Lacy Hunt On The Unintended Consequences Of Federal Reserve Policies

Authored by Mike Shedlock via www.themaven.net/mishtalk,

The Financial Repression Authority interviewed Lacy Hunt, Chief Economist at Hoisington Management on Fed policies.

The interview below first appeared on the FRA website along with a video.

The emphasis in italics is mine.

FRA: Hi, welcome to FRA’s Roundtable Insight. Today, we have Dr. Lacy Hunt. He’s an internationally recognized economist and the Executive V.P. and Chief Economist of Hoisington Investment Management Company, a firm that manages over $4.5 billion USD and specializing in the management of fixed income accounts for large institutional clients. He also served in the past as Senior Economist for the Federal Reserve Bank of Dallas, where he was a member of the Federal Reserve System Committee on Financial Analysis. Welcome. Dr. Hunt.

Dr. Lacy Hunt: Nice to be with you, Richard.

FRA: Great. I thought we’d have a discussion on a variety of topics relating to the economy and the financial markets. You recently mentioned that you thought this was the worst economic expansion recovery in U.S. history since 1790. Wow. Can you elaborate?

Dr. Lacy Hunt: If you calculate the average growth rate in the expansions since 1790, this is a long-running expansion, but it’s the slowest and in the last 10 years the household sector lagged very, very badly. The rate of growth in real disposable household income per capita is only 0.9 percent per year. And in the last 12 months, we’re up only 0.6 percent per year. So it’s a long-running expansion, but it’s been a poor expansion. There are certainly problems with some of the earlier data, but this appears to be the slowest expansion since the turn of the 18th Century and our households are the main problem for the growth rate lag.

FRA: And do you point a finger for this cause as primarily on the Federal Reserve or do you see structural changes happening to the economy?

Dr. Lacy Hunt: I think that the main element suppressing growth is the heavily leveraged U.S. economy. We have too much public and private debt, and this debt does not generate an income stream for the aggregate economy. As a result of the prolonged indebtedness, which is on the verge of going much higher because of problems in the governmental sector, the economy is now experiencing very poor demographics. We have a baby bust, a household formation bust, and the lowest birth rate since 1937. These demographics are exacerbating the problems because we have too much of the wrong type of debt and thus the velocity of money has been falling since 1997. Velocity this year is only 1.43 percent, which is the lowest since 1949. Furthermore, the debt creates a situation where monetary policy capabilities are asymmetric. In other words, a lot of action is needed to provoke even a muted impact on the economy, whereas the slightest monetary tightening goes a long way in depressing economic activity. So the root cause of this underperformance is extreme indebtedness.

FRA: And what about the Federal Reserve? How has it undermined the economy’s ability to grow?

Dr. Lacy Hunt: The Fed’s most serious mistake was made in the 1990s up until 2006 during which they allowed the private sector to become extremely over-indebted with the wrong type of debt. And, in essence, I think that quantitative easing, through the push for higher stock prices, created more problems than it has solved for the economy. QE caused the corporate executives to switch funds from real capital investments into financial investments through the paying of higher dividends, buying shares of their own companies, and buying back their shares from others. While this type of action does produce a higher stock market; it doesn’t generate a higher standard of living. And so, Federal Reserve policy has not improved the economy, although it certainly has well served components of the economy.

FRA: And due to that do you think that there’s been too much financial investment versus real economy investment in terms of diverting the economic financial resources away from the real economy?

Dr. Lacy Hunt: I think that’s the principal problem. Business debt last year reached a record high relative to GDP. As I said earlier, Fed policies have created a higher stock market but have not generated an improved standard of living. When the Reserve undertook quantitative easing, it was a signal to the corporate executives that the Fed preferred and would protect financial investments. But that meant financial assets were preferred over real side investments. And so QT is intermingling with the growth-depressing effects of too much debt. And the debt levels are getting ready to move substantially higher in our governmental sector. Government debt is already approaching 106 percent of GDP, a record high with the exception of a brief period during World War II. And by 2030, federal debt will be approximately 125 percent of GDP. For a long time, we’ve known about the issues that would inflate the entitlements — such as the prior-mentioned demographic problems — but there is an increasing likelihood that new federal programs with expenditure increases will further accelerate the growth in federal debt. I think there is clear evidence that increases in federal debt at these high levels relative to GDP over any measurable length of time, reduces economic activity. Thus, the multiplier is not a positive but negative figure, or otherwise exactly what economist David Ricardo hypothesized in his 1821 work. I have looked at the relationship between per capita changes in real GDP and government debt per capita and the relationship is negative, not positive. And so, we’re trying to solve an indebtedness problem by taking on more debt. You can get intermittent spurts of economic activity and inflation, but ultimately the debt is a millstone around the economy’s neck.

FRA: So would you say that we have migrated to a sort of financial economy?

Dr. Lacy Hunt: Let me give you a couple of examples. There’s so much liquidity in the financial markets, particularly the stock market, that a lot of the economic news is constructively interpreted even when it’s unconstructive. Virtually the world believes that the United States is experiencing large job gains and the idea that such productivity may be incorrect is hardly considered. But the rate of growth in payroll employment on a 12-month basis peaked at 2.4 percent in early 2015 and for the last 12 months, has sunk to 1.4 percent. What is even more critical — if you look at just the expansions and don’t include the recessions since 1968 – is that the average growth in employment in an expansion year was 1.9 percent. And in the last 12 months, we are half a percentage point under that figure. Yet, given these numbers, there is an erroneous perception that the employment gains are strong. And this view undermines the improvement in the standard of living. And because of the liquidity and the need of some investors to fully participate in the rising stock market, investors tend to overlook other important developments. If we go back to the 12 months ending November of 2015, real average hourly earnings were up about 2.5 percent. And in the latest 12 months, real average hourly earnings gained a miniscule 0.2 percent. The liquidity tends to push the focus away from the more realistic interpretation of the economy for certain types of assets.

However, the weak performance overall and the deceleration in some of the indicators that I just referred to is not unnoticed by the bond market. So, we have a dichotomy in which the stock market is strongly up but the long-term bond yields are down. Now, the short-term yields are up because they are under the control or heavy influence of the Federal Reserve. The Federal Reserve is in the process of raising the short-term rates and winding down their portfolio. They sold 20 billion dollars of government agency securities in October and November, pushing up the short-term rates. Erstwhile, the long-term rates — which look at some of the more important economic fundamentals — are actually declining.

