"Here"s What"s In It": Goldman Explains All You Need To Know About The Current State Of Tax Reform

To the delight of Donald Trump, just before 2am on Saturday morning the Senate passed the Republican Tax bill in a 51-49 vote, and with tax reform legislation now passing both chambers of Congress it looks very likely to become law by year-end, probably within the next two weeks according to Goldman Sachs which now ascribes a 90% probability of the legislation becomes law by year end.

In it latest assessment of the state of tax reform, Goldman analysts Alex Phillips and Jan Hatzius write that while largely a done deal, some differences between the two versions still need to be ironed out: "We expect the final structure of the bill to reflect more of the Senate bill than the House bill, including a 20% corporate tax rate effective in 2019, the Senate’s more restrictive limit on net interest deductibility, and the Senate’s treatment of pass-through income. Both proposals now include a $10k cap on state and local property tax deductibility, rather than full repeal, eliminating the most important political difference between the bills before the conference negotiations start."

Additionally, Goldman adds that while the corporate tax changes are likely to result in a net tax reduction in corporate tax liabilities, the size of the tax cut actually looks fairly small. Compared to current policy, the compromise legislation we expect to emerge from the conference committee would reduce the effective corporate tax rate by only a couple of percentage points.

Perhaps the most surprising take home from the Goldman analysis is that while the bank has increased its estimate of the growth impact from tax reform slightly, to around 0.3% in 2018 and 2019 - "reflecting the slightly larger amount of tax cuts in the Senate plan following revisions, and our expectations regarding the eventual compromise" - it still expects a relatively modest boost to overall economic growth.

That said, questions remains, most notably: "what"s in the actual bill?"

To answer, we publish the latest Goldman analysis for those still confused - which would be pretty much everyone - what is currently contained in the most sweeping tax overhaul in the US since the days of Ronald Reagan.

Tax Reform: The Home Stretch

Q: The Senate has passed the bill, now what?

A: Differences between the House and Senate bills are likely to be reconciled in a conference committee. A conference committee involves the appointment of conferees of both parties from the House and the Senate, with a majority of conferees needed to approve the final agreement. As a practical matter, House and Senate Republican leaders and a few other relevant Republican lawmakers are likely to negotiate the final agreement, as recent votes in the House and Senate demonstrate that Democratic support is unlikely to be needed to conclude the conference negotiation. Once the final conference report has been filed, the House and Senate must pass it once again before sending it to the President for signature. A simple majority would be required in both chambers, with no changes possible.

A possible alternative would be for the House to simply pass the Senate-passed bill, avoiding the conference process and expediting enactment. In light of the impending special Senate election in Alabama, upcoming fiscal deadlines, and general political uncertainty, congressional Republican leaders might consider this option if conference negotiations take longer than expected, though at this stage a conference committee looks much more likely.

We expect congressional Republican leaders to begin conference negotiations immediately, and believe they will target completion the week of December 11. If successful, this would produce final details around December 11-13, and final passage in the House and Senate December 14-15. One reason we expect this timing is because of the need to address expiring spending authority by December 8, which we expect to be extended temporarily through December 22, creating only a short period before year end when Congress is not addressing other fiscal deadlines.

Q: How likely is this to become law?

A: It is extremely likely that tax reform legislation becomes law, with a 90% chance it becomes law by year-end. Our view has been that once legislation has cleared the Senate, the odds of enactment would be quite high because the Senate has always represented the greatest obstacle to enactment. Reconciling differences in the conference committee represents a risk, but we do not believe congressional Republicans would allow tax reform to fail after having passed similar versions in both chambers. Even in the event that the conference negotiation bogs down, we expect that the House would simply adopt the Senate-passed version if there were no other alternative, though a compromise through a conference committee looks much more likely at this point.

Although the legislative process has been slower than we expected for the most of the year, over the last couple of months we have been consistently surprised at how quickly congressional Republicans have made progress on tax reform. The final step in the process, the House-Senate conference committee, often takes several weeks to complete; in 1986 it took conferees two months to reconcile differences between House and Senate versions of tax reform legislation, for example. However, it would not be unprecedented for a conference committee on major tax legislation to be completed in less time; the conference process for the 1981, 2001, and 2003 tax cuts took a week or less, for example. With the apparent motivation that congressional Republicans have to finish work on tax reform this year, we expect that a conference agreement between the House and Senate could be voted upon by mid-December. While it is possible that consideration of tax reform could spill over into January, at this point enactment in December looks far more likely.

Q: How does this compare to consensus?

A: Market pricing also reflects a view that tax reform is likely to become law. Over the last few weeks, high-tax stocks have outperformed low-tax stocks (Exhibit 2). This reflects, in our view, a growing expectation of tax reform, which should benefit companies with high effective tax rates more than companies with low effective tax rates. Prediction markets, which as recently as October ascribed only a 20% probability to tax reform being enacted this year, now imply a nearly 80% probability. The implied probability by the end of Q1 is around 95%. Our conversations with clients also suggest little remaining uncertainty regarding whether the bill becomes law. Instead, the focus has shifted to what changes might still be made, how differences between the House and Senate versions will be resolved, and what the effect will be across sectors.

Q: What changed in the Senate bill?

A: The pass-through, state and local tax (SALT), and capex expensing provisions became more generous, while alternative minimum tax (AMT) changes and profit repatriation rates became less generous. Among the major changes the Senate made prior to committee-passed version of the bill:

• Some property taxes would be deductible. The first $10k in state and local property taxes could be deducted under the Senate bill, bringing it into line with the House version. Previously no state and local taxes could be deducted from non-business income under the Senate version.


• The deduction for pass-through income has increased to 23%. The benefit would phase out for taxpayers with income above $500k, similar to the prior version. For taxpayers with total income near the limit who would otherwise be in the 35% bracket under this proposal, this would work out to tax rate on pass-through income of roughly 27%, rather than 29% under the prior version.


• Capex benefits would last slightly longer. Under the prior proposal, full expensing of equipment investment would have expired after 2022. With the recent revisions, the share of equipment that could be deducted in the year of investment would decline by 20pp after 2022, expiring fully in 2027.


• No AMT repeal, after all. The AMT imposes additional tax beyond the standard income tax on middle- and upper-income taxpayers with substantial deductions, among other circumstances. A separate AMT is applied to corporations. The House bill and original Senate bill would have eliminated the AMT; the revised Senate version increases the exemption amount for individuals but stops short of repeal; the corporate AMT appears to be left in place as well. Individual and corporate AMT repeal were estimated to reduce revenues by $770bn and $40bn respectively; this change is expected to offset the cost of some of the more generous provisions noted above.


• Higher tax rates on unrepatriated profits. The prior Senate n proposal would have taxed untaxed foreign profits at 10% if held in cash or liquid assets, or 5% if not. The current version steps up those tax rates to 14.5% and 7.5%.

Q: What happened to the “trigger” idea?

A: The trigger was dropped because it became politically unnecessary. Senator Corker (R-TN) and several other senators who were concerned about the deficit impact of the legislation had proposed a provision that would reverse some of the tax cuts several years from now if revenues had not grown more quickly than the official projections. As the revenue gain from the trigger would have been contingent on economic developments, the trigger was ruled noncompliant with the “Byrd Rule”, which stipulates that only provisions that have a fiscal effect can be included in budget reconciliation legislation. After this ruling, and other changes to the bill, all but one Republican senator had announced public support for the bill, meaning that it had sufficient support without the trigger. It is possible that the concept could be revisited if there is insufficient support for the final conference agreement without it, but at this point a trigger looks very unlikely.

Q: What are the remaining issues that need to be worked out?

A: The greatest policy differences between the House and Senate bills involve the AMT and top marginal rate, pass-through treatment, corporate provisions dealing with cross-border transactions, and net interest deductibility. Exhibit 3 summarizes the differences between the House-passed and Senate-passed versions, along with the estimated revenue effects over ten years estimated by the Joint Committee on Taxation (JCT). The right column of Exhibit 3 suggests what a potential compromise between the two versions might look like that would stay under the $1.5 trillion overall limit on revenue loss imposed by the recently passed budget resolution.

Q: Will the ACA mandate be repealed?

A: We expect the penalty on the uninsured to be set to $0, which would have the same practical effect as repeal. The Senate legislation sets the penalty on the uninsured to $0, which is estimated to generate over $300bn in budgetary savings over the next ten years. This is used to expand other tax cuts in the bill. House Republicans have been more supportive of repealing the individual mandate than Senate Republicans have, so Senate passage suggests that this change is likely to be included in the final version of the legislation, in our view.

Repealing the mandate would have two main effects. First, insurance coverage would decline. CBO has estimated that the level of uninsured would rise by 4 million in the first year after mandate repeal, and by 12 million in the third year.1 Given that the enrollment period for 2018 concludes in less than two weeks on December 15, around the same time that we expect tax reform legislation to become law, our expectation would be that the decline in coverage in 2018 would be somewhat smaller than the CBO estimate but that the effect in later years would be similar.

