your man back with the pin.”

The next day, the Morgan man arrived at Tiffany’s with the same box in new wrapping and a different envelope. In that envelope was a note which read:

“Dear Mr. Tiffany. The pin is truly magnificent. The price of $5,000 may be a bit rich. I have enclosed a check for $4,000. If you choose to accept, send my man back with the box. If not, send back the check and he will leave the box with you.” 

Tiffany stared at the check for several minutes. It was indeed a great deal of money. Yet he was sure the pin was worth $5,000. Finally, he said to the man: “You may return the check to Mr. Morgan. My price was firm.”

And so, the man took the check and placed the gift-wrapped box on Tiffany’s desk. Tiffany sat for a minute thinking of the check he had returned. Then he unwrapped the box to remove the stickpin.

When he opened the box he found – not the stickpin – but rather a check from Morgan for $5,000 and a note with a single sentence – “JUST CHECKING THE PRICE.”

Ah, but for the days of old, for bygone times when markets operated as price discovery mechanisms.

Howard Silverblatt, the man behind the Standard & Poor’s 500 index, has not been on Wall Street for quite as long as Cashin. Still, as he nears the 40-year mark at S&P, he too has earned the distinction of a true markets veteran.

Silverblatt’s recent work on share buybacks has cast a harsh light on one of the unfortunate outgrowths of accommodative Fed policy. This year’s third quarter marked the seventh consecutive three-month period in which over 20 percent of the S&P 500 constituents “bought their earnings per share (EPS) via buybacks,” in Silverblatt’s words.

Drilling down leads to the discovery that one-in-five companies have juiced their EPS by a minimum of four percent over the prior year via buybacks. How does this work? The act of reducing share count by at least four percent by definition boosts earnings PER share by the same amount. Looking ahead using companies’ more recent activity as a gauge, this year’s last three-month period will mark an eighth consecutive quarter of similar share count reduction.

At $559 billion over the past 12 months, buybacks are up 1.6 percent over 2014. Still, barring an extraordinary fourth quarter, 2015 will not be one for the record books. For now, the 2007 record of $589 billion looks to stand.

Of course, there is hope for short-sighted investors, if hope is what you’d call it. As Silverblatt quips, “The combination of low interest rates, even as Yellen & Co increases rates, and high cash levels continues to give companies the ability to set record shareholder returns.”

Or, as Cashin has said of this corporate conduct, “Companies have raised financial engineering to a Botox state.” It won’t surprise you that I couldn’t agree more.

Perhaps we should all make a wish that the gift of price discovery is under the tree this year, symbolically wrapped in that beautiful robin’s egg blue. How lovely it would be to resurrect those wondrous words uttered so long ago by J.P. Morgan: “Just checking the price.”

Fittingly it happened that, Silverblatt and Wall Street’s most ardent and succinct Fed policy critic, Peter Boockvar, rounded out a merry New York gathering where Fisher and Cashin shared their stories whilst marinating an ice cube or two. This holiday season, I will count among my many blessings the friendship of such wise men, especially that of Wall Street’s very own King among Men.


Mind the Cap

Mind the CapSomething is rotten in the state of U.S. monetary policy. This Wednesday will likely mark the beginning of the first rate-hiking cycle since the last one began nearly 12 ago. The “yield curve” depicts the yield of each bond from the shortest to the longest maturities. In robust economic times, the curve is upward sloping reflecting investors’ expectations of higher income in exchange for taking on the added risk of holding bonds for longer periods of time.

Back in June 2004, the difference between the ten-year and two-year Treasury notes was 190 basis points (bps), or one-hundredths of a percentage point. Today, that spread is 123 bps.

Starting points also must be taken into consideration. The fed funds rate at the point of the last lift-off was 1.0 percent compared to today’s zero. During the last tightening campaign, the Fed had to raise rates by a quarter of a percentage point four times to arrive at today’s spread. The current differential suggests that tightening in other forms has already begun.