Another element not in the public understanding, since the Federal Reserve no longer produces this sort of monetary analysis, is a very sharp slowdown in the money supply’s rate of growth, bank loans, and within important credit aggregates. Last year, the M2 money supply was up 7 percent. In the latest 12 months, it decelerated to less than 4.5 percent. The rate of growth in bank loans and commercial paper, which topped out on a 12- month basis about 9 percent, is now under 4 percent. So the Fed is raising the short-term rates, reducing the monetary base, and causing a tightening in the financial side of the economy. Some investors understand what is happening and yet it’s not in the general psyche because such monetary analysis is increasingly rare.

However, another more public indicator is the very dramatic flattening of the yield curve. And when the yield curve flattens in such a way, first of all, it’s a symptom that monetary restraint is beginning to bite. Now, the slowdown in money supply growth and the bank credit flattening of the yield curve will occur well before there is any noticeable impact on a broad array of economic indicators or long lags in monetary policy. But when the yield curve starts flattening, that intensifies the effect of the monetary tightening because it takes away or, at the very least, greatly reduces the profitability of the banks and all those that act like banks. Banks make a profit by borrowing short and lending long. When those spreads recede, bank profitability is hurt, particularly for the higher, riskier types of bank loans since not enough spread exists to cover the risk premium. So the banks begin to pull back, further intensifying the restraint pressing on economic growth. To the vast majority of investors, we have an economy that is apparently doing well, but in fact there are elements right beneath the surface that strongly suggest to me that the outlook for 2018 is considerably more guarded than conventional wisdom implies.

FRA: And do you see the potential for an inverted yield curve in the near future?

Dr. Lacy Hunt: I’m not sure that we will have to invert because the economy is so heavily indebted and the velocity of money is its lowest since 1949. Now, a number of people have pointed out that we typically invert before a recession and historically such inversions have been the case most of the time — but not always if you go back far enough in time — and you should since this is not a normal economy. For example, money supply growth since 1900 has averaged about 7 percent per annum, whereas, currently, the rate of growth in M2 is about 36 percent below the long-term average, indicating a very weak growth rate. And the velocity of money is lower than all of the years since 1942 — with the exception of 7 years — and the economy has never been this heavily indebted. And so the yield curve could possibly approach inversion, but it may or may not occur or stay there very long because at that stage of the game, the flattening of the yield curve will greatly intensify all the other effects — the reduction in the reserve, monetary, and credit aggregates, as well as the weakness in velocity. And when this reduction becomes apparent, the Federal Reserve will not be able to reverse gears quickly enough to ameliorate the impact produced upon future economic growth.

FRA: So do you still see a secular low in bond yields on the long into the yield curve remaining in the future sometime?

Dr. Lacy Hunt: The lows have not been seen. The path there will remain extremely volatile. We will have episodes in which the long yields rise. My attitude is that the long yields can go up over the short run for any number of causes. While many elements work out of the system in the long end, yields cannot stay up. When yields go up — especially now that the yield curve is flattening — this intensifies monetary restraint, which puts downward pressure on commodities. This puts upward pressure on the value of the dollar and cuts back on the lending operations. Something I think has been somewhat overlooked in general euphoria over the strength of economic indicators, is the that commercial and industrial loans for all of the banks in the United States are now only up one-tenth of one percent in the last 12 months. There are forward-looking elements that have historically been very important for signaling that change is ahead. They don’t tell us the timing — timing is always difficult — but they are flashing signals that should be observed.

FRA: And as this plays out, do you see monetary policy and fiscal policy is changing, like will we get fiscal policy stimulus? Will there be a change in monetary policy and how will that look like?

Dr. Lacy Hunt: Here’s my attitude: the new federal initiatives, whether tax cuts or infrastructure or otherwise will not provide a boost to the economy if they are funded with increases in debt — that’s where we’re at. And by the way, it’s been that way for some time. If you go back to 2009, we had a one-trillion-dollar stimulus package that was said to be inflationary and was going to boost economic growth, but yet we still had this very poor expansion and little inflation except for intermittent bouts here and there, largely from highly-priced inelastic goods. All the while, the inflation rate has trended lower.

For example, when President Reagan cut taxes, government debt was 31 percent of GDP and now that’s 106 percent on its way to 120-125 percent. And so if you go back and if you read Ricardo’s great article in 1821, he was asked whether it made a difference as to whether the Napoleonic wars were financed by taxes or by borrowing. Ricardo said that, theoretically, either way private sector activity was going to be suppressed. Now we have a lot of evidence, including some that I produced, that the government multiplier is negative, not positive, over a three-year period. Thus, the tax cuts may work for a very short while, but not on balance. And if the tax cuts were revenue-neutral and financed by reductions in government expenditures that would be a positive since the evidence shows tax multipliers are more favorable than expenditure multipliers. Such a theoretical proposal would provide greater efficiency for private sector spending and government spending. There’s also evidence that you would lower the cost of capital, but that’s not what we’re talking about is it? We’re talking about a debt-financed tax cut and we’re not talking about a revenue-neutral infrastructure plan, just as we were not talking about a revenue-neutral stimulus package in 2009. We’re talking about the debt-financed variety of tax cuts and at this stage of the game, this will make us more vulnerable, except for a few fleeting instances.

I will say this: when you have a debt-financed infrastructure program or tax cut, there will be pockets within the economy that will benefit, but the aggregate economic performance will not benefit and so fiscal policy, as I see it, is not really going to be helpful. The risk is that the debt buildup will add to the problems. There is extensive academic research indicating that when government debt rises above 90 percent of GDP for more than five years, this trend will reduce the economy’s growth rate by a third. Remember, we’re at 106 percent debt to GDP and there’s evidence these higher levels of debt have a non-linear effect. In other words, we use up growth at a faster pace. And there’s a lot of evidence from the available data that we’re even losing a half of our growth rate from the trend. For example, GDP has risen at 2.1 percent per capita since 1790. The latest 10 years produced a reduction to 1.0 percent. And so we should have lost only seven-tenths or come down at 1.3 over 1 but we didn’t and this is a consequence that we have to deal with. We’re not in a position to ignore the debt levels. Fiscal policy can be talked about, we can debate about it, and we can proclaim its benefits, but I don’t see them in the current environment just as I didn’t see them in 2009. I would change my tune if they were revenue-neutral, but that’s not the issue here.