Second, premiums in the individual market would increase. CBO has estimated that average premiums would rise by about 10% without the mandate. Younger and healthier individuals are the most likely to drop coverage without the mandate. This would leave the remaining risk pool older and less healthy, leading to an increase in premiums. That said, since ACA subsidies are designed so that the government pays the portion of premium that exceeds a certain percentage of an individual’s income, subsidized enrollees would be responsible for only some or, in some cases, none of the additional premium cost. By contrast, unsubsidized enrollees would bear the full increase. CBO has estimated that the individual insurance market would continue to be stable without the individual mandate.

Q: How will corporate interest deductibility change?

A: The outlook here is murkier than in most other areas, but fiscal constraints could lead lawmakers to include the more restrictive Senate proposal in the final version. The House-passed legislation restricts net interest deductibility to 30% of an income definition that roughly translates to earnings before interest, taxes, depreciation amortization (EBITDA). By contrast, the Senate restricts interest deductibility to 30% of an income definition that roughly translates to earnings before interest and taxes (EBIT). The difference is substantial, and JCT estimates that the more restrictive Senate version would generate nearly twice as much revenue as the House provision.

Exhibit 4 shows the average interest deduction by industry as a share of each definition, using 2013 data from the IRS. We note that in the House and Senate bills, utilities are excluded from the limitation; the real estate sector is excluded in the House bill as well, and companies in that sector would have the ability to opt out of the limitation in the Senate bill but would lose the benefit of full expensing if they did.

The outcome for this provision is particularly hard to predict but we believe a provision closer to the Senate provision seems more likely to prevail. In light of the need to offset other changes to the bill, we would expect that negotiators will lean toward the version that generates greater savings if they are able to pass the Senate which has tended to be the higher political hurdle for the tax bill in general.

Q: How will the corporate international provisions be settled?

A: We expect the Senate’s “inbound” provisions to prevail, but the “outbound” provisions are hard to predict. The House and Senate both include “outbound” provisions intended to impose a minimum tax on some of the foreign operations of US companies, and “inbound” provisions intended to combat the erosion of the domestic corporate tax base through transactions with foreign affiliates. The general structure of the outbound and inbound proposals is similar in the House and Senate proposals.

The inbound proposals are conceptually similar but differ in the details. In both cases, they would effectively tax deductible payments that a US company makes to its foreign affiliates. In the House, this is structured as a 20% excise tax, though companies would have the option to elect to be taxed on the associated foreign income instead. In the Senate, the proposal would effectively impose a 10% tax on related-party payments. An important difference is that the Senate provision would appear to exclude payments to related foreign manufacturers for cost of goods sold, while the House proposal could tax some of those payments, with potentially greater effects on cross-border supply chains. That said, even the Senate version is likely to have consequences that are only understood after the legislation has been enacted and companies start to implement the new rules.

The outbound proposals are slightly more straightforward. These would impose a tax on any foreign intangible income exceeding a specified return (e.g., 10% in the Senate bill) on foreign tangible assets (e.g., depreciable assets like equipment and structures). Exhibit 5 shows the effective combined US and foreign tax rate under the House and Senate bills. While the House bill would tax half of this income at the 20% domestic corporate rate, for a 10% effective minimum tax, the Senate uses a more complicated structure that taxes all intangible income from foreign assets as US income at the 20% rate, but provides a 37.5% deduction of all intangible-related income related to foreign sales, whether from US assets or foreign assets. This could remove the incentive to move intellectual property and other intangibles to foreign subsidiaries since they would receive the same treatment on their foreign sales regardless of where the assets were held. However, previous US tax regimes that taxed income from US-based assets differently depending on whether the income was generated by sales in the US or in other markets were repealed after they were challenged successfully in the WTO by trading partners. In light of the risk of another successful challenge, we believe the conference committee is slightly more likely to settle on a policy closer to the House
proposal in this area.

Q: When will the changes take effect?

A: Apart from the potential delay in the corporate rate cut, almost all of the changes will take effect at the start of 2018. There are essentially no retroactive tax cuts or tax increases in the House or Senate proposals, with the notable exception of the tax on accumulated untaxed foreign profits. The only major provision that does not take effect at the start of 2018 is the Senate corporate rate reduction, which remains at 35% in 2018 and drops to 20% starting in 2019. We expect this will be included in the final version, since it reduces the ten-year cost of the bill by more than $100bn. Proponents of the delay argue this would also spur more capital investment in 2018, as it would incentivize companies to pull forward capex that would be fully deductible against the 35% rate in 2018 rather than the 20% rate in 2019. Exhibit 6 shows the overall change in tax receipts estimated by the Joint Committee on Taxation, shifted to a calendar year basis. We note corporate tax receipts are estimated to increase in 2018 under the Senate bill, which results from tax payments related to deemed repatriated profits, which would not be offset by a lower corporate tax rate until 2019.

Q: How will the bill affect corporate tax liabilities?

A: It will reduce effective corporate tax rates much less than the 15pp drop in the statutory rate implies. For context, the JCT estimates of the revenue effects of the tax bills are made against a baseline that assumes roughly $3.9 trillion in corporate tax receipts over the next ten years. This suggests that a corporate tax cut of around $300bn/10yrs should result in only a reduction in the effective tax rate across companies of less than 10%. This would result in less than a 2pp decline in the average effective corporate income tax rate, using for example the 19% average effective rate estimated by the Congressional Budget Office (CBO).

The eventual effect also depends on what assumption one makes regarding the extension of expiring provisions. Under current law, corporate taxes would rise by roughly $250bn over the next ten years due to the expiration of the current 50% bonus depreciation policy for equipment investment and a number of smaller expiring policies would add about $150bn more over the next ten years. Exhibit 7 shows the same estimates of the tax changes shown in Exhibit 6, but adds the effect of expiring policies that have not been addressed in the TCJA.

If Congress took no further action on taxes over the next ten years, corporate taxes would actually increase slightly versus current policy. However, most assume that some of these provisions will be extended when they are set to expire; under the Senate-passed bill, 100% immediate expensing of equipment investment is scheduled to phase down by 20% per year starting in 2023 but Congress could step in to prevent this phase-down.

Q: What does this mean for growth?

A: We expect the legislation to boost growth by around 0.3pp in 2018 and 2019. This is based mainly on the Senate version of the bill, which delays the corporate income tax cut to 2019 but includes a tax cut for individuals (including pass-through income) of around 0.6% of GDP in 2018, slightly greater than what we had previously penciled in. The effect is spread over two years in part because some of the provisions that reduce individual income taxes would show up primarily as lower tax settlements in 2019 rather than reduced withholding from paychecks in 2018.

On the corporate side, we disregard the temporary increase in tax payments in 2018 related to the tax on deemed repatriation; we do not estimate a growth effect from those repatriated profits, either. While the corporate tax cut looks likely to take effect with a one year delay, in 2019, we note that there is likely to be some pull-forward of capex from 2019 into 2018, as companies attempt to maximize their deductions against the higher corporate rate.

We note that the effect in 2020 and beyond looks minimal and could actually be slightly negative, as the JCT estimates suggest that the tax cut that year would actually be slightly smaller than in 2019. Exhibit 8 shows our revised estimate of the growth effects of fiscal policy, incorporating an assumption similar to the fiscal effects of the potential compromise shown in Exhibit 3.

Q: What are the political consequences of tax reform?

A: We do not expect it to help Republican prospects very much. Congressional Republicans have suggested that passing tax reform should help them maintain their majority after the 2018 midterm elections. While passing tax cuts ahead of an election should improve the majority party’s prospects, it is less clear that tax reform will provide the political tailwind Republicans are expecting. Certain provisions are controversial, and the bill overall is relatively unpopular among voters; an average of recent polling shows 32% of voters support the legislation, which compares unfavorably with other major tax cuts like the 1981 or 2001 tax bills, or even the roughly revenue-neutral tax reforms enacted in 1986. This is likely because one in three voters believes their taxes will increase because of tax reform, with more Democrats expecting an increase than average.

If these concerns persist, voters are likely to be ambivalent, or worse, regarding tax reform. That said, sentiment might improve if voters perceive over time that their taxes have declined. The Joint Committee on Taxation (JCT) predicts taxes will decrease or stay the same for about 90% of voters through 2021 (Exhibit 9). The most controversial aspects of the legislation also have mixed implications; while voters favor repealing the individual mandate by two to one, for example, repealing SALT deductions continues to be unpopular and could become a liability in the dozen or so competitive Republican-held House districts in New York, New Jersey and California.

