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.

P = qe² (?)

Forget Milton Friedman and John Meynard Keynes. What would Albert Einstein say about quantitative easing? Maybe he would say that it really is all relative. Maybe not. My guess is the physicist and Nobel laureate would tell policymakers that their strenuous efforts to propel the economy simply don’t fit the equation he so famously wrote about in 1905. For those of you who’ve forgotten your high school physics (I’m right there with you; thank heavens we now have Google), Einstein is most revered for his theory of special relativity, conveyed by the deceptively simple equation, E=mc². The nutshell version, care of Britannica.com, goes like this: “the increased relativistic mass (m) of a body comes from the energy (E) of the motion of a body – its kinetic energy – divided by the speed of light squared (c²).”

Leave it to the New York Museum of Natural History to translate the equation into something children can comprehend. For starters, energy and mass are one in the same as long as you convert them by the speed of light multiplied by itself. If you could convert a penny by 90 billion kilometers squared per second, also squared, you would generate enough energy to power the New York City metropolitan area for over two years. Energy independence, here we come! Except for one little detail. Did I mention “could”? The vexing thing is accomplishing such a feat requires temperatures and pressures much greater than those found inside the sun. So a nix on the pragmatic and back to square one, or at least smaller feats such as using neutrons to split a uranium atom many times over to generate nuclear power.

Do central bankers the world over believe they’ve split their own atom, creating sufficient motion in the economy by unharnessing infinite buying power? Isn’t that, after all, what all of this unending quantitative easing (QE) is as the global tab pushes the $13 trillion mark? Not to mix equations, but the challenge to accomplishing this economic coup is that it’s not a zero sum game. Consider that at the extreme, buyers of Swiss long bonds can expect a yield of 0.55 percent over the course of the next 30 years. Step in off that spectrum one notch, and Italian two-year bonds are now trading at negative yields.

What has gotten us to such a surreal place? In the end, only history will satisfactorily close the door on this profligate era but it just might be that individual central bankers are deluding themselves into believing that they can win the currency war. Take the latest ongoing battle raging among global central bankers. Just when it looked as if there was a tentative truce at hand, the Fed launched a fresh attack with the September release of its FOMC statement, which mentioned the dollar by name, something once considered taboo, a strict preserve of Treasury officials. With that, the dollar began to weaken.

Then came the September employment report along with its unusual downward August revisions. Two consecutive months of sub-150,000 payroll growth. With a gasp and rumblings of QE4 unsettling the calm surface, much of the European Central Bank’s (ECB) own QE began to come undone as the euro strengthened against the dollar.

Market watchers could almost hear ECB head Signore Draghi’s saber rattling across the Atlantic. If the element of surprise was what was required, well then, he too could deploy such weaponry, which is exactly what he did at the conclusion of the ECB’s October meeting. Draghi’s premature pronouncement promising more QE to come surprised the stock market into a short-covering rally. Those poor souls betting markets would be taking a breather after the Fed-induced rally were caught off guard, forced to cover their positions propelling equities skywards. And instant, presto. The euro weakened.

Did you know that you can say ‘no’ in Mandarin five ways? All five were on audible display within hours of the ECB’s move with China’s announcement that it would lower rates for a sixth time. Do we think anyone has ever told Will Farrell how to say “More Cowbell!” in Mandarin? With that, the dollar is perched near its loftiest levels of the current cycle.

So the Fed met this week with weak oil prices that were supposed to have had a “transitory” effect on inflation and a strong dollar, which the script said would only impinge U.S. corporate earnings on a temporary basis. Uh-huh. Maybe it’s a good thing the fair Chair didn’t have to face the gauntlet of reporters this go round. We’ll have to leave it to what promises to be airway-choking Fedspeak in the six weeks leading up to their December deliberations to explain the substantive changes made in the October statement.

For now, we can only wonder at the mystery of the changes to the statement. Those international developments that caused them such angst at the September Federal Open Market Committee (FOMC) meeting — vanished into thin air. Inserted in its place “next meeting” – the most explicit a reference if there ever was one to a temporal rate hike target. Of course, the dollar strengthened anew conveying a sense of another truce at hand. As long as we agree to be on the losing end of the global stick, other central bankers can carry out their own expansive QE programs in relative peace.

Could it possibly be that simple? It’s hard to believe that today, October 29th, marks the one-year anniversary of the final open market purchases by the Fed to grow its balance sheet. With complete acknowledgement that correlation is not causation, the nearby graph certainly makes for a charming depiction of coincidence. The representation is as old as QE illustrating how the S&P 500 rose in lockstep with the growth of the Fed’s balance sheet. Could a pedestrian picture provide plentiful evidence to policymakers to elicit pause about the prospect of shrinking the balance sheet? Maybe more investors should be asking this question.