To me, inflation is a money-price-wage spiral not a wage-price spiral as with the Phillips curve. The way inflations begin is by money supply growth acceleration not being offset by weakness in velocity, which shifts the aggregate demand curve inward. Remember, the aggregate demand curve is equal to money times the velocity by algebraic substitution as evidenced in all the leading textbooks on macroeconomics. So you have declines in the money supply and velocity, which will make the aggregate demand curve shift inward over time. This shift gives you a lower price level and a lower level of real GDP. It doesn’t happen every quarter or even every year, but it’s the basic trend. Thus, monetary policy is in the process not of decelerating money supply growth and by a significant amount. If the Fed adheres to their schedule of quantitative tightening, I calculate M2 will grow by the end of the first quarter – it’s currently running around four and a half percent – and the year over year growth rate will be down to less than 3 percent. And so monetary policy is taking steps to lower the reserve monetary and credit aggregates, and these actions will further flatten the curve because they can press the short rates upward. But I think the long-term investors will understand that the inflationary prospects on a fundamental basis are weakening not strengthening.

FRA: And do you see these trends as being exacerbated on the emerging government pension fund crisis? Could there be more debt used to solve that like for bailouts? Do you see that potentially happening?

Dr. Lacy Hunt: Well the main problem with government debt is that we’re going to have approximately one million folks a year reach age 70 in the next 14 to 15 years and we’ve known that this was coming, but we didn’t prepare for it. We’ve made a lot of promises under Social Security Medicare and the Affordable Care Act and government debt will have to be used to fund the entitlement benefits — I don’t see any other way around it. Another overlooked problem is that the actual federal fiscal situation is much worse than these surface numbers. For example, in the last three years, the budget deficit worsened each year. If you sum the budget deficits for 2015, 2016 and 2017, the sum is 1.2 trillion, but a lot of what was previously called “outlays” have been moved off budget — we call them investments (such as student loans) and there are other examples. The actual increase in federal debt in the last three years is 3.2 trillion. So the budget deficit is actually greatly understating what is happening to the level of federal debt which wasn’t always the case. Furthermore, the deficit was made worse by a 2015 bipartisan deal between Congress and the White House. And while neither party is blameless — they both agreed on the deal — yet it doesn’t change the fact that the federal situation is deteriorating and at a much worse rate than the deficit numbers themselves indicate.

FRA: And what about for state and local jurisdiction locales, in terms of their government pension funds? Could there be federal level bailouts at that level?

Dr. Lacy Hunt: Again, what are they going to bail them out with? You’re going to have to sell Federal Securities. And one of the multipliers on new sales of Federal debt is negative, not positive. Forget what was taught you in your macroeconomic class 30, 20, or even 15 years ago. When I was in graduate school, I was taught that the government multiplier was somewhere between four and five percent. Now, it looks like the multiplier is at best zero and even possibly slightly negative.

FRA: Great insight as always. How can our listeners learn more about your work, Dr. Hunt?

Dr. Lacy Hunt: We put out a quarterly letter as a public service. Write to us at hoisingtonmgt.com and we’ll put your name on the subscription list. We don’t spam you with marketing so please go ahead and subscribe.

FRA: Okay, great. Thank you very much for being on the Program, Dr. Hunt. Thank you.

Dr. Lacy Hunt: My pleasure Richard. Nice to be with you

Economics as Taught

Note Lacy"s comments on what he learned in graduate school. Lacy once told me that he had to "unlearn" nearly everything he was taught in school about economic.

Multiple generations of economists have been trained to believe inflation is a good thing, saving is bad, that there are no consequences for piling up debt.

 

"Subprime Is Contained" (& Other Evidence That "They Really Don't Know What They're Doing")

Authored by Jeffrey Snider via Alhambra Investment Partners,

Ben Bernanke, then Chairman of the Federal Reserve, told Congress in March 2007 that subprime was contained. He will rightfully be remembered in infamy for that, but that wasn’t the most egregious example of being wrong. Even putting it in those terms risks understating the problem and why it stubbornly lingers. Being really wrong is claiming that IOER will establish a floor for money market rates, and then finding out it actually doesn’t.

No, what policymakers did especially in the early crisis period was altogether worse; they demonstrated conclusively that though they shared this world with the rest of us, they inhabited and continue to inhabit a totally different planet.

Given the anniversary date and our human affinity for round numbers (ten years or a lost decade), there is a desire to revisit some of the worst of the list which happened just before August 9, 2007.

My favorite has always been Bill Dudley, as I recounted last at the ninth anniversary of nothing being done:

As far as the issue of material nonpublic information that shows worse problems than are in the newspapers, I’m not sure exactly how to characterize that because I guess I wouldn’t know how to characterize how bad the newspapers think these problems are. [Laughter] We’ve done quite a bit of work trying to identify some of the funding questions surrounding Bear Stearns, Countrywide, and some of the commercial paper programs. There is some strain, but so far it looks as though nothing is really imminent in those areas.” [emphasis added]

He spoke those words, recorded for posterity, on August 7, 2007, at the regular FOMC policy meeting. As noted earlier today, both Countrywide and the whole commercial paper market would be decimated really within hours from his “inspiring” confidence.

What really stands out is for Dudley to have been the one who said them, because as head of the Open Market Desk he had to be technically proficient in a way that the others could avoid (and why so often in its history policy discussions especially about these great things would often flow through whomever was the Open Market Desk chief at that moment in time). He proved still to be an empty suit like the rest, but he was always that much less of one. So if the best the Fed had to offer was so thoroughly unaware, is it any wonder what happened then and continues to happen now?

One day after Dudley’s private embarrassment, one Bank of England governor and future chief perhaps joined his level in the Hall of Fame of Famous Last Words. Meryn King remarked on August 8, 2007:

So far what we have seen is not a threat to the financial system. It’s not an international financial crisis.