Jail, Drugs And Video Games: Why Millennial Men Are Disappearing From The Labor Force

Last week, Goldman Sachs pointed out a very disturbing trend in the US labor market: where the participation rate for women in the prime age group of 25-54 have seen a dramatic rebound in the past 2 years, such a move has been completeloy missing when it comes to their peer male workers. As Goldman"s jan Hatzius put in in "A Divided Labor Market", "some of the workers who gave up and dropped out of the labor force during the recession and its aftermath still have not found their way back in." In fact, the labor force participation rate of prime-age (25-54 year-old) women has rebounded quite a bit and is now only moderately below pre-crisis levels, but the rate for prime-age men remains well below pre-crisis levels.

While Goldman did not delve too deeply into the reasons behind this dramatic gender gap, BofA"s chief economist Michelle Meyer did just that in a note released on Friday titled "The tale of the lost male." As we have discussed previously, and as Goldman showed recently, Meyer finds that indeed prime-working age men - particularly young men - have failed to return to the labor force in contrast to women who have reentered. According to Meyer, while this reflects some cyclical dynamics, including skill mismatch and stagnant wages, what is more troubling is that there are several new secular stories at play such as greater drug abuse, incarceration rates and the happiness derived from staying home playing games.

The macro implications, while self-explanatory, are dire: with the labor force participation rate among young men unlikely to rebound, the unemployment rate should fall further and cries of labor shortages will remain loud, even as millions of male Americans enter middle age without a job, with one or more drug addition habits, and with phenomenal Call of Duty reflexes. Here"s why.

First the facts

The overall LFPR is at 62.7%, up from the lows of 62.4% in 2015 but still considerably below the peak in 2000 of 67.3%. BofA estimates that more than half of the decline in the LFPR is due to demographics - as the population ages, the aggregate participation rate naturally falls. However, even after controlling for demographics, the participation rate of prime-working age individuals has failed to recover. As shown by Goldman above, and in BofA"s Chart 1 below, "this reflects the fact that men have not returned to the labor force. This is not a new phenomenon as the participation rate for prime working aged men has been on a secular downshift for the past several decades. However, it stands in contrast with the participation rate of women of the same age cohort which has rebounded nicely."

Looking at age cohorts, the weakness among men is particularly acute among 25-34 years old where the rate has continued to slip lower. This is offset by a modest uptrend in participation among men aged 45-54 years old (Chart 2). In other words, the millennial men have remained on the sidelines of the labor market.

Now the theories

Why haven"t men - particularly millennial men - returned to the labor market? According to Meyer, on the one hand, there are the typical business cycle explanations which center on the mismatch in skills. There is also the theory of stagnant wages which may discourage new entrants into the labor market. On the other hand, there are secular changes for men, including the rise in pain medication usage (opioid drug abuse), incarcerations, and prioritization of leisure (think video games).

BofA reviews each in order, starting with the story of mismatch

The recession resulted in more severe job cuts for men than for women, in part due to the nature of the downturn; indeed, male employment fell by a cumulative 6.9% vs a 3.2% drop for women. The goods-side of the economy shed workers, particularly in construction and manufacturing, which tend to be more male-dominated. Both sectors were slow to recover, leaving workers to become detached from the labor market with depreciating skills. Moreover, the destruction of jobs in these sectors discouraged the younger generation from attaining the skills necessary to enter these fields. A prime example is the construction sector: the average age of a construction worker increased to 42.7 in 2016 from 40.4 pre-crisis, reflecting the fact that there were fewer young workers becoming trained in the discipline. By mid-2013, builders started to complain about the difficulty in finding labor, particularly skilled workers. This illustrates how the Great Recession displaced workers and led to a mismatch of skills.

Logically, there is also the influence of rising wages - or the lack thereof - on the incentive to work. Wage growth has been slow to recover on aggregate with only 2.4% yoy nominal wage growth as of October. However, there are differences by education with relative weakness for less educated men (Chart 3). This shows the demand shift away from this population, leaving them on the fringe of the labor force. Accordingly, the labor force participation rate for men with only a high school diploma has declined by 6.2% since 2007 vs. the 5.3% drop in the college educated cohort.

The pain from opioids

Moving to the more depressing narratives, BofA next explores the possibility that the rise in drug abuse - particularly opioids - is leaving men unemployed and displaced from the labor force. Recent work from Alan Krueger found that the rise in opioid prescriptions from 1999 to 2015 could account for about 20% of the decline in the male labor force participation rate during that same period. Referencing the 2013 American Time Use Survey - Well-being Supplement (ATUS-WB), 43% of NLF prime age men indicated having fair or poor health, a stark contrast with just 12% for employed men. The same cohort also reported significantly higher levels of pain rating, with 44% having taken pain medication, opioids particularly, on the reference day. It is hard to prove causality - is the increase in pain causing more dependence on opioids, leading to a drop in the labor force participation, or did the lack of job opportunities lead this population to drug abuse? Either way, it seems to be a factor keeping prime aged individuals from working - both men and women, according to Kreuger"s analysis.

Incarceration on the rise

The rising number of incarcerations imposes another issue. Although prisoners are not counted toward the total civilian non-institutional population when calculating the LFPR, the problem associated with the labor market goes beyond prisons. The growing number of incarcerations has left more people with criminal records, making it difficult for them to reenter the workplace. Indeed, the share of male adult population of former prisoners has increased from 1.8% in 1980 to 5.8% in 2010 (Chart 4). The Center for Economic and Policy Research has also found that people who have been imprisoned are 30% less likely to find a job than their non-incarcerated counterparts. Not surprisingly, a look into the details by demographic cohort finds that men make up nearly 93% of all prisoners, of which one third are between the ages of 25 and 34.

Why work when you can play video games

Finally there is the question of preference - is it possible that we are seeing more young men choosing leisure over labor? According to the ATUS (time use survey), between 2004-07 and 2012-15, the average amount of time men aged 21-30 worked declined by 3.13 hours while the number of hours playing games increased by 1.67 and the hours using computers rose by 0.6 (Chart 5). Once again there is a question of causality - are young men playing video games because it is hard to find work or because they prefer it over working? Using the 2013 Supplement ATUS, Krueger finds that game playing is associated with greater happiness, less sadness and less fatigue than TV watching and it is considered to be a social activity. This can create a loose argument that the improvement in video games has increased the enjoyment young men get from leisure, putting a priority on leisure over labor. It also begs the question over whether welfare benefits for the unemployed aren"t just a touch too generous, but that is a discussion best left for another day...

Whatever the reasons behind the collapse in male - and especially Millennial - labor force participation, the undeniable result has led a number of industries to report persistent labor shortages. To get a sense of this, BofA compares the ratio of the rate of job openings to hires across major industry using the JOLTS data. All major sectors have witnessed an increase in the ratio (Chart 6). (Note that due to trend differences across industries, it is more important to look at the relative changes in ratios instead of their absolute values). The biggest relative increase was in construction followed by transportation and utilities. This is the goods side of the economy where men tend to be a larger share of the working population, therefore highlighting the challenges in the economy from the shortage of men participating in the labor force. This is consistent with Beige Book commentary which highlighted in the latest edition that "Many Districts noted that employers were having difficulty finding qualified workers, particularly in construction, transportation, skilled manufacturing, and some health care and service positions."

There are two implications: number one, the unemployment rate is set to fall further. In October we already touched 4.1% and are just a few thousand workers away from a 3-handle on the unemployment rate. The second is that wages should be rising. As Meyer writes, while it has yet to translate to a decisive higher trend in wage inflation, "we continue to argue that further tightening in the labor market will gradually succeed in generating faster wage growth." To be sure, modest upward pressure on wages - especially if it is felt across industries and education levels - could encourage some return of labor, but it will likely be slow given the structural challenges addressed above. The consequence: cries of labor shortages will remain loud, even as wages finally rebound from chornically, and troublingly, low levels. In fact, some speculate that the wage rebound - once it emerges - could be sharp and destabilizing, and ultimately, as Albert Edwards predicted, could result in a "nightmare scenario" for the Fed (and capital markets) which will suddenly find itself far behind the tightening curve.

Goldman Raises December Rate Hike Odds To 80%

Having pointed out a glaring error in today"s payrolls report, which indicated that there was at least one math error in calculating the average hourly earnings number, and as a result casts doubt on every other piece of data released by the BLS, we urge algos and the handful of carbon-based traders, to take anything released by the BLS with a boulder of salt, especially data on wage inflation, until the BLS provides an explanation for what is going on.

Until then, here is Goldman methodically going "by the numbers", and validating the market"s reaction that sent December rate hike odds to the highest in one year, as moments ago Goldman chief economist, Jan Hatzius, revised his odds of a December hike from 75% to 80%.

Nonfarm payrolls fell 33k in September—considerably below expectations—however, we believe temporary hurricane effects likely explain all or most of the weakness. In fact, the employment report appears strong on net after taking into account hurricane effects, given the drop in the unemployment rate to a new cycle low and the upward revisions to average hourly earnings. We increased our Fed probabilities, with subjective odds of a December hike at 80% (vs. 75% previously).