 (Graph courtesy of Paradigm Advisors)

BTIG’s eagle-eyed Oliver Wiener raised this very issue pointing to a recent Bloomberg article that suggested reinvestment is really where the action is at when the Fed meets. Consider that $215 billion in Treasurys are set to mature in 2016, vanishing off the Fed’s balance sheet. Another $800 billion are due to roll off through 2018. Will the powers that be attempt to communicate that shrinkage is not tightening, just as they attempted to do so at the onset of the reduction in the pace at which they were expanding the size of the balance sheet?

It’s plain to see that while tapering might not have been tightening (open debate material), it did a whole lot of nothing for the stock market. It doesn’t take a PhD in physics to determine that a steady state is not one and the same with reverse motion. In fact, when it comes to the balance sheet, achieving a steady state requires heavy lifting. Chew on this one – net Treasury issuance this year is projected to be $400 billion thanks in large part to the barely discernible interest expenses Uncle Sam has to pay the nation’s creditors. Even so, the Fed’s $175 billion in purchases to prevent balance sheet shrinkage will command a remarkable 44 percent of net issuance.

Our communicative central bankers have emphasized in the past that rate hikes would be step one in a progressive tightening process and that shrinking the size of the balance sheet could notproceed a first hike. The trick will be convincing investors to not run for the hills. As it is, sustaining stock prices has required record levels of both mergers and share buybacks this year.

Howard Silverblatt, Standard & Poor’s spreadsheet-armed market veteran of veterans, reports that during the current third-quarter earnings season, roughly one-in-four S&P 500 companies have bought back enough shares to boost earnings by four percent or more. Helping finance the gorging is a $1.2 trillion debtfest; U.S. investment grade and high yield corporate bond issuance in the first nine months of this year has smashed all prior years’ records.

With about half of company results in, Silverblatt shared some revealing details: “Companies continued to reduce their share count resulting in 24 percent of them (S&P components) adding at least four percent of tail winds to their third quarter 2015 earnings per share over the same quarter last year. At this point, this should be the seventh consecutive quarter in which at least 20 percent of the index adds tailwind of at least four percent. While it’s always nice to have the wind at your back (as compared to the currency headwinds), old-fashioned growth would be nice—which, as measured by the 2.1 percent decline in year-over-year sales (which are not impacted by buybacks), does not have a strong presence in the market.  Of note, if I exclude energy’s 30.4 percent year-year-over sales decline, the index sales are up 1.5 percent—better, but not the growth we’re looking for.”

Ain’t financial engineering grand? In what could be the quote of this young century, a market watcher who goes by the clever name of Macroman made the following observation: “Buybacks come and go but debt lasts forever (or until it’s paid back).”

In that same spirit, but a bit more elegantly worded, Michael Spence and former Fed governor Kevin Warsh wrote a must-read in Monday’s Wall Street Journal titled, “The Fed Has Hurt Business Investment,” which presciently preceded yet another terrible report on capital investment. The article’s most notable tidbit, from yours truly’s perspective, is that half of earnings in the QE era can be attributed to share buybacks rather than investment in the future.

What a sad legacy for the next generation to inherit, especially considering America’s proud traditions of innovation and hard work. Were it only the case that the neutrons the Fed has been firing into the economy yielded sustainable energy instead of frenetic speculation. Einstein gifted the world with the revelation that energy and mass are different forms of the same thing. If only monetary policymakers could understand that the very nature of financial repression holds that QE and the paper gains it produces for a time are not one in the same with regenerative prosperity.

And yet investors are clearly looking past the statement that accompanied the October FOMC all but guaranteeing a rate hike will arrive in holiday gift wrap. It’s no coincidence that recent speeches by some of the most influential and influenced members of the FOMC have moved the payroll and inflation goal posts using the subtle weapon of verbal suasion. The question is why? The business cycle has not been slayed removing forever the prospect of recession. And if it’s sooner rather than later that the economy succumbs, more QE is likely to follow. What if the real plan is to raise rates and maintain the size of the balance sheet? What if indeed.

My wise friend, The Lindsey Group’s Peter Boockvar, has an exceedingly simple theory to explain the root of investor fascination with QE, one that Einstein himself would probably applaud. “Quantitative easing is simply psychological.” Investors want it to be something that it is not. Perhaps the pennies investors perceive to be falling from heaven are simply that, pennies.