He said these words at the behest of the ECB in front of the assembled press ostensibly to impart calm. Also noted earlier today, it was the European Central Bank that made the first crisis move the very next day in a record liquidity injection.

If officials didn’t realize what was happening monetarily, and they didn’t, there was obviously no way for them to predict what would happen economically. One follows the other, so if you think the monetary system is infected only with raw, mistaken emotion to be easily cleaned up by genius and effective policy intervention, then you will likewise believe the consequences to the real economy quite small and completely manageable.

In its bland policy statement that accompanied the August 7, 2007, policy meeting, the FOMC voted affirmatively (and quite purposefully) for this language:

Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy. [emphasis added]

I could go on and on with these examples, but you get the point; the main of which is to paraphrase one religious sentiment. No Money, No Economy; Know Money, Know Economy.

These last ten years have proved beyond any doubt in gross empirical fashion policymakers and economists (redundant) don’t get either money or economy.

What Do Rate Hikes Have To Do With Crashing Libor-OIS Spreads?

One of the more perplexing moves in recent weeks has been the rapid collapse in the Libor-OIS spread, traditionally a signal of bank credit risk, which has confused many rates traders due to contradictory signal it is sending in a world in which the Fed is supposedly tightening.

As we pointed out last Friday, one probable explanation for this is the gusher of bank funding availability that the world"s central banks (and even more so China) has unleashed. Nowhere is that more evident than in the total decoupling between "easing" financial conditions, and "tightening" monetary policy.

... something which Goldman itself pointed last week, when it remarked that its financial conditions index was the "easiest" it has been in 2 years.

Furthermore, another potential explanation for the plunge in the spread emerged two weeks ago, when DB"s rates strategists suggested that it could be a function of Japan"s sudden revulsion toward US paper, and especially hedged Treasury exposure, which Deutsche pointed out resulted in a sharp tightening in the JPY cross-currency basis, which in turn compressed Libor-OIS.

Now, in a follow up note, Deutsche picks up where it left off at the end of April, and highlights what we documented last week, namely that since peaking last September at 44bps, 3m Libor-OIS has collapsed each time the market got excited about higher rates. In fact, whenever the fed funds implied probability of a rate hike jumped just prior to an upcoming FOMC meeting, a drastic narrowing of Libor-OIS ensued.

So the question then is what do rate hikes have to do with Libor-OIS spreads?

According to Deutsche Bank, the simple answer is that all signs point to the problem being there is weak demand for short-term unsecured borrowing.

As short rates increase, banks have little reason to pay up for short-term funding when they can just term out their debt. The yield curve remains very flat, and demand for corporate debt seems ever insatiable. Although there is still plenty of activity in the commercial paper market, banks are issuing opportunistically only at rates favorable to them. This week, the rate on a 90-day AA financial CP was 1.06%, virtually unchanged since after the March hike.

At the same time, DB notes that cash has been trickling back into prime money market funds. The spread between prime institutional fund yields and government institutional fund yields, although smaller than at the beginning of the year, remains very attractive at 30 bps currently. Of note, six months after money market reforms and exactly zero funds (that we know of) had dropped below a $1 NAV, money market investors are venturing back into prime funds for better returns on their cash. In May, prime money funds saw total assets rise above $400bn for the first time since October.

With these dynamics in mind, a number of things would have to happen to reverse the tightening in Libor-OIS.

• First, if the Fed slows its rate hikes in favor of letting its SOMA portfolio mature, longer rates should climb and the curve would steepen.


• Second, if credit spreads widen, banks would also find it more expensive to issue term debt.

In both these scenarios, bank issuers might bring some of their funding back to the front end, which should drive up CP rates and consequently Libor. Another possibility is if bills cheapen, perhaps driven by an increase in net supply, government money funds could become attractive to investors again and some of their assets might come back from prime funds. This in turn reduces the pool of cash looking to invest in commercial paper, which also drives up their rates.

Japan Is Dumping A Record Amount Of Foreign Bonds: Here Are The Implications

Back in February, around the time Bloomberg caught up to what we had been discussing for the past year, namely the historic dumping of US Treasurys by offshore official investors (such as central banks and reserve managers, just as the selling had in fact reversed and foreigners had resumed buying once more) we noticed that it was not China but Japan that had emerged as one of the most aggressive sellers of Treasuries following material Mark-to-Market losses on existing TSY holdings, prompting the foremost ex-Fed shadow banking expert Zoltan Poszar to declare the selling "a deer in the headlights moment".

Fast forward two months, when according to the latest update from Deutsche Bank, Japan"s revulsion to fixed income products has accelerateed, and the Pacific island was a net seller of foreign bonds again in the past week, divesting another $12bn worth of securities. It was not only the third straight week of selling out of Japan, according to MOF data, but more remarkably, the the year-to-date divestment of $66bn in foreign bonds YTD is the biggest since 2002, the first full year of such data is available.

What is prompting the sudden liquidation? According to Deustche, "profit-taking most likely explains Japan’s selling."

Ten-year Treasury yields declined in April to a lower level than any previous month since the Trump election. In the process, yen cross-currency basis has tightened to levels not seen since January 2016. Japanese investors use the yen basis (or more precisely, their derivative FX forwards) to hedge the currency risk of their coupon flows from non-yen bonds. The basis tightens when there is a drop in demand to swap yen for dollar.

The next chart, which shows the distinctive inverse relationship between cumulative Japanese purchases of foreign bonds and the 3m yen basis, should be useful to anyone still confused by what has been the biggest driver behind the gradual drop and sudden recent spike in the USD-JPY currency basis: it all has to do with Japanese TSY demand, and hedging costs (which we pointed out had risen so high last August it made TSYs and JGBs look equally priced to Japanese investors).

However, it"s not just the Yen basis (and thus relative USD shortage) that is impacted by the Japanese appetite (or lack thereof) for US paper. As the Deutsche fixed income team writes, the lack of love shown by Japanese investors for Treasuries might also be responsible for low 3m Libor fixings and the collapse in Libor/FF spreads.