And the breakdown:

1. Nonfarm payrolls fell by 33k in September—113k below expectations—and growth in prior months was revised down by 38k on net. However, we believe temporary hurricane effects likely explain all or most of the weakness. We had previously estimated a drag of 125k from hurricane effects, and it appears to have been even larger: the BLS commissioner reported “a sharp employment decline in food services and drinking places and below-trend growth in some other industries likely reflected the impact of Hurricanes Irma and Harvey” (food service employment alone fell by 105k). Gauging the magnitude of the impact is difficult, but given the commissioner’s statement and given the sharp rise in the household “not at work due to weather” series, our working assumption is that all or most of the weakness was hurricane-related—and likely transitory. The state-level payrolls data released October 20th will provide substantial clarity on the magnitude of the impact. By industry, goods-producing industries added 9k jobs in September reflecting a rise in construction employment (+8k). Private service-providing employment fell 49k, as a 111k drop in leisure and hospitality payrolls was partially offset by growth in education and health (+27k) and trade, transportation, and utilities (+26k) jobs. Government payrolls rose 7k. The breadth of job gains weakened likely due to hurricane effects, with the payrolls diffusion index – the net share of industries adding jobs during the month – falling to 55.7% from 60.2%


2. The household measure of employment was very strong, rising 906k in September following the 74k decline in September. The 939k gap between employment growth in the household and payroll reports was the largest ever excluding months with level adjustments to population controls. Household employment on a population- and establishment survey-adjusted basis rose only 7k, as the numbers of workers on unpaid leave from their jobs—which are included in household employment but not in establishment employment—rose by 908k (SA), presumably largely driven by the hurricanes. The unemployment rate fell in September to 4.22% from 4.44%, as the surge in household jobs more than offset the increase in the participation rate to 63.1% (from 62.9%). While the unemployment rate may in principle have been pushed down by hurricane effects (for instance if the response rate drops more among unemployed), we think this is unlikely because the BLS noted that “there was no discernible effect on the national unemployment rate” and because historically natural disasters have led to moderate increases in the unemployment rate. Another reason to doubt that the decline in the unemployment rate was due to the hurricanes is that household employment was strong (as opposed to the labor labor force being weak). The broader U6 underemployment rate fell 3 tenths to 8.3%, as the shares of marginally attached and the U3 rate fell.


3. Average hourly earnings increased by a larger-than-expected 0.45% in September (mom), and a significant upward revision to July growth (+0.2pp to +0.5%) resulted in the year-over-year rate increased to +2.9% from a previously reported pace of +2.5% in August. While the composition effect due to the decline in the share of low-wage leisure and hospitality workers may have boosted September earnings, the upward revisions in prior months were large. Average weekly hours held steady at 34.4.


4. Our preliminary wage tracker—which distills signals from several wage measures—shows 2.4% for Q3, up from +2.2% in Q2.


5. We believe the headline payrolls miss is considerably less important than usual for the monetary policy outlook, because hurricanes clearly affected the data, other US growth data has been firm, and there are two more employment reports between now and the December meeting to make up for the weakness. We actually think the most important takeaway from the report was the upward revision to average hourly earnings, with wage growth now reported at just below 3%. Given this and given the drop in the unemployment rate to a new cycle low, we increased our Fed probabilities, with subjective odds of a December hike at 80% (vs. 75% previously).

Of course, if the BLS" wage growth calculation is wrong, everything changes. Until then, here"s a look at where the market-implied odds of a December hike are: not surprisingly... right at 80%.

Stocks Sink After Trump Tax Plan Leak - Here's What Wall Street Thinks

US equity markets ran up overnight but appeared to hit a "sell the news" moment as President Trump"s tax plan was leaked.

For now, it seems like the takeaway is that Trump wants Corporate/Small Business cuts at all costs and is willing to stick it to rich people with "at least as progressive" actions, if that"s what it takes to get the cuts. As Wall Street analysts generally agree for now, the devil is very much in the details... and those are yet to come.

Via Bloomberg,

COWEN (Chris Krueger)

• Offers initial takeaways: "The low bar was met" but the devil’s in the details, with no explicitly detailed offsets and no revenue/deficit number


• Creates way more questions than answers although progress has been made as 9 pages tops the 5-paragraph precis released earlier this year


• No revenue number makes the rest "almost an academic exercise"; highlights there was nothing on Obamacare taxes or capital gains, no Roth-ification, bank tax or border adjustment


• Still believes nothing will pass on taxes this year or next

GOLDMAN (Jan Hatzius)

• Prior to release, had written that proposal seemed likely to reduce revenues by ~$4t over 10 years; by contrast, debate in Congress has ranged from revenue-neutral tax reform to recent proposal allowing for $1.5t tax cut over 10 years


• Sees proposal as having to be scaled substantially to fit within fiscal constraints Congress is likely to impose


• Even so, tax reform is "finally starting to move," recent developments suggest rising probability tax legislation will be enacted by early 2018

KBW (Brian Gardner)

• Reminds investors outline was expected to be more of a wish list than a final document; tax rates in plan are subject to change, may rise once Congress actually writes legislation; sees corporate rate as likely to be higher than 20%


• Had expected most of details of other tax policy issues (deductions, exemptions, etc.) would be left out, since policymakers didn’t want to give interest groups targets to shoot at this early in the process

BMO (Aaron Kohli, Ian Lyngen)

• Prior to release, had "plenty of open questions," including the Senate reaction, whether there’s enough support within GOP rank- and-file to push reforms through in the House, and how cuts will be accounted for in offsetting revenue


• Expects debate on eliminating state/local tax deductions; also worries proposal is simply a "more exacting" version of Trump’s tax reform wish list; "it’s always folly to presume that precision implies accuracy and we fear that’s what the markets are currently trading"


• BMO on board with notion that a sizable cut will boost inflation over the next few years; not as certain anything more than minor cut will pass

HEIGHT SECURITIES (Stefanie Miller)

• Suggests investors "take a step back and evaluate" why Big Six are releasing tax framework; the blueprint’s purpose isn’t to set final policy details, but rather to advance the process and give Freedom Caucus Members cover


• Also provides tax writers opportunity to offer opening salvo ahead of more serious negotiations down the road


• No matter what’s in the blueprint, still puts 75% odds on Congress passing measure that cuts corporate rate to at least 25%

"The Lost Generation": Goldman Unemployment Charts Explain Just How Spoiled Millennials Are

This morning, Goldman"s Econ team, led by Jan Hatzius, set out to identify why wage growth has been elusive despite the fact that unemployment rates and other labor utilization measures signal an economy at full employment.  For evidence of labor market "slack" they decided to take a look at how recessionary college graduates handled the post-recession labor market as their lack of skills often make them the most vulnerable to a weak job market.

While the unemployment rate and other labor utilization measures signal an economy at full employment, wage growth has been weaker than expected recently, raising questions about the true degree of slack. To the extent that some pockets of excess slack remain, the cohort that came of age during the Great Recession would seem a natural place to ?nd it, given the pronounced and long-lasting effects of recessions on young workers.

In today’s daily, we review the labor market experience of the cohort graduating college or beginning careers during or immediately after the recession. Unsurprisingly, unemployment rose sharply in this segment from 2007 and 2010. However, since then, jobless rates have improved dramatically on both an absolute and relative basis – particularly over the last year – and the unemployment rate in this cohort is now under the national average. Relative wages have also partially recovered, and broader measures of utilization suggest that minimal excess slack remains in this cohort.

While not terribly surprising, they found that the young folks who graduated in the immediate aftermath of the "Great Recession" suffered relatively steep wage degradation relative to the overall population. 

Average earnings trends in the household survey show a similar pattern of underperformance and subsequent recovery. As shown in Exhibit 3, usual weekly earnings in this cohort declined by 6% relative to the population during and after the recession (on an age-adjusted basis). However, despite a partial recovery, the earnings gap remains: relative wages on this basis have only retraced a third of the post-recession decline (qualitatively consistent with the predictions of the academic literature).

But what is surprising is why those wages haven"t recovered meaningfully despite the fact that unemployment rates among the same cohort have fallen precipitously.  

And while Goldman didn"t point this out, perhaps there are some interesting, if overlooked, clues in the following two charts that lend some insight into the behaviors and attitudes of the current millennial generation as compared to previous generations that came of age during previous recessionary periods.

The chart on the left is particularly telling if you just compare the 1981 recession to 2008.  In the immediate aftermath of the recession, the unemployment gap for young people declined in both instances for the first 4 quarters of the recession. 

That said, the experience beyond Q4 is quite different as the 1981 cohort experienced a massive surge in employment while millennials in 2008 simply continued to decline and only bounced slightly off the lows.  Now, one could say this is an unfair comparison because the 2008 recession was deeper and more protracted than the 1981 recession. But, what we find most intriguing is that the 1981 cohort saw a massive surge in employment despite suffering the greatest wage decline of any of the recessionary periods for the past 35 years, and nearly double the experience of the 2008 recession.