The Lindsey Group’s Peter Boockvar recently documented the other prominent differences between then and now. In the four quarters through 2004’s second quarter, gross domestic product growth averaged 4.25 percent vs. 2.2-percent now. The unemployment rate was 5.6 percent vs 5 percent today and the factory sector was still squarely in expansion mode compared to today’s slump to contraction territory. Meanwhile, housing starts are running at about half their mid-2004 pace. And the consumer is a shadow of its former self: at 2.9-percent, today’s year-over-year rate of retail sales growth, netting out autos, gasoline and building materials, is half of what it was back then.

The powerhouse of the U.S. economy was then and remains consumption. The anemic level of retail sales would thus be confusing given the price of gasoline being below $2 a gallon for most Americans were it not for the one critical factor. According to a new Harvard study, a record number of renters are spending more than 30 percent of their incomes to lease the roof over their head; that amounts to nearly half of all renters. Meanwhile, the percentage of home sales that go to first-time buyers remains depressed at 31 percent, far from a normal market’s 40-percent level.

Housing is more burdensome than it has ever been for middle-income Americans. It’s no wonder they have less residual to spend on life’s little non-necessities. Inflation, it must be noted, is also running below the level Fed officials have traditionally deemed appropriate. And commodity prices’ continued declines have decimated millions of workers’ incomes and exacted tremendous damage on exporting nations’ economies. Finally, the strong dollar acts as a further depressant on U.S. exporters and emerging markets.

The last several months have also witnessed not only an acute rise in financial market volatility but a meltdown in the riskier corners of the credit markets. Couple this with the traditional evaporation of liquidity as yearend approaches and logic demands to know why policymakers would dare risk raising interest rates.

And yet, the financial markets have nearly fully priced in a rate hike today. Any lingering doubts were extinguished in the wake of Chair Yellen’s stating she stands ready to withstand a double dissent from two of the governors on the Federal Open Market Committee. Fed District president dissents have become common in their prevalence in recent years. But there have only been four governor dissents since 1995.

A double dissent would be remarkable, historically speaking, revealing a deep level of discord among Committee members. So why chance it?

Perhaps it’s the complete unknown that’s driving the insistence of lift-off. The mechanics of raising rates is complex against a backdrop of an atrophied fed funds rate market. Enter the repurchase, or repo market, the overnight market in which banks and other financial institutions pledge securities collateral in exchange for cash. Today’s repo rate has effectively replaced yesteryear’s fed funds rate.

Ensuring the smooth functioning of the repo market is thus critical to the successful implementation of a rate hike. The sheer size of the Fed’s balance sheet given its $3.4 trillion in purchases of Treasurys and other securities presents a convenient solution to the potential for an insufficient supply of collateral.

The expansion of its ‘reverse repo facility,’ which absorbs liquidity via money markets funds, would accomplish the task of ensuring market functionality. So too, though, would the sale of Treasurys off the Fed’s balance sheet; this maneuver would also soak up cash while simultaneously supplying collateral to a market starved for it.

The crucial difference is at the core of why the Fed is acting against every grain of its traditional modus operandi. Raising the cap of the reverse repo facility does not release collateral from the Fed’s balance sheet. The immense size is thus preserved.

The program is currently capped at $300 billion per day. This figure is a pittance of the potential demand from the $2-trillion plus in yield-starved institutional reserves sitting on bank balance sheets. Policymakers have gone to great lengths to ensure that a raised cap could be subsequently lowered. All things considered, it would be quite the feat to force that big of a genie back into its bottle, ensuring the balance sheet would not shrink.

By June 2006, which marked the close of the last tightening cycle, the fed funds rate had risen to 5.25 percent. Today’s markets are barely pricing in two more quarter-percent hikes in the New Year. Unless the economy is poised to become the longest in postwar history, chances are what little tightening can be accomplished will be quickly reversed as recession descends.

As for the Fed’s balance sheet, what if the maintenance of its current size becomes critical to the smooth functioning of overnight rate markets? Looking back in years to come, some may conclude that the Fed never intended to initiate a cycle per se but rather to make a calculated move to effect long term monetary policy by proxy.