The details:

In US money markets where Japanese banks also raise dollars, the rates they’ve been paying on commercial paper and certificates of deposit have narrowed vis-a-vis the rates they pay on repos. CP and CD rates are of course used by banks as the main input for daily Libor submissions. Three of the 17 contributing banks to USD Libor are also Japanese. The narrowing of rates Japanese banks pay to borrow dollar using CP/CDs versus repos is further evidence that unsecured funding costs have dropped, which is reflected in the tightening in Libor-FF spreads.

That said, the recent revulsion toward fixed income products out of Japan will probably not last for two reasons.

First, as DB notes, April typically tends to be a month when Japanese investors sell foreign assets as they take profits at the start of the fiscal year. Seasonality would suggest that Japan becomes a buyer again in May, with especially strong appetite for foreign bonds in the July to September period. Consequently, we would look for Libor-FF spreads to find some support in the coming month, especially if Treasury yields become attractive again.

The second reason comes from BofA.

In a recent report, the bank"s FX and rates strategists published a piece summarizing the investment plans of nine Japanese life insurance companies for the first half of their fiscal year (which began April 1st). This is what BofA found:

Over the past few years in particular, insurers have been amassing foreign bonds, and particularly US Treasuries, but that fund flow will probably change if US rate hikes continue. Foreign bond investment is increasingly dependent on yields, FX, and FX hedge costs, and will probably become more fluid. In the United States, rate hikes are expected to continue, so the USD/JPY hedge cost cannot be expected to decline much. As par the plans announced, many will likely be less active in hedging foreign bond than last year. Investment in unhedged foreign bonds is expected to be heavily dependent on levels of FX relative to assumptions (see below), and it is more likely to increase. Domestic yields have sunk due to the BoJ’s negative interest rate policy, making fund management in JGBs difficult and prompting the major insurers to stop selling a number of yen-denominated life insurance products.

In other words, the story remains largely the same in that domestic yields are too low for buying JGBs, and life insurers remain without any other option but to buy foreign bonds (Figure 1). However in a key change foreign bond purchases are likely to take place increasingly on a currency unhedged basis (Figure 2), which has two major implications for both Treasurys and US corporate bonds.

First it reduces the need to reach for yield, which means less buying of BBBs and BBs and longer maturities; however it also means that Treasurys across the curve are suddenly far more attractive to Japanese buyers as investors will no longer need to offset up to 80 bps in hedging costs.

Second Japanese life insurance buying is likely to be less steady and more tactical, depending on interest rates and FX. This means more (less) buying when rates vol is low (high). The FX assumption is that the USD/JPY is in the range 100-125 and will increase toward fiscal year end. That means currently at 111 we are in the middle of the range, but since the dollar is expected to appreciate buying will take place here and increase should the dollar weaken, decrease should it strengthen.

This dynamic, together with recent technicals (recall earlier we showed that Treasury futures traders had just experienced the biggest short squeeze in history), mean that the reflation trade could be further jeopardized due to yet another feedback loop linking a weaker dollar (and thus USDJPY), with lower yields, which in turn leads to even more weakness in the USD, and so n. Ultimately, it will be up to the Fed to break this latest adverse feedback loop, although with the US economy growing at just 0.7% in Q1, it will take a significant leap of faith by Yellen and the "data dependent" Fed that US output will recover by Q2 when the Fed is expected to hike by another 25 bps.

The Full Breakdown Of How Trump Tax Policies Will Impact S&P Earnings

While we remain in the purely abstract, theoretical and hypothetical realm of Trump tax reform - there have been no concrete proposals floated yet, with Trump as recently as a week ago slamming the critical border-adjustment tax, only to full reverse himself on it just a few days later - Bank of America has created a useful matrix taking a deep dive into the potential (and we do underline the word potential, because at this rate Trump may spend much of his first year dealing with immigration reform and Obamacare) implications of Trump"s tax reform.

As Bank of America"s Savita Subramanian writes in a note titled "Death and Tax Reform", the BofA strategist predicts that tax reform in its entirety could add as much as $5-6 to near-term S&P 500 EPS "as benefits are front-loaded." Whether or not tax reform would be accretive to EPS is highly dependent on the implementation details, which it then analyzes. 

Starting at the top, according to Savita 2017 could be a watershed year from a tax reform perspective. Trump has continuously stated that tax reform is a priority, and there is evidence of widespread support in Congress. Tax reform could be enacted through reconciliation without the risk of being filibustered, suggesting the timing could be imminent. Corporate tax reform could have a significant impact on S&P 500 earnings, corporate behavior and capital markets. Much has been written on the timing, funding and process by which corporate tax reform could be enacted. In this report, we use House Speaker Paul Ryan’s Blueprint proposal as a starting point in quantifying the impact of corporate tax reform on the S&P 500, with some scenario analysis to account for differences included in the final bill (such as Trump’s proposals). The bank"s analysis is focused specifically on the impact of corporate tax reform, however we recognize that there are many other factors that can impact the sensitivity analysis (e.g. changes to household income tax rates, infrastructure spending, etc.).

BofA estimates that the Blueprint proposal would initially boost S&P 500 EPS by $5-6, assuming the end of interest expense deductions only applies to new debt, or is phased in over time. But the devil is in the details. Over time, the loss of the interest tax shield would be a significant drag on earnings as existing debt is refinanced. Additionally, the corporate tax rate is critical in determining whether or not the tax reform policies end up being accretive to earnings on a sustained basis. Savita estimates that at the 20% tax rate, the Blueprint would be modestly accretive, the benefit would triple under Trump’s proposed 15% tax rate, but at a higher 25% tax rate that would appease the deficit hawks in Congress, the benefit would turn to a negative over time (Table 2). The bank also estimates a one-time $8-9 charge to GAAP EPS that would be associated with the discounted repatriation tax.