Translation, when recession struck in 1981, Baby Boomers and Generation X got off their asses and took any job at any wage they could find to make ends meet.  But, when recession struck in 2008, millennials simply moved in with mom as opposed to taking a job that didn"t fully reward their extensive skillset garnered from 4 years of rigorous anthropology studies at a preppy New England liberal arts college.

Goldman: The Fed Will Hike This Week, But Here Are "The Two Most Interesting Questions"

On Wedensday the FOMC will hike rates by another 25 bps - an event which the Fed Funds market prices in with near virtual certainty, while Goldman calls the rate increase "extremely likely" - and only a "tail" event like an extremely weak CPI report on Wednesday morning, hours ahead of the Fed announcement, has any chance of preventing  this outcome. So with the next rate hike virtually inevitable, questions are focused on not only the Fed"s exit strategy for balance sheet normalization and what the "dots" or funds rate path will look like, but how the Fed squares rising rates with the recent string of inflation misses.

As Goldman"s Jan Hatzius writes, data since the March meeting has sharpened the dilemma that both sides of the mandate are sending increasingly different signals about the urgency of further tightening. "The unemployment rate has fallen 0.4pp since the March meeting and our current activity indicator and real GDP estimates signal that above-trend output growth will produce further labor market improvement. But the year-over-year core PCE inflation is now 0.2pp lower than at the March meeting."

While conceding that a hike is guaranteed, Goldman notes that two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening?


• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be?

As a result of the weaker than expected inflationary prints, Goldman believes the recent data do not call for a major change in the Fed’s policy outlook. While Hatzius expects the FOMC to lower its estimate of the structural unemployment rate by a tenth next week, even with that assumption, the new data have broadly offsetting implications for the policy outlook in standard Taylor rules. Highlighting recent Fed communications, Goldman believes the Fed will follow "a balanced approach in dealing with the dilemma."

It also means that the statement will likely characterize economic activity as "picking up but recognize that inflation slowed since earlier this year." On the other side, Goldman sees a signal of heightened inflation concern as the main dovish risk and an upgrade of the balance of risks as the main hawkish risk.

Previewing the Fed"s Summary of Economic Projections (SEP), expect a modest downgrade to GDP growth for this year, coupled with declines in the unemployment rate to 4.3% this year and 4.2% next year. At the same time, projections for core PCE inflation are likely to fall to 1.8% this year and probably 1.9% in 2018. Reflecting the offsetting data news, expect the “dot plot” to show relatively stable funds rate projections.

On to Yellen"s press conference, which should provide some clarity on whether the next tightening step after June will be balance sheet normalization or a third funds rate hike. Goldman, as well as much of the street, expects balance sheet adjustment to start in September and the Fed hiking cycle to resume in December. With respect to the balance sheet, the Fed will initially cap the amounts of securities that can run off in any given month of $10bn for UST and $5 billion for MBS, that rise over four quarters to caps of $40 billion and $20 billion, respectively.

* * *

Some more details. Here is Goldman on the current economic situation, and how it will be (mis)read by the Fed.

Another rate increase from the FOMC next week is now extremely likely. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The committee probably also still expects a total of three hikes and the start of balance sheet adjustment in 2017.  

But two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening? We expect both lower unemployment and inflation paths in the Summary of Economic Projections (SEP) but relatively stable funds rate projections as the labor market and inflation data surprises, in the words of San Francisco Fed President John Williams, roughly “wash out”.


• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be? We expect a detailed balance sheet announcement in September and a third rate hike in December but the reverse order is also plausible.

We believe both labor market and growth data in hand make a strong case for a rate increase next week and to remain upbeat about the outlook. Both our current activity indicator —down from 4.0% in February to 3.0% in May— and real GDP estimates—up from 1.2% in Q1 to our 2.3% Q2 tracking estimate—signal above-trend output growth (Exhibit 1, left panel). The medium-term growth outlook is also decent despite the lower odds of significant fiscal easing. The more important reason why growth should stay firm is the easing in financial conditions. Our FCI is at the easiest level since early 2015 and has  eased by 50bp since the March FOMC meeting. As the right panel of Exhibit 1 shows, the expected effect on GDP growth from changes in financial conditions for 2018H1 is now more than 0.3pp higher than at the March meeting.

Spare capacity continues to diminish, and the unemployment rate has fallen 0.4pp since the March meeting to a 16-year low of 4.3% (Exhibit 2, left panel). While nonfarm payroll growth has recently softened a bit, the average monthly gain of 162k year-to-date is still double our 85k estimate of the “breakeven” rate needed to keep the unemployment rate unchanged. While slack measures have declined more than expected, weak inflation data in April and especially March pushed the year-over-year pace of core PCE inflation 0.2pp lower than at the March Meeting (Exhibit 2, right panel). Both a Taylor rule framework and recent Fed communications suggest that the new data have broadly offsetting implications for the policy outlook.

Exhibit 3 translates the labor market and inflation surprises into changes in the appropriate funds rate via a standard Taylor rule framework. The original Taylor rule implies that a 0.2pp decline in inflation lowers the appropriate funds rate by 30bp while a 0.4pp reduction in the unemployment rate raises the appropriate funds rate by 40bp. In a modified “Taylor 1999” rule, the impact of employment is doubled  relative to the original version. This means that the impact of a 0.4pp reduction in unemployment rises from 40bp to 80bp. The left panel of Exhibit 3 thus suggests a 10-50bps higher appropriate funds rate.

But the decline in the unemployment rate may overstate the surprise if some decline was expected. Similarly, the decline in inflation can understate the surprise if some firming was expected. The middle panel of Exhibit 3 therefore compares actual unemployment and inflation moves to our expectations as of the March meeting and has less hawkish implications than the left panel. Finally, a lower estimate of the structural unemployment rate also reduces the decline in the unemployment rate gap. On net, we estimate the new data—combined with a 0.1pp downgrade of the structural rate—would have an exactly neutral effect in the Taylor 1999 rule that Chair Yellen has discussed repeatedly.

What has the Fed communicated in recent week.

Recent Fed communication suggests that the committee will also consider surprises on both sides of the mandate as roughly offsetting. As Exhibit 4 shows, several Fed officials have emphasized that there is now little labor market slack left. The inflation language in the May minutes was quite balanced as ”most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee’s objective may have slowed.”

Since the May meeting, inflation for April has been weak for core CPI (0.9% annualized) but roughly in line for core PCE (1.8% annualized). The April inflation reports and recent comments by some Fed officials including Chicago Fed President Evans suggest that additional signs of heightened inflation vigilance are a dovish risk relative to our expectations. Governor Powell said that “there are good reasons to expect that inflation will resume its gradual rise but it is important to demonstrate a strong commitment to achieving our symmetric 2 percent objective” while Philadelphia Fed president Harker said that “we’re still on track for inflation” and that he is “looking at the trend.”

In light of these developments we expect to the committee to make three key changes to its post-meeting statement next week. First, we expect the committee to replace “consumer prices declined in March” by “inflation slowed since earlier this year” reflecting the core CPI miss in April. Second, we expect the statement to upgrade the growth assessment with verbiage along the lines of economic activity “appears  to have picked up” and to note that household spending “appears to be accelerating”. Third, we expect the committee to tacitly signal balance sheet run-off later this year by adding the qualifier “for the time being” to the description of its existing reinvestment policy.

A signal of heightened inflation concerns is the key dovish risk. The committee may, for instance, drop the “somewhat” from “inflation continued to run somewhat below 2 percent”. In terms of hawkish risks, an upgrade of the balance of risks is possible through the removal of “roughly”, reflecting improved domestic and international growth. We also expect Minneapolis Fed President Neel Kaskhkari to dissent as he recently described the move of inflation in “the wrong direction” as “concerning”.

What about the revised Summary of Economic Projections

The June FOMC meeting will include the quarterly update to the SEP. We expect significant changes to the unemployment and inflation projections but relatively stable funds rate forecasts, reflecting offsetting job market and inflation news.

1. Slightly lower GDP growth: Assuming our Q2 GDP tracking 1. estimate of 2.3%, GDP growth will average 1.7% annualized over the first half of 2017, so it would take a 2.4% growth rate in H2 to meet the policymakers March SEP estimate of 2.1%. We expect the 2017 median to fall to 2.0%, with risk tilted to the upside. We forecast that the median estimates for GDP growth in 2018-2019 and in the longer-run will remain unchanged.

2. Lower unemployment rate. The unemployment rate fell 0.4pp since the March meeting when the median unemployment rate projection was 4.5% for the forecasting horizon. We expect the median to fall to 4.3% in 2017, 4.2% in 2018 (with risks of 4.3%) and 4.3% in 2019. The estimate of the structural unemployment rate is quite likely to fall further from 4.7% to 4.6% in response to large declines in the actual rate and recent news on prices and wages. The decline in NAIRU would limit somewhat the projected employment overshoot but is a close call.