The bank then focuss on topics that have large implications for US equity investor, but it is important to consider corporate tax reform holistically rather than drawing major implications from each measure in isolation:

• Reducing the US corporate tax rate


• Repatriation - mandatory tax on overseas profits


• Border adjustment tax


• Removal of interest expense deduction

These tax considerations summarized:

Cutting corporate tax rate could add $8-9 to EPS

Our starting point is the US statutory corporate tax rate. If it were lowered from 35% to 20% and the US moved to a territorial tax system (no longer taxing foreign profits), it would boost S&P 500 EPS by an estimated 12% ($17 to 2018 EPS). We assume companies would be able to retain half of the benefit ($8-9) and the remainder would be passed on to customers or competed away. For instance, a lasting impact to Utilities" profits is unlikely, as the benefit would be passed on via regulated pricing. 

Repatriation: Buybacks could boost EPS by 3%

Both Trump and the Blueprint support a mandatory (as opposed to 2004"s optional) tax of overseas earnings of US firms’ subsidiaries at reduced rates. Non-Financials in the S&P hold at least $1.2tn (mostly Tech and Health Care). If half was used for buybacks, this could add 3% ($4) to S&P 500 EPS. A redux of 2004 where companies used 80% of cash for buybacks may be less likely, in our view. For if repatriation is accompanied by an end to interest expense deductions, companies may choose to pay down debt over buybacks.

Border adjustment tax (BAT) hits EPS by $5-6

While Trump has described the BAT as being “too complicated,” White House press secretary Spicer’s recent comments call into question his stance. This is a key component of the Blueprint and would generate significant revenue. First-order impacts could be significant, with border adjustments detracting $5-6 from 2018 EPS — nearly 80% of the drag comes from the consumer sectors. The second order impacts — product pricing, pricing within the supply chain, exchange rates, foreign policy reactions, etc.-— while harder to quantify, are important to consider.

End to interest deductibility could detract 4% from EPS

We estimate that over time, the removal of the interest expense deduction would detract about 4% from S&P 500 EPS. The ending of interest deductibility could also increase the cost of debt by an incremental 25%, which could have longer term ramifications for capital structures and funding.

The government revenue associated with each of these is included in the table below.

From a sector and industry perspective there are haves and have-nots based on each policy, but in aggregate most sectors have some puts and some takes based on tax reform. The table below shows some relevant aggregate statistics by sector that are used in the subsequent analysis.

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Next, BofA breaks down the impact of the four components of tax reform starting with...

Cutting the corporate tax rate

The best starting point for analyzing corporate tax reform is the US statutory corporate tax rate, as this rate is critical in determining the impact of other proposed changes (border adjustments, interest deductibility, etc.). If the tax rate were lowered from 35% to 20% and the US moved to a territorial tax system (no longer taxing foreign profits), all else equal, we estimate an initial boost to S&P 500 EPS of 12% ($17 to 2018 EPS). However, over time, some of this benefit could be passed on to customers via lower prices — for instance, it is unlikely that there will be any major long-lasting impact from tax reform for Utilities sector profits, as any benefit/cost would likely be passed through to customers when incorporated into each company"s regulated pricing. The benefit would also be offset by some of the other changes discussed in subsequent sections. We assume that S&P 500 companies would be able to retain half of the benefit, or roughly $8 of 2018E EPS. Below, we show the estimated EPS impacts on each  sector based on a tax rate of 20%.

While the effective tax rate of the S&P 500 is generally about 28% (currently closer to 25% due to the recent commodity recession), we estimate that the tax rate for the S&P 500’s domestic operations is much higher at roughly 33% — although this includes state and local taxes. If all companies with tax rates above the proposed new tax rate of 20% were to drop to 20%, and no companies provisioned for US taxes  on foreign profits, we estimate the domestic effective tax rate for the S&P 500 would fall in line with its foreign tax rate of roughly 19%. This would represent a 9ppt decrease in the current S&P 500 tax rate and a 12% increase in EPS. We show the sensitivity to S&P 500 EPS to different assumed tax rates in the chart below, but we reiterate that these estimates exaggerate the actual impact on profits, as a significant portion of these benefits would likely be passed on to consumers via lower prices. We assume that in aggregate, roughly half of the gains from the lower tax rate would be retained (i.e. half of the amounts shown in the sensitivity analysis in Chart 2).

The market is beginning to price in the benefits of tax cuts , but we may still be in the early days – note that potential beneficiaries of fiscal stimulus (i.e. infrastructure spending) have seen an 18% multiple re-rating but de minimis fundamental support, whereas potential beneficiaries of lower corporate tax rates have seen performance driven nearly equivalently by multiples and earnings.

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Repatriation

Repatriation likely under both Blueprint and Trump plans

Mandatory tax on overseas profits of 8.75% under Blueprint, 10% under Trump. The US currently operates under a tax system in which the domestic earnings of US corporates are taxed at the federal US corporate rate (35%) and any overseas earnings that are repatriated are taxed at this rate less a credit for foreign taxes paid on those same earnings. Many multinationals’ foreign earnings thus remain parked offshore, allowing corporations to avoid the tax hit associated with bringing them back to the US. Both Trump and the House (under Ryan) have proposed a mandatory tax of overseas earnings of US firms’ foreign subsidiaries at reduced rates, such that this cash can be brought back and put to work in the US. This differs from the 2004 repatriation tax holiday, which was optional.

Under the Blueprint, accumulated overseas earnings will be subject to a transition tax of 8.75% (for those held in cash/cash equivalents) or 3.5% (for all other holdings), with companies able to pay the tax liability over an eight-year period. This would be part of broader tax reform, where a proposed territorial tax system would exempt companies’ foreign income from US taxes and prevent future buildup of overseas profits as companies would be free to bring them home. Trump’s plan calls for a one-time deemed repatriation of overseas corporate profits at a 10% tax rate.

The Tax Policy Center estimates that a repatriation tax holiday would generate approximately $150bn in tax receipts under Trump’s plan (over 10 years) and $140bn under the Blueprint (over 8 years). The Tax Foundation similarly estimates that a repatriation act could drive spending amounting to $185-200bn in revenues through 2025, which could help fund infrastructure/defense spending.

S&P 500 companies could bring back over $1tn – mostly in Tech & Health Care. Our FX team has written that US corporates in aggregate (including Financials) hold ~$2tn in cash overseas, and their work suggests that nearly half is concentrated within 20 companies. Similarly, as we discuss below, half of the repatriated cash following the 2004 Homeland Investment Act came from just 15 companies, predominantly in Pharma and Tech. Our own analysis of the S&P 500 (based on filings and estimates from our analysts) suggests that non-Financials in the S&P hold approximately $1.2tn overseas, nearly three-quarters of which is in Tech and Health Care (Chart 4).

Post-repatriation cash use: will this time be different?

Valuations, investor preference, growth & leverage ratios suggest less buybacks While any potential restrictions on the use of repatriated earnings are still unknown, we suspect that a pick-up in buybacks is likely, but that a lower proportion will be used for buybacks today than during the last repatriation holiday. Valuations were generally more attractive in 2004-2005 on most metrics (Table 9), and we’ve found that buybacks tend to be more rewarded when stocks are cheap (Chart 8). Additionally, the largest buybacks have not generated alpha for the last several years, as investors have increasingly agitated for companies to use their excess cash on pro-growth investments (namely capex.) According to BofAML’s latest Global Fund Manager Survey, 60% of investors want companies to increase capex spending, vs. 17% who want companies to return cash to shareholders (Exhibit 1). This compares to a majority of investors desiring companies to return cash to shareholders when the HIA was passed in late 2004.

Companies may also feel less pressure to bolster per share metrics by reducing share count if top line is recovering and organic growth is finally materializing. And from a capital structure perspective, if leverage loses its tax benefit, given that leverage ratios are already high (see below) companies may be less likely to reduce their equity capital base, as that would marginally increase their weighted average cost of capital.

Special dividends, pay-down of debt may be other likely uses

Companies may also return the cash to shareholders by issuing a one-time special dividend: income remains in-demand, given that both interest rates and dividend payout ratios remain historically low. And if a repatriation tax holiday comes within the context of broader tax reform that includes an end to the deductibility of interest expense, companies may choose to pay down debt over other uses of cash, in an attempt to skew their balance sheets less toward debt and more toward equity. Deleveraging balance sheets may also be spurred by a demonstrable move in interest rates over the last twelve months. Leverage for S&P non-Financials has steadily been ticking up over the last few years, and, if we exclude the cash-rich Technology sector, leverage is approaching all-time highs (Chart 9).

Potential EPS impacts

$8-9 (6-7%) hit to GAAP EPS from the mandatory tax

We estimate that the tax of accumulated overseas profits of $1.2tn should result in a cash tax impact of $100-120bn (which may be allowed to be paid over 8-10 years), and a one-time hit to GAAP EPS of $8-9 (a lower $65-80bn, given that a several large multinationals such as AAPL already provision a portion of their overseas profits for US taxes and have effective US tax rates well above the US statutory rate). Our analysis assumes Trump’s/the Blueprint’s proposed rates of 8.75%/10%, and that all overseas profits are hit with this one-time tax, as suggested by their plans. See Table 10.

Note that our estimate of ~$1.2tn of cumulative profits overseas is based on estimates from us, our fundamental analysts, and company filings, where in many cases only overseas cash but not other indefinitely invested earnings are disclosed/estimated. Thus, the tax on these earnings could be slightly higher, though the Blueprint would tax earnings not held in cash at a lower 3.5% rate. (We conservatively assume our estimated $1.2tn is all cash and use the higher 8.75% rate under the Blueprint and 10% under Trump’s plan in our below analysis).

We estimate share buybacks add $4 (or as high as $6) to EPS (GAAP & non-GAAP)

If the full $1.2tn that we estimate is overseas for the S&P 500 ex. Financials & Real Estate is brought back (given the tax is mandatory and will be paid either way) and 50% is used on buybacks (~3% of S&P 500 market cap), this could add ~$4 to S&P 500 EPS. And if 80% (~4% of market cap) were used on buybacks, similar to NBER’s estimate of what occurred following the 2004 tax holiday, this could add $6 to EPS. (The difference between the Trump and Blueprint tax rates is small, leading to only cents in index EPS). If one assumed companies only brought half of their offshore cash home immediately, even though the full amount was taxed, these benefits would be cut in half.

Note that buyback programs may span several years, which could spread out some of the EPS benefit below. But if one assumes a buyback is fully executed in Year 1, this provides a one-time boost to EPS growth and a recurring benefit to future EPS given a permanently lower share count.

Cross-asset implications of repatriation

Repatriation should spur USD-buying – up to 40% may be non-USD denominated.  While few companies disclose the currency composition of their offshore cash, our FX team estimates that 60-75% is already in USD while 25-40% is non-dollar-denominated. (If we extrapolate based on the S&P 500’s geographic revenue exposure, the largest proportion could be in Europe, followed by emerging Asia). This may create USD strength via buying pressure (which they estimate could amount to $250-$400bn if half of all offshore cash, which they estimate at ~$2tn, was repatriated). Their analysis of the EUR-USD during the last repatriation holiday suggests an “announcement effect” is likely, as the dollar strengthened ahead of the bulk of the actual repatriation flows.

Repatriation could put upward pressure on bank funding costs. Our rates team’s analysis of some of the largest multinationals with offshore cash suggests ~70% of cash is invested in securities with maturities greater than one year, likely given the assumption that these funds would be indefinitely reinvested, and the remaining 30% has longer maturities. See table below. They believe repatriation could  put upward pressure on bank funding costs as firms reduce their holdings in these short-term investments. According to Crane Data on offshore money fund holdings, our rates team cites that $161bn of offshore funds are held in commercial paper and CDs, of which the majority are from financial institutions with Japan, France and Canada the largest issuers.

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Border adjustment tax analysis

A new tax policy outlined in the Blueprint proposal that has been getting a lot of attention recently is the border adjustment tax, or the application of border adjustments to a company’s imports and exports. While Trump has described the proposal as being “too complicated,” it is a key component of the Blueprint plan and should not be ignored. Additionally, White House press secretary Sean Spicer’s recent reference to “…the plan taking shape right now, using comprehensive tax reform as a means to tax imports from countries…” could be a sign that Trump is not as against the proposal his other comments would indicate.