3. Lower core PCE inflation. We expect the 2017 median core PCE projection to fall to 1.8% and perhaps 1.7%. To reach 1.8% by year-end, monthly core PCE inflation would need to accelerate to an annualized rate of at least 1.9%. We believe the 2018 forecast also drops a tenth to 1.9% as some members now likely feel a bit less confident about the inflation outlook.

 

4. Relatively stable median dots. We expect most participants, especially those in the center of the committee, to stick to their March dots reflecting offsetting inflation and unemployment moves. We also believe that the committee probably still expects a total of three hikes in 2017. The retirement of Tarullo lowers the numbers of participants to 16 from 17 in March and is likely to move up the median 2018 dot from to 3 to 3-1/2 hikes next year. As the FOMC is extremely likely to hike for the second time this year next week, we expect that the 2017 one-hikers will shift to projecting 2 hikes in total for this year. We also assume that the new Atlanta Fed President Bostic votes like his predecessor Lockhart and that the new Richmond Fed President Mullinix lowers the Richmond Fed dots a bit.

Finally, how will the Fed "renornalize" its Balance Sheet.

We expect to get some more clarity next week on balance sheet runoff at the press conference and possibly also with an augmented Policy Normalization Principles and Plan. We continue to look for normalization to be announced in September. Here we update our projections for balance sheet runoff:

1. Start Date: We expect a detailed announcement in September  but would not be surprised if it came in December as guidance has been mixed. The May minutes suggest a start in September as an announcement at the December meeting would leave little time to “begin reducing the Federal Reserve’s Securities this year”. But guidance on the start of runoff by Governor Brainard after the funds rate gets midway to its long-run value of 3.0% and by New York Fed President Dudley “sometime later this year or next year” supports December. We think that announcing the start of balance sheet adjustment in September and keeping open the option of foregoing the third 2017 hike is the more prudent course of action given the mixed recent data and the potential for fiscal turmoil in Washington in Q3 related to the need for a debt ceiling hike and an extension of spending authority. We think the detailed announcement in September will be followed by the actual start of runoff of assets in October.

2. Process for phasing out reinvestment: The May minutes signaled that the committee will preannounce a schedule of gradually increasing caps to limit the amounts of securities that can run off in any given month. Our assumption is that that the initial caps are $10 billion a month for UST and $5 billion a month for MBS. The caps would rise each quarter by $10 billion and $5 billion to $40 billion and $20 billion respectively. Exhibit 7 shows that caps allow for a gradual runoff and deal with the variability associated with MBS prepayment and the irregular monthly schedule of maturing assets. The caps will remain in place after the phase-in but then only bind in roughly a third of the months for Treasuries until mid-2020 when the balance sheet reaches its projected terminal size.

3. Terminal size: We expect the Fed to maintain a balance sheet that 3. is relatively large by historical standards given several advantages of a large balance sheet related to monetary policy implementation and regulatory needs. Our calculations suggest that a monetary policy implementation through a floor system implies a terminal size of roughly 15.5% of GDP. While support from the New York Fed for the large balance scenario makes this outcome quite likely, there is no urgency yet in deciding on the size and on the composition of the terminal balance sheet.

Goldman"s conclusion:

A third consecutive quarterly rate increase next week is now extremely likely, in our view. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The data news since March has sharpened the dual mandate dilemma policymakers are facing. Our own view is that the inflation and unemployment surprises have been roughly offsetting but that the range of outcomes has widened somewhat. While the inflation outlook is uncertain, the dilemma will most likely resolve itself as inflation gradually accelerates. We therefore expect policymakers to remain focused on tightening mostly with the funds rate but also soon with the balance sheet tool.

And while we agree with Goldman in theory, one thing the bank has omitted in principle is that according to the Fed"s own commercial loan data, the US economy may be just 4-6 weeks away from posting its first negative C&I loan print since the financial crisis: a virtually failsafe indication of an imminent (or concurrent) recession.

Which means that, as we explained yesterday, the Fed is about to hike in not only a disinflationary phase of the economic cycle (which is largely a function of the slowdown in the Chinese commoity bubble, and the collapse in the Chinese credit impulse), but also into what may be an outright recession in the US. If so, look for the yield curve to do what it has always done in the past after the Fed hikes rates: flatten, then flatten some more, than go horizontal, and eventually invert.

Goldman Pushes Back Rate Hike Forecast Citing Slowing Job Growth And Weak Inflation

After last month"s "much stronger than expected" jobs report, Goldman was convinced that the Fed would hike in June and September, while disclosing its balance sheet tapering announcement in December. However, after today"s disappointing jobs report, Jan Hatzius has flipped the last two, and says that he "now expects the third hike of 2017 to occur at the December meeting (we previously expected a hike in September and a balance sheet in announcement in December)."

The reason for the switch is that "the committee will prefer to wait for clarity on the outlook before implementing a third hike this year – particularly given signs of slowing job growth and the recent drop in core inflation."

Key excerpt:

Given the drop in the U3 and U6 unemployment rates and the lack of additional catalysts between now and the June meeting, we are increasing our subjective probability of a hike at that meeting from 80% to 90%. We are also moving forward our forecast for balance sheet normalization. We now expect the committee to announce a tapering of maturity reinvestments in September, and we now expect the third hike of 2017 to occur at the December meeting (we previously expected a hike in September and a balance sheet in announcement in December). This change reflects recent detailed discussion of the balance sheet among committee members, as well as our view that the committee will prefer to wait for clarity on the outlook before implementing a third hike this year – particularly given signs of slowing job growth and the recent drop in core inflation.

Expect the rest of Wall Street to jump on the bandwagon shortly,

Goldman Asks If Yellen Has Lost Control Of The Market, Warns Of Fed "Policy Shock"

Just hours after the Fed"s March "dovish" rate hike, when stocks paradoxically surged to all time highs and yields tumbled, Goldman found something strange: "surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices." Even more surprising is that according to Goldman, its financial conditions index, "eased sharply, by the equivalent of almost one full cut in the federal funds rate." In other words, the Fed"s 0.25% rate hike had the same effect as a 0.25% race cut!

Goldman"s Jan Hatzius then went on to note that this was "almost certainly not" the desired outcome that Janet Yellen had been going after, and that markets had in fact misread the Fed"s tightening intentions. The Goldman chief economist then asked rhetorically "how will the committee respond to this potentially undesired move" and answered "at the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time."

Nearly two months later, with stocks at new all time highs, and financial conditions even easier than they were the first time Goldman warned that the market had misread the Fed"s intentions, Goldman goes back to this most sensitive of topics and writes that despite two rate hikes and indications of impending balance sheet runoff, financial conditions have continued to ease over the past six months.

Despite two rate hikes and indications of impending balance sheet runoff, financial conditions have continued to loosen in recent months. Our financial conditions index is now about 50bp below its November 2016 average and near the easiest levels of the past two years.

Hatzius then asks if - in not so many words - the Fed has lost control of the market, or if the Fed will simply have to punish the market with a "monetary policy shock" to make it clear that the Fed demands tighter conditions to delay the next recession. To wit:

Does this mean that 1) monetary policy has lost its ability to affect financial conditions or 2) Fed officials just need to deliver more rate hikes if they want to bring about an FCI tightening?

According to Hatzius, "the answer is 2)" and that the Fed has not lost control of the market just yet. Which brings up another question:

If the Fed retains its ability to steer financial conditions, why have financial conditions eased recently despite ongoing hikes? The answer is that Fed policy—especially Fed policy communicated around FOMC meetings—only accounts for a relatively small part of the ups and downs of financial conditions. And other developments such as the sharp pickup in global growth have been helpful for US financial conditions by boosting risk assets while keeping the US dollar from appreciating sharply in response to higher short-term interest rates. While it is difficult to say whether future non-monetary policy shocks will be positive or negative for US financial conditions, our finding that the impact of Fed policy on financial conditions remains (at least) similar to the longer-term average suggests that Fed officials should be able to achieve their goals for financial conditions by moving the funds rate if they try hard enough.

Fed Policy Retains Sizable Impact

What Goldman really meant to say is that the Fed"s 50 bps in rate hikes since December have been drowned and offset by the trillions in new credit created out of China. That credit expansion is now ending however, and China"s credit impulse has tumbled into negative territory (but that"s a different topic).

Going back to Goldman, Hatzius adds that "we find that the sensitivity of financial conditions to monetary policy shocks has been quite high recently, at least when we identify these shocks using bond market moves around FOMC meetings. This suggests that the easing of financial conditions is due to other factors, most obviously the improved global environment, not reduced traction of monetary policy."

What form will this monetary tightening "shock" take place? "

Our best (though uncertain) answer is that the committee will need to deliver 50-75bp more hikes per year than priced in the forwards to stabilize the economy at full employment. This is roughly consistent with our current funds rate call that we will see an average of 3-4 hikes per year through the end of 2019, compared with market pricing of just over 1 hike."

Of course, if Goldman is wrong and the Fed has no intention of sending risk assets into a tailspin with a monetary policy "shock", then there is no saying just how much further the combined effort of China"s gargantuan, if cooling, credit expansion, coupled with the "dovishly" hiking Fed can take stocks. However, by now it is becoming clear to even the most resentful permabulls - and even Goldman  - that the longer the Fed delays the day of reckoning out of pure fear of the unknown, the greater the chaos and loss in asset values when the Fed no longer has the luxury of picking when to pull the switch.

"This Is Not The Reaction The Fed Wanted": Goldman Warns Yellen Has Lost Control Of The Market

With stocks soaring briskly around the globe following Yellen"s "dovish" hike, and futures set for a sharply higher open with the Nasdaq approaching 6,000, something surprising caught our attention: in a note by Goldman"s Jan Hatzius, the chief economist warns that the market is overinterpreting the Fed"s statement, and Yellen"s presser, and cautions that it was not meant to be the "dovish surprise" the market took it to be.

Specifically, he says that while the FOMC delivered the expected 25bp hike, with only minor changes to its projections. "surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices."

Even more surprisng is that according to Goldman, its financial conditions index, "eased sharply, by the equivalent of almost one full cut in the federal funds rate."

In other words, the Fed"s 0.25% rate hike had the same effect as a 0.25% race cut!

The implication from the market"s reaction is that at current levels, financial conditions are poised to make a substantial positive contribution to growth in 2017, from a starting point of essentially full employment, inflation close to the target, and a sub-1% funds rate; which in light of concerns about an economic overheating due to Trump"s fiscal policies is precisely the opposite of what Yellen wants. Hatzius warns that "the FOMC will lean against this, and will deliver more monetary tightening than discounted in the bond market."

It gets better: Goldman"s chief economist - like virtually all other carbon-based market participants - admits he was stunned by the market reaction to the Fed rate hike. While Hatzius agrees that the general direction of the market response makes sense, "the magnitude greatly surprised us" and adds that Wednesday"s price action was scored by Goldman"s models "as the third-biggest dovish surprise at an FOMC meeting since 2000, at least outside the financial crisis."

And the punchline: when asked rhetoricall if "the FOMC was aiming for this outcome?", Hatzius says "No, almost certainly not."

The committee may have worried that a rate hike—especially a rate hike that was not priced in the markets or predicted by most forecasters as recently as three weeks ago—might lead to a large adverse reaction on the day, and wanted to avoid such an outcome by erring slightly on the dovish side. But we feel quite confident that they were not aiming for a large easing in financial conditions. After all, the primary point of hiking rates is to tighten financial conditions, perhaps not suddenly but at least gradually over time. And even before today’s meeting, at least our own FCI was already fairly close to the easiest levels of the past two years and this was likely one reason why the committee decided to go for another hike just three months after the last one.

In other words, whether on purpose or otherwise, according to Goldman the Fed, which now wants to tighten financial conditions (i.e., see asset prices lower) not only achieved the opposite, but has now lost control of the market.

So "how will the committee respond to this potentially undesired move?"

At the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time.

Our modal forecast remains for a total of three hikes this year, with remaining moves at the meetings in June and September, followed by four hikes each in 2018 and 2019. We see a 60% subjective probability that the next hike occurs at the June 2017 meeting, 10% for July, and 20% for September. We also expect an announcement of gradual balance sheet rundown in December; if this does not occur, the likelihood of a fourth 2017 hike would increase.

Of course, if the first of two, three or four rate hikes in 2017 is any indication, the market, already sloshing in trillions of excess liquidity, will simply take the Fed"s next tightening as an indicator of easing, and send risk assets to even more obscene highs.

* * *

Here is the full Q&A from Hatzius on why following the Fed"s 3rd rate hike in a decade, "Financial Conditions Move in the Wrong Direction":

Q: What surprised you at today’s FOMC meeting?

A: There were certainly a few dovish surprises, relative to both our expectations and our read of the consensus. First, none of the FOMC participants who projected three hikes or less for 2017 in December seems to have moved to four hikes or more; we expected two participants to move up, and some forecasters had even projected an increase in the median to four hikes. Second, the Fed’s estimate of the structural unemployment rate declined by a tenth to 4.7%; this coincides with our own estimate, but we didn’t expect the committee to make this move today. Third, we did not expect Minneapolis Fed President Kashkari to dissent in favor of unchanged rates, and we don’t think others did either. Fourth, the explicit statement that the inflation target is symmetric also came as a surprise, to us and likely others. And fifth, the statement was modified to say that the committee looks for a “sustained” return to 2% inflation.

Q: So was it a big dovish surprise overall?

A: It didn’t seem like it to us. First, the surprise in the dots, while real, seemed fairly small compared with past SEP meetings, with no changes in the median number of hikes in 2017 and 2018 or the median long-term funds rate. Second, the structural unemployment estimate moved only 0.1 point, has been trending down for several years, and is still above the committee’s forecast for the actual rate. Third, the predictive power of dissents from regional Fed presidents—especially dissents against a move that the committee is making, as opposed to dissents in favor of a move the committee has not yet made—is limited. Fourth, Fed officials have often noted that their inflation target is symmetric; moreover, the move seemed to be “defensive” in nature, as Chair Yellen noted in the press conference that it was designed to take the sting out of the recognition that there is no longer a sizable “current shortfall” in inflation. And fifth, the word “sustained” may have been equally defensive in nature, clarifying that a temporary rise in (headline) inflation to 2% or more is not, on its own, sufficient to meet the committee’s goal.

Moreover, there were also a few slight hawkish surprises. First, in the press conference, Chair Yellen declined the invitation to give much meaning to the word “gradual”; in fact, she noted that “…rates were raised at every meeting starting in mid-2004, and I think people thought that was a gradual pace, measured pace…” although she hastened to add that the committee is not envisaging “anything like that.” Second, the median pace of hikes in 2019 rose to 3½ from 3. These are minor, but they illustrate that not all the news was dovish.

Q: So what do you make of today’s market response?

A: The direction makes sense, but the magnitude greatly surprised us. As shown in Exhibit 1, our factor model for discerning monetary policy surprises from the co-movement of different asset prices scored today"s price action as the third-biggest dovish surprise at an FOMC meeting since 2000, at least outside the financial crisis. (The only two non-crisis meetings that were clearly bigger were the August 2011 move to calendar guidance and the September 2013 decision not to taper QE; the March 2015 and March 2016 cuts in the dots were similar to today’s move.) And as shown in Exhibit 2, our FCI eased by an estimated 14bp on the day—about 2.3 standard deviations and the equivalent of almost one full cut in the funds rate—and is now considerably easier than in early December, despite two funds rate hikes in the meantime. Our interpretation is that markets must have been positioned for much more hawkish news than we had thought.

Exhibit 1: According to Our Factor Model, This Was a Large Dovish Surprise

Exhibit 2: Our FCI Has Reversed Most of the Recent Tightening

Q: Do you think the FOMC was aiming for this outcome?

A: No, almost certainly not. The committee may have worried that a rate hike—especially a rate hike that was not priced in the markets or predicted by most forecasters as recently as three weeks ago—might lead to a large adverse reaction on the day, and wanted to avoid such an outcome by erring slightly on the dovish side. But we feel quite confident that they were not aiming for a large easing in financial conditions. After all, the primary point of hiking rates is to tighten financial conditions, perhaps not suddenly but at least gradually over time. And even before today’s meeting, at least our own FCI was already fairly close to the easiest levels of the past two years and this was likely one reason why the committee decided to go for another hike just three months after the last one.

Q: How will the committee respond to this potentially undesired move?

A: At the margin, it will likely make them more inclined to tighten policy. Using today’s estimated close, our FCI impulse model now implies a boost of about ½pp to real GDP growth in 2017, from a starting point of roughly full employment and inflation close to the target. So further FCI easing implies at least some risk of economic overheating—which in turn would increase the risk of recession further down the road. We expect the committee to lean against such an easing over time.

Q: So what do you expect from the Fed for the rest of 2017?

A: Our modal forecast remains for a total of three hikes this year, with remaining moves at the meetings in June and September, followed by four hikes each in 2018 and 2019. We see a 60% subjective probability that the next hike occurs at the June 2017 meeting, 10% for July, and 20% for September. We also expect an announcement of gradual balance sheet rundown in December; if this does not occur, the likelihood of a fourth 2017 hike would increase. At the margin, today’s FCI move has increased our conviction that the committee will need to deliver more tightening than priced in the markets at this point.