This policy would effectively result in the tax authorities recognizing all sales that take place in the US (regardless of where they are produced) and all the domestic costs incurred to produce goods and services for customers (regardless of where the sale takes place). As a result, net importers (such as many retailers) would suffer, as they would have to pay taxes on their domestic sales without being able to deduct a significant portion of their costs of production. Conversely, net exporters (companies with much of their production in the US but sales outside of the US) would stand to benefit from not having to pay taxes on their foreign sales while being able to deduct a significant proportion of production costs (Exhibit 3). Purely domestic companies would be unaffected.

Even if border adjustments are enacted, there is significant uncertainty around implementation details. For this analysis, we focus on the first-order impact of border adjustments, but we recognize there would be significant second order impacts on the pricing of products, pricing within the supply chain, foreign exchange rates as well as foreign policy reactions. (We discuss many of these second order impacts later in this report.) For the current exercise, we also ignored the cost of services as the implementation of these rules would be more complicated. See the Methodology section for more details.

We estimate that at a 20% tax rate, border adjustments would detract $5-6 from 2018 EPS, with nearly 80% of the drag coming from the Consumer Discretionary and Consumer Staples sectors (roughly evenly split). This impact includes a 50% haircut to account for offsets from alternate sourcing, currency rates and pricing power. On one hand, we may be drastically underestimating the impact because we have not included the second-order impacts on the supply chain. For example, many retailers source the bulk of their goods from domestic suppliers, who source their goods from overseas suppliers. So while the original retailer may not feel the direct tax hit from importing goods, the supplier that took the tax hit would likely pass along a significant portion of this via a higher cost. On the other hand, the supplier  or the retailer could look for alternate domestic sources for those products, but it would largely depend on whether the cost differential of production between the US and overseas exceeded the border adjustment tax. Some key components in determining the cost differential are the foreign exchange rates (more on this below) and labor costs. In the end, the net impact of the border adjustment taxes will be driven by a complex interplay between corporate tax rates, pricing power, foreign exchange moves, foreign versus domestic availability and cost differentials.

Offsetting BAT with a little math and some price increases

A company could fully offset the border adjustment tax by raising prices such that the after-tax increase in sales would exceed the drag from the lost deduction of costs. All else equal, the break-even price increase would be equivalent to the cost of goods sold as a % of sales multiplied by net % imported and the tax to after-tax ratio, which at a 20% rate is 0.25 (20%/80%). As an example, a company with a 25% gross margin that imports 30% of its goods would need to increase its prices by of 5-6% to offset the border adjustment tax.

Offsetting BAT with FX

Some of the increase in the after-tax cost of imported goods can also be offset by a strengthening dollar. For example, companies producing goods in Mexico, which stand to see a 25% increase in the cost of imported goods, should see the cost increase partially offset by the 13% devaluation of the Mexican Peso against the US dollar since the election. The net cost increase is a more digestible 9%, especially when you also consider that the Peso has devalued nearly 30% since its 2013 peak. While it may offer little consolation to corporates, the US Dollar Index is up over 25% since mid-2014, so the border adjustment tax would presumably act as a reversal of the lowered cost of overseas production over that period.

Border adjustment sensitivity analysis

The table below illustrates how the change in the tax rate and the application of the border adjustment tax would impact the domestic earnings of a hypothetical company with sensitivity to different tax rates and net export assumptions. We assumed the company has a 40% gross margin, operating expenses are 20% of sales and an initial tax rate of 35%. As you would expect, the biggest benefit would accrue to  companies with significant net exports at a high domestic tax rate (bigger tax shield) and the most negative impact to significant net imports at a high domestic tax rate (higher taxes on higher taxable income).

Below we highlight industries which could potentially benefit most / be hurt most by the BAT.

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No interest tax shield

Another key offset to the lower corporate tax rate is the proposed ending of the deduction of net interest expense. We assume that this rule would apply to new debt and that existing debt would be grandfathered. This tax shield removal would increase the cost of debt by an incremental 25% (not to mention the 100bp+ rise in long-term interest rates seen since the summer of 2016). In the table below, we illustrate the impact on S&P 500 corporate profits. We estimate that over time, the removal of the interest rate deduction would detract about 4%, or $4-5 from S&P 500 2018 EPS.

Many investors assume that interest deductions would likely apply only to new debt, and if this were the case, the drag would be gradual for the overall S&P 500 as debt matures and is refinanced. Companies have shifted the composition of their debt toward longer maturities and fixed rates. We estimate an average S&P 500 debt maturity of over eight years, with just one-third maturing within the next three years. The grandfathering of existing debt is a reasonable assumption, but not a sure thing, in our view. There is a possibility that legislators apply it to all debt on the grounds that most companies are expected to be net beneficiaries of comprehensive tax reform.

There is also a possibility that this policy is phased in over a number of years, with certain portions of the existing debt losing their interest deductibility over time.

The most negatively impacted companies would clearly be the ones with the most leverage, in addition to those with depressed earnings (Metals & Mining, Energy, etc.). We have again excluded Utilities from this analysis, because although the sector has a lot of leverage, for these companies, there would likely be a pass through to customers in determining their allowed rate increase.

How will levered companies react?

Companies will likely grow comfortable with a smaller amount of debt, retain more earnings, use less cash for dividends and share buybacks, and potentially draw down cash if they have it. If a tax holiday is also granted, that might offset the loss of benefit. Companies that regularly issue long-term debt may choose to reduce that burden to offset the tax change, and find those funds elsewhere. We find it unlikely that the change would result in a surge in equity issuance, unless the change applies to existing debt, which is unlikely in our view. While this change should be taken as a line item in a wholistic bill, there are victims and beneficiaries here. Corporations that have high leverage ratios, low retained earnings, high interest expense to earnings ratios, no cash overseas offset from repatriation, and those that have recurring long-term debt needs may be most at risk.

Other implications

While some argue that companies will try to raise outsized amounts of IG capital ahead of the deadline to lock in funding with the tax benefit before the loophole is closed, there is likely to be a provision in the legislation that would treat such debt as new debt. In our Investment Grade Strategist Hans Mikkelsen’s view, demand for IG credit could materially reduce over time. The tax change could also dampen Leverage Buyout (LBO) activity, according to our High Yield strategist Michael Contopoulos, where these funds are already struggling to generate high returns – note that LBO funds are currently sitting on close to $1tn in cash looking for a home, according to Preqin’s third quarter update.