RBC: "The Fed Is Now Forced To Walk Back The Market's Incorrect Dovish Interpretation"

First, it was Goldman"s chief economist Jan Hatzius, who in a fascinating note explained why the market has totally misread the Fed"s tightening intentions, claiming the market surge is "not the reaction the Fed wanted", alleging that the market"s dramatic "easing" response was "not the outcome the FOMC aimed for" and concluding that "at the margin, it will likely make them more inclined to tighten policy", a polite way of saying that the Fed may now not be behind the inflationary curve, but that it is certainly behind when it comes to "explaining" to the market that it has run ahead of itself.

Now, in a follow up note, RBC"s head of cross-asset strategy makes the exact same point as Goldman, and warns that "the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher."

And since Goldman still has a direct hotline, both literal and symbolic, to former Goldman employee Bill Dudley who is in charge of the NY Fed, it would not be surprising if during the Fed"s next public appearance, an FOMC member makes it very clear that having both of its core original mandates, inflation and emloyment, supposedly under control, it is now taking on the 3rd one - preemptive market stability, by making sure that risk assets are halted in their bubbly tracks.

Below are the key excerpts from today"s note by RBC"s Charlie McElliggott:

FED CREATES MORE ROPE TO HANG THEMSELVES WITH

#HOTTAKES:

• Despite hiking, the Fed missed a major opportunity to play “catch-up” without disrupting the market—as price-action showed that investors were clearly prepared for ‘hawkish’ outcomes.


• Instead, the FOMC / Yellen’s commentary (in light of the above ‘hawkish positioning’ dynamic) actually created EASIER / LOOSER financial conditions, with real rates collapsing lower on the session.  This will make the eventual exit-process that much more difficult—thus, “more rope to hang themselves with.”


• With Yellen noting that the Fed intended to keep its policy accommodative for “some time”—in conjunction with the overly simplistic market take on the lack of movement in the average dot (FAR more nuanced than that) and the ‘hawkish’ buy-side positioning--the Fed also created significant (under)performance frustration across many strategies yesterday, with the exception of a 2 standard deviation ‘+++’ day for many risk-parity portfolios (which essentially run ‘short convexity’ long only cross-asset books, which are now likely to be in-process of ‘levering-up’ off of the ‘vol crush’).


• For the above reasons, I believe the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher.

COMMENTARY:

So the Fed hiked….and nominal rates gapped lower, breakevens traded higher, real rates collapsed, and financial conditions LOOSENED.  Why?  To me, the moves were largely positioning-related, being caught wrong-footed inherently with regards to ‘expectations.’  I do not believe the Fed intended this to be a dovish message, and they are going to have to clarify this to the market in coming weeks, in turn risking / creating more volatility.  There is a fixed-income short / ED$ steepener to be laid-back-out soon. 

To sum up the ‘by-and-large’ client reaction to yesterday’s post-Fed response (with a touch of relief from the Dutch election sprinkled-in) on a scale of 1 to 10, I’d say the buy-side gave it a “MEHHH.”  Optically and absolutely, yesterday WAS of course a day of positive performance for many funds long risky assets, considering SPX +20 handles, EEM +2.6% (+2 SD move), IWM +1.6% (+2 SD move), HYG +1.4% (+3 SD move), LQD +0.9% (+2.6 SD move) et cetera. 

Instead though, it felt ‘empty’ or like a missed performance opportunity for many, because despite your longs doing ‘okay,’ many of your shorts were up just as much, if-not-more.  And regarding the longs, the stuff that did ‘really well’ yesterday is generally underweighted OR in many cases, has recently been pared-back (i.e. cyclical beta equities).  Case-in-point, look at this example within the equities space:

• HF VIP Longs + 0.7% against HF VIP Shorts +0.7%


• High HF Concentration +0.9% against Low HF Concentration +1.0%


• MF Overweights +0.6% against MF Underweights +1.0%

Ugh.

This was an interesting rally because it looked like the old “QE”- varietal, where the interpretation of anything ‘dovish’ (in this case ironically it was a dovish HIKE via a simplified read basically that "unch on median / average dot" countered the recently hawkish momentum / rhetoric / data) actually sent UST"s sharply higher (TY largest ‘up’ day since June ’16) / rates sharply lower / USD sharply lower (BBDXY a -3 SD move lower and largest ‘down’ day since July ’16).  Real rates lower = easier financial conditions = Risk-on, Vol smoked = ‘short convexity’ vol trigger strategies likely driving mechanical re-levering.

The real news to me in the Fed message was two-fold:

• First, the dot shift was beautifully spotted by Mark Orlsey and Tom Porcelli going-into the event.  Looking at the simple scale of the absolute move in the average- or median- dot simply doesn’t ‘cut it’ in the case of “what is to come”—it is far more nuanced.  As such, the takeaway I think the market has initially-missed was the fact that the marginal dot ‘shift higher’ came from the bottom of the plot—i.e. IT WAS THE MOST DOVISH FED MEMBERS WHO UPPED THEIR DOTS.  This dynamic is going to have to be ‘trued-up’ in coming months considering the data trajectory (new 5 year highs in Bloomberg US Econ Surprise Index yday) and is likely to be a source of interest rate-driven cross-asset volatility.


• The second notable takeaway from yesterday was Yellen’s very modest backing-away from prior comments made from Fed officials regarding an absolute-level FF rate (1.00%) acting as a ‘trigger’ for cessation of reinvestments to shrink their balance sheet.  This is important bc again, Fed members have made this a point of focus going-forward, and their time-horizon window is shrinking now.  From a markets perspective within the mortgage space, losing the ‘buyer of last resort’ (into the daily Fed buybacks) will cause ripples, because if rates are going higher against you as a MBS trader—which is inherently a negatively convex product—you HAVE TO hedge by hitting TY.  This is a down-the-road discussion (now a 2018 story), but again will be a source of rate volatility in the future that could be ‘disorderly.’

Regardless of the medium- / long- term potentials…as such with the rates collapse lower on the day, duration sensitive equities were a large part of the equities leadership—e.g. defensives, divy yielders, low vol types like reits, utes, telcos (outside of energy sector with crude"s relief rally), while mega-allocations in tech, consumer discretionary and financials were, relatively speaking, "dead weight" and lagged index.  Of course too, the other leadership driver in stocks was the ‘reflation stuff’ that’s been ‘getting pitched’ over the past month like steels, metals & mining, oil services, E&Ps, high beta materials and industrials etc.  That stings for the majority of equity funds with regards to their current sector allocations, long ‘secular growth’ after reducing a fair bit of their "cyclical beta"‎ / value exposure in 1Q17. Much of yesterday’s leadership was curious ‘late cycle’ stuff, which o/p ‘early cycle’ by an astounding~140bps:

Obviously, the above dynamic is especially frustrating for many equity HF"s.   When you see the broad SPX tape + 0.8%, Russell 2k +1.6 and R3k‎ +0.9% but as a long / short you were only able to eek-out 40bps to 50bps simply due to you net long exposure, it stinks.  Even worse, mkt neutrals strats which simply don"t work in "gap higher" tapes. ‎

‎Bigger picture macro, the rates move spanked fixed-income shorts, while the Dollar crush crunched longs (especially against GBP, EUR and select EM).  Another “ouchy.”  And think about the initial "trump reflation" worldview themes from 4Q16 where it was Emerging Markets that was viewed as the "biggest loser"...and now is the "high flyer" (EEM +12.3% YTD) as the protectionist rhetoric is ‘walked-back’ (Navarro comments yday) and some thinking (benevolently) that US growth is soon to be the "higher water which will raise all boats."  Long EM over DM is now one of the most popular strategy calls going, FWIW.

But was yesterday really about US growth—was that really the case‎?  I"d say that in light of the recent ‘trend trades’ and positioning dynamics, a day where you see fixed-income, (long) duration-sensitives, defensives, low vol, late cycle and EM leadership ‘run higher,’ it speaks to folks looking to buy the "stuff that"s been left behind" in a classic “PM exposure grab” style, yelling to his trader "find me some cheap stuff!"  More "lottery ticket" mode than anything else, as evidenced by GDXJ (Jr Gold Miners ETF) finishing +11.5% higher on the day yesterday--a +3.1 SD-move. ALL OF THE LULZ.

As far as the current framework / narrative we’ve been operating under since midyear ’16, it shouldn"t be lost on anybody that this wasn"t a “higher growth = higher nominal rates = equities rally" which has obviously been the story of all global markets since secular lows for rates were put in last summer.  It was instead an ‘easier conditions,’ central bank driven rally of old QE-era.  As described above, this felt a lot more like “...greedy, not growth-y.”  

I think there"s an important message in there.

RBC US ECON TEAM SHOWS 2017 DOT SHIFT WAS ACTUALLY ‘HAWKISH’:

MARK ORSLEY SHOWS 2018 DOT SHIFT WAS ACTUALLY ‘HAWKISH’ / HIGHER AS WELL: