Trump Expected To Announce His Pick For Fed Chair In Next Two Weeks

In the latest update on Trump"s search for the next Fed Chair, Reuters reported that the search has narrowed down to 5 finalists - Yellen, Warsh, Taylor, Powell and Cohn (condolences to Jeff Gundlach: his dark horse candidate, Neel Kashkari did not make the cut) - and that after meeting Yellen on Thursday, Trump will have discussed the Fed job with all five candidates. More importantly was the news that Trump is expected to announce his decision for next Fed Chair in the next 2 weeks, before he leaves for his Asian trip on November 3.

• YELLEN, WARSH, TAYLOR, POWELL AND COHN ALL CANDIDATES FOR FED CHAIR -WHITE HOUSE OFFICIAL


• FED CHAIR SEARCH NOW NARROWED TO FIVE FINAL CANDIDATES, WHITE HOUSE OFFICIAL SAYS


• AFTER YELLEN MEETING, TRUMP WILL HAVE DISCUSSED FED JOB WITH ALL FIVE FED CANDIDATES -WHITE HOUSE OFFICIAL


• TRUMP EXPECTED TO ANNOUNCE FED DECISION BEFORE HE LEAVES FOR ASIA TRIP NOV. 3 -WHITE HOUSE OFFICIAL

Yesterday, the USD and bond yields turmoiled briefly following news that Trump had warmed to the candidacy of San Fran professor John Taylor, father of the Taylor Rule and advocate of rules-based monetary policy, and who is widely perceived as a mega hawk. The news sent the USD surging and hit bonds.

That said, Taylor"s hawkishness appears to have worked against him, and after surging to 2nd spot on Predictit yesterday, Taylor was tumbled to 4th spot this morning.

That said, Taylor"s hawkish reputation may be unwarranted. As SocGen"s Kit Juckes wrote this morning, what rate the Taylor Rule indicates is dependent on a variety of assumptions. To wit:

President Trump is reported to have taken away a favourable impression of John Taylor after he met the Stanford University economist and inventor of the ‘Taylor Rule". As the President ponders who to appoint as the next Fed Chair, he now only has Janet Yellen to meet with, and Professor Taylor is the new market favourite. That, in turn, has given the dollar a bit of support and sent yields a bit higher as everyone contemplates what the Taylor Rule would imply for monetary policy. It"s generally concluded that a rules-based approach would deliver higher rates faster than we would see under the current policy framework.

Anyone armed with a Bloomberg terminal can type in TAYL GO and see where a Taylor rule estimate of appropriate rates is, and if they want, they can play with the critical elements of the rue - the estate of ‘neutral" real rates, NAIRU, and the inflation target. On the basis of a 2% neutral real rate, and a 4% NAIRU, the Fed is a long way behind the curve, which may be reason enough to think that a Taylor Fed would be more hawkish. On the other hand, lower the NAIRU (which may be reasonable given what we"ve seen from the labour market data in recent years) and you can get that estimate down. A 3% NAIRU throws out a 1.5% Funds rate, for example. And if Professor Taylor really wants to fine-tune his rule, he can head down the road from Stanford to the San Francisco Fed, 36 miles away, and have a chat with Stanford alumni and head of the San Francisco Fed, John Williams. He developed an estimate of neutral rates with Thomas Laubach, which moves over time and is currently at -0.2%. See Professor"s comments on a debate about that here . Plug Williams-Laubach"s R* into Bloomberg"s TAYL function with a 4% NAIRU and rates ‘should" be 0.5%. Now cut NAIRU to 3% and we"re at -0.75%. By way of indication, I"ve plotted some variants of this below, though I haven"t adjusted the Wiliams-Laubach R* all the way through the time series so they are only relevant in the recent past. The lesson is clear however - the rule"s just a rule, it"s how it"s used that matters.

Choose your rule - but neither R* or NAIRU are necessarily constant through time

For now, however, Taylor"s hawkish reputation precedes him, and - for a president who realizes he needs rates as low as possible for as long as possible - that will hardly boost Taylor"s application. In fact, as we noted yesterday, the most likely outcome at this point is that Trump simply asks Yellen to continue for one more term.

Riding The ‘Slide’: Is This What the Next Bear Market Looks Like?

Submitted by ffwiley.com

Even as the Fed’s decision makers are beginning to worry less about recession and more about bubbly stock prices, we’re not yet moved by their attempts to curb the market’s enthusiasm. After all, the fed funds rate sits barely above 1%, which not too long ago qualified as a five-decade low. And other indicators, besides interest rates, aren’t exactly predicting the next bear, either. Inflation is subdued, credit spreads are tight, banks are mostly lending freely and the economy is growing, albeit slowly. It just doesn’t feel as though we’re close to a major market peak.

All that being said, we’re not so much about feelings as we are about delving into history (nerds that we are) and seeing if there’s anything we can learn. Let’s look at the last 90 years to see if any bear markets began under similar conditions to those today.

We’ll consider thirteen bears, as listed in the table below. (Our list may be different to yours, mainly because we use Robert Shiller’s monthly average S&P 500 prices, instead of daily prices, but also because we reset the cycle whenever the market falls 20% from a peak or rises 20% from a trough.)

Next we narrow the list by excluding bears that began during recessions, because we don’t think the economy is recessing as I write this (or recessing imminently—see here.) That removes the first three bears—those that began in 1929, 1930 and 1932. Every other bear began as the economy was expanding, which explains why market peaks are so difficult to predict.

We also exclude the bear that crossed the 20% threshold in June 1940 and can’t be separated from geopolitics. Hopefully, modern geopolitical risks won’t explode as they did then, but we can always return to the “WWII bear” if WWIII breaks out (presuming we’re alive and blogging).

After the exclusions, nine bears remain. We examine each one to determine how many were predicted by rising inflation, one of the strongest bear-market indicators. Rising inflation erodes purchasing power, invites monetary restraint and unsettles both lenders and investors. Judging by the next chart, it helped trigger at least seven of the nine bears:

The chart shows seven bears emerging from an inflation “shock” of 3% or more (referring to an increase from twelve months before a market peak to when stocks reached the bear market threshold of –20%). In each of those cases, it seems pointless to attempt to draw parallels to today. Inflation is currently below 2% and down almost a percent from January. Without an inflation shock in sight, we shouldn’t rely on the seven “inflation bears” to predict the future.

That leaves two bears we haven’t yet considered. In one of the two—the bear that began in August 2000—inflation contributed to the market’s reversal, but monetary policy and credit conditions were more telling. Policy rates rose, credit spreads widened and bank lending standards tightened—all before the market peak. Market conditions at that time were quite different to those today, as shown in the table below (which also includes the October 2007 peak for added context):

In other words, twelve of the original thirteen bears emerged from some combination of recession, inflation, world war, monetary tightening, and troubles in credit markets. In each case, market conditions were uglier than they appear now. The twelve bears tell us to be optimistic—they’ll continue to hibernate until conditions worsen. But we’ve yet to consider the 1962 bear, which finally supplies a potential match for today.

The lead-up to the 1962 bear looks eerily similar to 2017. Commentators called it the Kennedy Slide. Before the Slide, the market hadn’t fallen 20% on a month-average basis since 1946. And the bull gathered speed after JFK won the presidency. Sound familiar? Here’s a chart comparing the S&P 500 (SPY) in the three years after Kennedy’s election to the first ten months after Donald Trump’s election (there’s a joke somewhere in the respective trajectories, but we would like to keep our G rating):

Conclusions

The Kennedy Slide offers a reasonable guide to how a future bear could develop if key indicators remain benign. Consider that the Slide defied four fundamentals you wouldn’t normally associate with falling stock prices:

• Inflation was subdued, peaking at 1.3%.


• Monetary policy was close to neutral, with the discount rate at 3%.


• Growth was strong, reaching 7.4% in Q1 1962 and 4.4% in Q2, after Q4/Q4 growth of 6.4% in 1961.


• Credit spreads were testing 18-month lows of just above 1% (for the Moody’s Baa Corporate versus the 10-year Treasury).

Surely those cozy fundamentals explain the market’s rocket-fast recovery. Stocks reached a new all-time high in September 1963, just 21 months after the prior high. That’s the shortest period on record from one all-time high through a bear market to the next all-time high—faster even than the recovery from the 1987 crash.

And what might 1962 tell us about the future?

Well, as of now, inflation, monetary policy, growth and credit are only marginally less cozy than they were then. If that continues, we would bet on a rapid recovery from a Trump Slide, should one occur. But it’s important for inflation, monetary policy, growth and credit to remain nonthreatening. Any of those fundamentals could change rapidly, and they tend to correlate. (We expect monetary policy to be a particular risk within a couple of years, as discussed here.) Should the four fundamentals deteriorate, we would ignore the 1962 bear and turn to other bears for clues about what happens next. Considering the unprecedented period of monetary stimulus, we would then expect an ill-tempered bear, one that might resemble the bears that began in 1930, 2000 and 2007.

When we pass the next market peak, in other words, four key fundamentals should tell us whether we’ll “ride the slide” or experience something much worse.

Pound Surges To One Year High After Carney Says He Is "Among Majority" Expecting Tighter Policy

Having surged earlier in the day following an unexpectedly hawkish BOE statement, moments ago GBPUSD jumped to fresh session highs after BOE Governor Mark Carney said the pound"s decline is boosting prices, and added that he’s among the majority of MPC with view that policy may need to be tightened in coming months.  Some other comments:

• CARNEY SAYS HE SEES SHIFT IN BALANCING ACT FOR BOE


• CARNEY SAYS WE WILL TAKE DECISION ON RATES BASED ON DATA


• CARNEY SAYS POSSIBILITY OF A RATE HIKE HAS DEFINITELY INCREASED


• CARNEY SAYS TALKING ABOUT A MODEST ADJUSTMENT IN INTEREST RATES

The jawboning, which in typical central banker fashion was not accompanied by any action, sent cable to session highs just shy of 1.3400...

... and the highest since last September.

Adding to the urgency, is a note from Goldman in which the bank has revised its call, and instead of seeking a first rate hike in Q4 2018, Goldman now expects it to take place in November. The full note:

European Views: BoE — on hold, but greater urgency in its tightening bias. We change our call to a November hike

• The BoE"s MPC voted 7-2 to leave Bank Rate unchanged (at 0.25%) at its September policy meeting. Mr McCafferty and Mr Saunders continued to vote for an immediate rate increase.


• All MPC members agreed that "monetary policy could need to be tightened by a somewhat greater extent over the forecast period than current market expectations". But in a key hawkish development relative to what we expected, "a majority of MPC members" signalled that they have a bias towards tightening policy "over the coming months".


• The bias to tighten policy in coming months is based on "the prospect of a continued erosion of slack and a gradual rise in underlying inflationary pressure". It would require some downside news to discourage the MPC from raising rates in coming months.


• We change our call to expect a 25bp rate rise in November, rather than a first rate rise in 2018Q4. We do not change our fundamental outlook for the UK economy. We view today"s communication as hawkish news on the BoE"s reaction in the face of a broadly unchanged outlook. After November, we expect the next subsequent rate rise in 2018Q4.

In parting we will just say that the BOE has been here many times before, with Carney warning of imminent rate hikes as far back as 2014. We are still waiting...

A Thought Experiment On Why Wages Are So Weak

By Steven Englander, head of research and strategy at Rafiki Capital Management

I propose a microeconomic rationale for why macro wage performance is so weak, despite tight labor markets. The idea is that we are getting paid less for our job-specific knowledge because technology is making it easier to replace us without major loss of productivity with less skilled workers. The implications for markets:

• Flattish Phillips curve and low wage inflation continue for an indefinite period


• Living standards may increase because of lower price relative to wages, not higher wages relative to prices


• Monetary policy will have to get on with dealing with a low inflation economy -- this means setting aside obsessions about balance sheet reduction and setting up the facility to use fiscal policy as needed when the zero bound is approached


• It’s relatively positive for equities in innovating sectors


• Long-term bond yields will be driven by monetary policy fears, not long-term inflation worries


• Short-term policy rate moved will be capped by the sensitivity of the economy to interest rates which may not be large. Note that this cuts both ways – both tightening and easing may be ineffective.

The thought experiment

My idea is that wages are driven by how scared your boss is that you are going to leave. If replacing you, retraining your successor and waiting for him to climb the experience curve is costly, he will pay a lot to keep you from leaving. If you are a cog in a wheel, then he won’t care much.

Imagine an economy of a bus driver, a taxi driver, a cook, a translator, a baby sitter, a doctor and a foreign exchange strategist.... Conceptually you can measure average job specific content by asking the following question: if you randomly reallocated jobs among these workers how much would productivity fall? For example, if the FX strategist was given the cook’s job and the cook became a doctor and the doctor a taxi driver and so on, what would happen?

Say in Economy A, there is specific knowledge or character traits needed: a bus driver needs the specifics of driving a bus safely, a taxi driver knowledge of the street grid, the translator an excellent command of relevant languages, the baby sitter some proven degree of responsibility, the cook of recipes and technique, the doctor the body of medical knowledge, the FX strategist how to say ‘current account’ and so on. Now imagine the chaos and productivity loss, if the random reallocation occurred and none of the occupants of new jobs had the required skills.

Now, say in Economy B, the bus is programmed to avoid dangerous manoeuvres, all taxi drivers have a GPS (unlike NYC where none seem to), the translator has automated translation at his fingertips, the baby sitter is aware the house and liquor cabinets are cameraed, the cook has a set of packets to mix (or almost equivalently the packets are sent to your home for you to mix), the doctor a diagnostic program and the FX strategist a chatty virtual assistant that can say ‘current account’. If a random job reallocation occurred in this economy the productivity loss would be much less. My conjecture is that wages would be lower
because there would be no need to bid to retain workers if they were readily substitutable, or if the same jobs could be filled with less specialized workers with no major productivity loss.

Wage compression is very likely to be a feature in Economy B relative to Economy A – that is, the premium one receives for job specific knowledge and experience would fall. If you throw in a bit of capital saving technological progress from the sharing economy and economies of scale from the low marginal cost of replicating many IT-based innovations, you could end up with a kind of immiserization of parts of the skilled and semi-skilled working classes.

Evidence is partial, but it is not straight forward to test this speculation. Figure 1 shows wage levels in selected industry groupings. Note that wages in motor vehicles and parts (bright blue) started way above over industries, but is now average for durable goods (red line) and below education and health services (green line) which started way below. Motor vehicles and parts are now way below the average wage in the private sector, having started above 50% higher in the 1990s.

In Figure 2 we index these industries to 100 in 2000. We note that wages in leisure and hospitality (light blue) and education and health (green) have both grown faster than in durables manufacturing (red) and above the average for all private industries. Vert similar patterns emerge if we index to 2011.

So wages have grown slower in high paying industries, faster in low paying industries and the net is the mediocre observed wage growth. What isn’t consistent is Atlanta Fed wage evidence that suggests the quit rate is back to normal for this time of the cycle and the wage premium for quitters is as high as it was in the early 2000s. The other side is that the Atlanta Fed data shows the gap between increases of skilled and unskilled workers as having narrowed.

Macro/market implications

The problem for central banks is that we know little of what triggers such shifts in labor market power, how long they last and what ends them. As long as these shifts persist, the Phillips Curve will look flatter in  two-dimensional Unemployment Rate/Wage Inflation space. A well-specified wage equation that account for such structural changes would have a steeper inflation/unemployment trade off than one without the term but capturing the effects we discuss above is not so easy.

The type of technological progress would imply lower price pressures because the wage weakness would be transmitted in part into prices. (Full disclosure, you have to believe that there is an unmeasured component of actual productivity change here, although it may show up as quality-adjusted labor productivity, rather than standard output per-worker or worker-hour).

These disinflationary pressures may be hard to fight. Combine this with investment that is not overly responsive to interest rates and you have a situation where getting the inflation that you want may be impossible without risking undesirable levels of asset price inflation. It sounds as if the Fed is already there. There is nothing inevitable about this outcome, but it emerges easily if the disinflationary pressures are strong enough and the interest rate responsiveness is low enough.

One policy response is to live with it. Ultra-low inflation countries such as Japan and Switzerland have done just fine by many measures and the zero bound becomes an issue in a recession, not during an extended recovery. By ignoring it you have some ability to rein in asset market exuberance, but you are compromising on inflation and possibly activity targets.

This does not necessarily stop you from raising rates, but you are faced with a dilemma. If raising rates is effective you end up with the downturn you wanted to avoid, if raising rates is ineffective you are fooling
yourself in thinking that the margin versus the zero bound means that you are all clear in the next downturn. Being able to raise policy rates to three percent without tanking the economy very likely means that you can cut them in the next recession, you won’t have much of an impact. Hawks would argue that reducing the risk of a financial market bubble reduces the risk of a recession down the road.

It seems to me that whichever way you turn, fiscal policy has to be taken out of the doghouse. Post election, Fed officials reversed their pre-election love affair with fiscal policy, arguing that the economy does not need it. One might say that if the inflation undershoot turns out to be persistent, fiscal policy will become even more necessary to offset structural pressures. And if you think that high liquidity is contributing to asset market ebullience, then a bit of fiscal stimulus combined with monetary tightening can maintain activity and unwind some of the asset market pressures.

Modest long-term price pressures are probably positive on the fixed income side. Long-term disinflationary pressures and modest investment will keep downward pressure on long-term bond yields even if the Fed tightens at the short end in response to fiscal policy. The use of fiscal likely means being more relaxed about the size of the balance sheet. Debt-to-GDP would have to grow both cyclically and structurally, but debt servicing may not grow very rapidly because of the low inflation and the Fed’s interest income being recycled back to the Treasury. Short-term policy rates may swing around a lot versus stable but relatively low long-term rates.

The central bank could take a hard line and maintain or shrink the balance sheet even as fiscal expansion was put in place. Still, it would hardly help macroeconomic stabilization if government finances were called into question, so willy-nilly it is likely that the balance sheet would absorb some of the debt incurred via fiscal policy.

Caveat emptor – this analysis is pretty long term. In the short to medium term, I expect central banks like the Fed and ECB to try and follow up their rhetoric with liquidity tightening and for this to be reflected in long-term rates. Only if/when it turns out that the tightening is unsustainable will the forces I discuss above come into play.

On the equity side, if you can replace a skilled worker with a less skilled worker that is an attractive proposition. It is not as exciting as booming demand but it still reaches the bottom line. The social consequences are mixed. It is possible that this reduces the returns to certain types of training and education, both specialized and generic, but overall demand for relatively undifferentiated blue-collar labor will go up as will their wages. Improvements in living standards are likely to come via lower prices than higher wages. This is hardly the American dream. However, it is often difficult to put together policies that efficiently offset technological forces to provide distributional equity, and if other jurisdictions are not so focussed on distribution, you can end up with the worst of both worlds. It is possible that workers will drift to occupations where differentiated skills can earn a higher return – so maybe fewer doctors and lawyers but more dancers with the stars.

If you look at any central bank econometric model, the demand side has decades of development, the supply-side and particularly the modelling of technological change is primitive, distribution is virtually  nonexistent and asset market bubbles a problem because they should not exist in the model world. These secondary issues have become first order issues. Unaddressed they mean incomplete policy regimes and surprising and disappointing outcomes.

Why Wages Are So Weak - A Thought Experiment

Authored by Steven Englander via Rafiki Capital Management,

A thought experiment on why wages are so weak

I propose a microeconomic rationale for why macro wage performance is so weak, despite tight labor markets. The idea is that we are getting paid less for our job-specific knowledge because technology is making it easier to replace us without major loss of productivity with less skilled workers. The implications for markets:

• Flattish Phillips curve and low wage inflation continue for an indefinite period


• Living standards may increase because of lower price relative to wages, not higher wages relative to prices


• Monetary policy will have to get on with dealing with a low inflation economy -- this means setting aside obsessions about balance sheet reduction and setting up the facility to use fiscal policy as needed when the zero bound is approached


• It’s relatively positive for equities in innovating sectors


• Long-term bond yields will be driven by monetary policy fears, not long-term inflation worries


• Short-term policy rate moved will be capped by the sensitivity of the economy to interest rates which may not be large. Note that this cuts both ways –both tightening and easing may be ineffective.

The thought experiment

My idea is that wages are driven by how scared your boss is that you are going to leave. If replacing you, retraining your successor and waiting for him to climb the experience curve is costly, he will pay a lot to keep you from leaving. If you are a cog in a wheel, then he won’t care much.

Imagine an economy of a bus driver, a taxi driver, a cook, a translator, a baby sitter, a doctor and a foreign exchange strategist. Conceptually you can measure average job specific content by asking the following question: if you randomly reallocated jobs among these workers how much would productivity fall? For example, if the FX strategist was given the cook’s job and the cook became a doctor and the doctor a taxi driver and so on, what would happen? 

Say in Economy A, there is specific knowledge or character traits needed: a bus driver needs the specifics of driving a bus safely, a taxi driver knowledge of the street grid, the translator an excellent command of relevant languages, the baby sitter some proven degree of responsibility, the cook of recipes and technique, the doctor the body of medical knowledge, the FX strategist how to say ‘current account’ and so on. Now imagine the chaos and productivity loss, if the random reallocation occurred and none of the occupants of new jobs had the required skills.

Now, say in Economy B, the bus is programmed to avoid dangerous manoeuvres, all taxi drivers have a GPS (unlike NYC where none seem to), the translator has automated translation at his fingertips, the baby sitter is aware the house and liquor cabinets are cameraed, the cook has a set of packets to mix (or almost equivalently the packets are sent to your home for you to mix), the doctor a diagnostic program and the FX strategist a chatty virtual assistant that can say ‘current account’. If a random job reallocation occurred in this economy the productivity loss would be much less. My conjecture is that wages would be lower because there would be no need to bid to retain workers if they were readily substitutable, or if the same jobs could be filled with less specialized workers with no major productivity loss. 

Wage compression is very likely to be a feature in Economy B relative to Economy A – that is, the premium one receives for job specific knowledge and experience would fall. If you throw in a bit of capital saving technological progress from the sharing economy and economies of scale from the low marginal cost of replicating many IT-based innovations, you could end up with a kind of immiserization of parts of the skilled and semi-skilled working classes.

Evidence is partial, but it is not straight forward to test this speculation. Figure 1 shows wage levels in selected industry groupings. Note that wages in motor vehicles and parts (bright blue) started way above over industries, but is now average for durable goods (red line) and below education and health services (green line) which started way below. Motor vehicles and parts are now way below the average wage in the private sector, having started above 50% higher in the 1990s.

In Figure 2 we index these industries to 100 in 2000. We note that wages in leisure and hospitality (light blue) and education and health (green) have both grown faster than in durables manufacturing (red) and above the average for all private industries. Very similar patterns emerge if we index to 2011. So wages have grown slower in high paying industries, faster in low paying industries and the net is the mediocre observed wage growth. What isn’t consistent is Atlanta Fed wage evidence that suggests the quit rate is back to normal for this time of the cycle and the wage premium for quitters is as high as it was in the early 2000s. The other side is that the Atlanta Fed data shows the gap between increases of skilled and unskilled workers as having narrowed.

Macro/market implications

The problem for central banks is that we know little of what triggers such shifts in labor market power, how long they last and what ends them.  As long as these shifts persist, the Phillips Curve will look flatter in two-dimensional Unemployment Rate/Wage Inflation space. A well-specified wage equation that account for such structural changes would have a steeper inflation/unemployment trade off than one without the term but capturing the effects we discuss above is not so easy. 

The type of technological progress would imply lower price pressures because the wage weakness would be transmitted in part into prices. (Full disclosure, you have to believe that there is an unmeasured component of actual productivity change here, although it may show up as quality-adjusted labor productivity, rather than standard output per-worker or worker-hour). 

These disinflationary pressures may be hard to fight. Combine this with investment that is not overly responsive to interest rates and you have a situation where getting the inflation that you want may be impossible without risking undesirable levels of asset price inflation. It sounds as if the Fed is already there. There is nothing inevitable about this outcome, but it emerges easily if the disinflationary pressures are strong enough and the interest rate responsiveness is low enough.

One policy response is to live with it. Ultra-low inflation countries such as Japan and Switzerland have done just fine by many measures and the zero bound becomes an issue in a recession, not during an extended recovery. By ignoring it you have some ability to rein in asset market exuberance, but you are compromising on inflation and possibly activity targets.

This does not necessarily stop you from raising rates, but you are faced with a dilemma. If raising rates is effective you end up with the downturn you wanted to avoid, if raising rates is ineffective you are fooling yourself in thinking that the margin versus the zero bound means that you are all clear in the next downturn. Being able to raise policy rates to three percent without tanking the economy very likely means that you can cut them in the next recession, you won’t have much of an impact. Hawks would argue that reducing the risk of a financial market bubble reduces the risk of a recession down the road. 

It seems to me that whichever way you turn, fiscal policy has to be taken out of the doghouse. Post election, Fed officials reversed their pre-election love affair with fiscal policy, arguing that the economy does not need it. One might say that if the inflation undershoot turns out to be persistent, fiscal policy will become even more necessary to offset structural pressures. And if you think that high liquidity is contributing to asset market ebullience, then a bit of fiscal stimulus combined with monetary tightening can maintain activity and unwind some of the asset market pressures. 

Modest long-term price pressures are probably positive on the fixed income side. Long-term disinflationary pressures and modest investment will keep downward pressure on long-term bond yields even if the Fed tightens at the short end in response to fiscal policy. The use of fiscal likely means being more relaxed about the size of the balance sheet. Debt-to-GDP would have to grow both cyclically and structurally, but debt servicing may not grow very rapidly because of the low inflation and the Fed’s interest income being recycled back to the Treasury.  Short-term policy rates may swing around a lot versus stable but relatively low long-term rates. 

The central bank could take a hard line and maintain or shrink the balance sheet even as fiscal expansion was put in place. Still, it would hardly help macroeconomic stabilization if government finances were called into question, so willy-nilly it is likely that the balance sheet would absorb some of the debt incurred via fiscal policy. Caveat emptor – this analysis is pretty long term. In the short to medium term, I expect central banks like the Fed and ECB to try and follow up their rhetoric with liquidity tightening and for this to be reflected in long-term rates. Only if/when it turns out that the tightening is unsustainable will the forces I discuss above come into play.

On the equity side, if you can replace a skilled worker with a less skilled worker that is an attractive proposition. It is not as exciting as booming demand but it still reaches the bottom line. 

The social consequences are mixed. It is possible that this reduces the returns to certain types of training and education, both specialized and generic, but overall demand for relatively undifferentiated blue-collar labor will go up as will their wages. Improvements in living standards are likely to come via lower prices than higher wages. This is hardly the American dream. However, it is often difficult to put together policies that efficiently offset technological forces to provide distributional equity, and if other jurisdictions are not so focussed on distribution, you can end up with the worst of both worlds.   It is possible that workers will drift to occupations where differentiated skills can earn a higher return – so maybe fewer doctors and lawyers but more dancers with the stars.

If you look at any central bank econometric model, the demand side has decades of development, the supply-side and particularly the modelling of technological change is primitive, distribution is virtually nonexistent and asset market bubbles a problem because they should not exist in the model world.  These secondary issues have become first order issues. Unaddressed they mean incomplete policy regimes and surprising and disappointing outcomes.

"Who Moved My Punch Bowl?"- Morgan Stanley Says A Repricing Of The "Central Bank Put" Is Imminent

Some potentially displeasing "Sunday Start" thoughts to market bulls, from Chetan Ahya, Morgan Stanley"s global co-head of economics, who warns that in light of the recent "hawkish tilt" by central banks, the message is clear: "central banks are more watchful of financial stability risks: It is in this context that central banks now appear to be keen to lean against easy financial conditions so as to pre-empt the rise of financial stability risks. To assess financial stability risks, Fed Vice-Chair Fischer had recently highlighted the Fed’s framework in a recent speech in which he highlighted the “four broad cyclical vulnerabilities: (1) financial sector leverage, (2) non-financial sector borrowing, (3) liquidity and maturity transformation, and (4) asset valuation pressures”."

As a result, "financial stability risks will hold the key: In the 2004-07 episode, as inflation was well-behaved, the pace of monetary tightening by central banks was slower than warranted, which resulted in a build-up of financial stability risks as financial conditions stayed easy, private sector leverage in both the non-financial and financial sector rose sharply and asset markets were buoyant."

All of which means that "markets will therefore have to deal with the repricing of the central bank put – a key feature of the post-crisis world: Whether policy-makers are tightening via rates or balance sheet actions, or imposing more macro-prudential norms, the message is clear – the global monetary policy stance has taken a hawkish turn and will continue to do so."

* * *

His full note below:

Who Moved My Punch Bowl?

By Chetan Ahya, Morgan Stanley"s global co-head of economics

Global central banks have sent out hawkish signals, as evident from the ECB president’s speech in Sintra, the release of the FOMC meeting minutes and in the UK Governor Carney’s remarks last week followed by the statement from the Prudential Regulation Authority on consumer credit. Bond yields in the US, Germany and UK have risen by 23bp, 22bp and 25bp, respectively in the past two weeks, partly reflecting the repricing of central banks’ policy response. We don’t think this disrupts a synchronised global recovery, but it has the potential to boost USD and rate volatility, and drive US credit underperformance.

Amid this hawkish tilt, central banks appear to be dismissing the recent weakness in inflation prints: Incoming inflation data prints have been subdued, particularly in relation to central banks’ targets. However, as we have explained in a previous Sunday Start, part of the recent weakness in inflation has been due to sector-specific or idiosyncratic factors which are in turn predominantly due to supply-side adjustments, rather than a reflection of weak underlying aggregate demand.

Indeed, global growth is holding up well, as the latest GDP growth tracking estimates for the US and euro area point towards 2.8%Q and 2.7%Q SAAR growth in 2Q17, up from 1.4%Q and 2.3%Q SAAR in 1Q17, respectively. Moreover, the ISM/PMI prints in the US, euro area and China have held up well too, with the headline prints the highest in three years in the US, at a six-year high in the euro area and close to a five-year high in China. In particular, the forward-looking components like new orders and new export orders have risen too, in some cases to multi-year highs. Against this robust economic growth backdrop, we believe that output gaps will continue to narrow, labour markets will continue to tighten and wage growth and generalised demand-pull inflation pressures will lead to a pick-up in inflation.

In this context, as long as growth stays on the recovery path, central banks should continue to remove monetary accommodation: This view was most recently articulated by ECB President Mario Draghi when he alluded to the need to adjust policy parameters in order to keep pace with the economic recovery.

To be sure, central banks are not necessarily just watching inflation: As has been the case in the previous two business cycles (which amounts to a 20-year period), inflation has not breached the 2%Y target of most DM central banks. Indeed, we expect only a gradual rise in G3 aggregate core inflation to 1.7%Y by December 2018. In other words, an inflation surge may not be the key reason why central banks will tighten aggressively and bring about an end to the business cycle.

Rather, financial stability risks will hold the key: In the 2004-07 episode, as inflation was well-behaved, the pace of monetary tightening by central banks was slower than warranted, which resulted in a build-up of financial stability risks as financial conditions stayed easy, private sector leverage in both the non-financial and financial sector rose sharply and asset markets were buoyant.

In this cycle, central banks are more watchful of financial stability risks: It is in this context that central banks now appear to be keen to lean against easy financial conditions so as to pre-empt the rise of financial stability risks. To assess financial stability risks, Fed Vice-Chair Fischer had recently highlighted the Fed’s framework in a recent speech in which he highlighted the “four broad cyclical vulnerabilities: (1) financial sector leverage, (2) non-financial sector borrowing, (3) liquidity and maturity transformation, and (4) asset valuation pressures”.

As non-financial private sector leverage and asset valuations have risen, central banks in DM are therefore adopting a hawkish tilt in order to lean against the build-up of potential financial vulnerabilities: For several years post-credit crisis, DM central banks had to persist with unconventional monetary policy support as both the private financial and non-financial sector were risk-averse and deleveraging. Today, private sector risk attitudes in DM are normalising, and in fact the private sector is now re-leveraging in several parts of DM, particularly in the US. Indeed, normalisation of private sector risk attitudes is one of the key reasons behind our bullish view on global growth and why we expect central banks to take away monetary accommodation.

Markets will therefore have to deal with the repricing of the central bank put – a key feature of the post-crisis world: Whether policy-makers are tightening via rates or balance sheet actions, or imposing more macro-prudential norms, the message is clear – the global monetary policy stance has taken a hawkish turn and will continue to do so. For markets, we think this can support USD over the next several weeks, especially against JPY, as US economic surprises bottom and USD positioning is light. We think that US rate volatility can rise from historically low levels, especially in the front end. And we think that a late-cycle environment colliding with less central bank accommodation will lead to US credit underperformance versus equities.

The Internet Helped Kill Inflation In America, Says Credit Suisse

Whether or not San Francisco Fed President John Williams is right about US inflation and employment being about as close to the central bank’s targets as investors have seen - as he told CNBC two days ago - is irrelevant: The central bank is going to raise interest rates two more times this year no matter what happens to consumer prices, says Credit Suisse Chief Investment Officer for Switzerland Burkhard Varnholt.

That"s because it"s pointless waiting around for prices to rise when the real reason inflation is low - and will likely remain low – has nothing to do with the Fed, but with a structural shift in the US economy that’s being driven by technology giants like Amazon and Uber. Burkdard says these companies have “turned most companies and sectors into price takers rather than price makers."

“Well look, inflation has been gone for quite some time and what’s really killed inflation clearly isn’t the Federal Reserve’s monetary policy but the Internet – it’s the sharing economy, the network economy it’s the uber-deflationary companies like Uber, Amazon, Airbnb and the like who have transformed most companies and most sectors into price takers rather than price makers.”

When asked if there’s anything about the market that investors might be ignoring, Burkhart replied that investors might be underestimating demand for bonds in the coming years – especially at the long end of the curve.

“Monetary policy in 2017 will be about ‘walking the talk.” That means two rate hikes as [the Fed has] guided the public to expect will likely come forward, but that’s a small step in not a big picture, because the big picture – is that capital markets yields will remain lower for longer in the absence of inflation and also in the presence of structural excess demand for long-dated government securities from aging populations whose pension funds.”

Williams, who isn’t a voting member of the Fed’s interest-rate setting committee this year, has stuck to the Fed party line of calling for three rate hikes this year despite core consumer prices rising just 1.9% in April, the slowest pace in 19 months, while the labor force participation rate remains near multidecade lows.

JPMorgan: "Large Parts Of Society Are Not Seeing Any Growth In Income And Job Opportunities At All"

Last week, BofA"s HY credit strategist Michael Contopoulos, laid out a list of the four things that keep him up at night, which included:

1. Zombie Companies And Massive, Rising Student Debt Loads 

2. Sliding Used Car Prices, Rising Delinquencies And Subprime Defaults

3. Declining Loan Growth, Lack of commodity rebound and tighter balance sheet

4. Lack of Investment, No Small Business Creation And No Earnings growth

(there was more in the full article)

Having let the genie out of the bottle, just 24 hours later it was JPM"s turn to unveil its own answer to this same question, and in his weekly Froday note, JPM"s Jan Loeys said that when it comes to what "keeps the bank up at night" in the context of the bank"s economic outlook "regime change is the main risk."

While that in itself is hardly unexpected or new, what we found surprising is that even JPM now admits that "large parts of society are not seeing any growth in income and job opportunities at all and thus demand change"  and as a result "regime change could thus come from politicians deciding we have gone too far in the trade-off between stability and growth."

And in a preview of things yet to come, JPM concedes that "the anger of those left behind by slow and stable growth could lead to more populist measures that eventually give us both less stability and less growth."

Or, alternatively, just wait until all those who voted for Trump in hopes of a radical systemic overhaul, end up being disappointed.  That"s when the real regime change will begin.

Here is the full excerpt from JPM"s note explaining what keeps America"s most valuable bank up at night:

The most frequent question we receive from you today is: What keeps us awake at night? To us, the main risk to our strategy and markets is a change in what we like to call the regime we are currently in.

The regime we believe we are in is one of a slow and stable global expansion, with cautious economic agents, conservative fiscal authorities, and determined central banks that provide easy money, but retain strict control on financial leverage. We note there are many potential shocks, from political turmoil to policy errors, that could disturb markets, but we will treat them as just volatility that should not affect our strategy if these shocks do not change the regime we are in. The shocks that keep us awake are the ones that could change the current regime into another one.

• Regimes do not last forever. Some die because they do not deliver the goods to society and voters demand change. Some die of their own success. The Global Moderation Regime from the mid-80’s to 2007 brought good growth, low macro volatility and shallow recessions. The longer it lasted, though, the more agents assumed it would be forever, thus inducing them to apply less caution and more leverage. This ultimately made the regime vulnerable to a regional fall in house prices in 2006-07 that would otherwise not have done that much damage.


• We note the current slow-and-stable regime risks coming to an early end if too many economic agents are dependent on easy money, or if it does not deliver the goods to society. This analyst thinks the latter risk is more acute as large parts of society are not seeing any growth in income and job opportunities at all and thus demand change.


• Regime change could thus come from politicians deciding we have gone too far in the trade-off between stability and growth, and that it is time to let companies and banks loose, through deregulation and tax reform/stimulus. Alternatively, the anger of those left behind by slow and stable growth could lead to more populist measures that eventually give us both less stability and less growth.


• The alternatives to our Slow-and-Stable regime could thus be called Growth, and Populism. Slow-and-Stable has been good for both equities and fixed income, with equities outperforming. A Growth Regime could boost equities even more, but would likely hurt fixed income badly as it would bring more inflation and monetary policy tightening than investors are prepared for. Populism would likely hurt both equities and bonds.

Optimist's Burden Of Proof - Are Bonds "Distracted" Or "Depressed"?

Authored by Jeffrey Snider via Alhambra Investment Partners,

The idea that interest rates have nowhere to go but up is very much like saying the bond market has it all wrong. That is one reason why the rhetoric has been ratcheted that much higher of late, particularly since the Fed “raised rates” for a third time in March. Such “hawkishness” by convention should not go so unnoticed, and yet yields and curves are once more paying little attention to Janet Yellen. When Mohamed El-Erian wrote in what was I guess an oped in the Financial Times on Monday that bond investors were “distracted”, it was his subtle way of attacking them as wrong.

In that way, we are truly back to late 2013 and early 2014 all over again. But back then the Fed’s positivity side, thus bad for bonds, had a whole lot more going for it (even if it was in total still a thin catalog). Recovery at that point was at least plausible under the undetermined guidance of QE3 (and 4), whereas today not even Fed officials talk that way or even bring themselves to mention QE.

This isn’t to say that the bond market or eurodollar futures have everything right, far from it. As I argued earlier this week, these very markets were way off at several points and for several years. Treasuries as well as eurodollar futures were firmly within the camp of higher interest rates and monetary policy support until 2011. In other words, bond investors then were wrong, and even though it took several years to fully appreciate the implications of the con job that was QE, the bond market and eurodollar futures curve have been far more right than wrong since then (the noted exception being late 2013).

On its own, that doesn’t mean bond investors are now infallible and that treasury yields and the eurodollar curve together make up the definitive guide to the universe. Everything is about probabilities and really a spectrum of them, which means in simple terms the bond market deserves the benefit of the doubt where clearly economists and policymakers do not. Therefore, if there is a disagreement all over again between bonds and economists, particularly in similar fashion to 2014 and 2015, it does not make much sense to follow the latter particularly as interpretations on that side continue to rely upon the so far unreliable unemployment rate view of the economy.

For the balance of presumed error to shift back in the favor of this mainstream interpretation will require far more tangible proof than “interest rates have nowhere to go but up.” Having already heard it before several times, and having witnessed that, no, interest rates can actually go lower, there needs to be compelling evidence to that effect.

To this point in 2017, already the second quarter, it remains absent. The payroll report today was but another reminder of that case, especially beyond the headline Establishment Survey number that while disappointing did not describe the full impact of that disappointment. By almost every facet of the BLS data did the unemployment rate fail, which was particularly troubling given that the rate itself fell to a new “cycle” low. In other words, there is no indication that unemployment rate today has any more meaning and significance than it did in 2014 when last “interest rates had nowhere to go but up” because the Fed was tapering.

Instead, economic indications beyond payrolls continue to suggest only sustained weakness. There is improvement in most accounts beyond the labor market, to be sure, but like the labor market data nothing that is close to convincing that a positive inflection is even realistic let alone close at hand. To emphasis that point further, the Atlanta Fed’s GDPNow tracking model was reduced today to project just 0.6% real GDP growth in Q1 – such a low level despite “residual seasonality” already built in even though there hasn’t been found any evidence any such thing as residual seasonality ever existed in the GDP data set.

When it comes to economic interpretation, pointing to the unemployment rate was never enough even if it satisfied everyone in the media. To do so now only further calls into question that position, for if the unemployment rate is all you have to define a “better” economy then you truly have nothing. As I wrote in late January last year, right amidst the then “unexpected” turmoil:

The very basis for this persistent over-optimism has been the BLS figures, both the Establishment Survey and the unemployment rate. Yet, despite robust numbers on either account we are in this mess already. And it was economists and their unemployment rate devotion who told us last year that the “best jobs market in decades” would almost guarantee nothing but the best for the rest of it. It was in many ways the entire basis for the assertions of “transitory.”

More than a year later, not even the Establishment Survey can be included on that sunny side of the ledger. When in the mainstream the bond market’s pessimism is decried as surely wrong, it is done so on the basis of econometric models that are, to put it simply, backward.

It is the backwards priorities of economics; to view all modeled outlooks as if “more real” than observed condition including market prices. Such Aristotelian process raises more questions than confidence, especially surrounding labor statistics. If the labor market is so robust, why are there no wage gains? To the orthodoxy, it’s not a puzzle but an article of faith; there have to be wage gains, just pushed off to some point in the future.

Even after two years of “full employment” the wage acceleration of full employment remains conspicuously missing; to the point that it in all likelihood the Fed’s models have given up on it. The latest payroll report suggests only continued significant slack which can only mean chronic weakness well beyond the unemployment rate’s overly narrow focus (participation problem). If there is any policy debate left it is only about what has caused this depression (or secular stagnation, low/negative R*, or however you wish to characterize what is a no-growth baseline).

Having seen through these statistics for what they really are, the treasury as well as eurodollar market reflects considerable and legitimate economic doubt drawn from realizing what money is (a whole lot more than bank reserves) and what it certainly wasn’t (QE). It is the optimists who share the burden of proof that this time is any different. The longer that evidence remains missing, the greater that burden. This is not a “distraction” as El-Erian would have it, but rather very ugly reality unchanged by time or effort.

Let’s Play FOMC Bingo: Minutes Show 15 Instances of Uncertainty

Submitted by Mish Shedlock of MishTalk

The Fed released Minutes of the December 13-14, 2016 FOMC Meeting today.

Let’s dive into the minutes to dissect the amount of Fed uncertainty.

1. Market-based measures of uncertainty regarding monetary policy at horizons beyond one year moved up, suggesting that some of the firming in OIS rates could reflect a rise in term premiums.


2. The declines in EME currencies and risky asset prices were reportedly driven by higher U.S. yields as well as by uncertainty about possible changes in U.S. trade policies.


3. The staff viewed the uncertainty around its projections for real GDP growth, the unemployment rate, and inflation as similar to the average of the past 20 years. The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff’s assessment that monetary policy appeared to be better positioned to offset large positive shocks than substantial adverse ones. In addition, the staff continued to see the risks to the forecast from developments abroad as skewed to the downside.


4. In their discussion of their economic forecasts, participants emphasized their considerable uncertainty about the timing, size, and composition of any future fiscal and other economic policy initiatives as well as about how those polices might affect aggregate demand and supply.


5. Many participants underscored the need to continue to weigh other risks and uncertainties attending the economic outlook. In that regard, several noted upside risks to U.S. economic activity from the potential for better-than-expected economic growth abroad or an acceleration of domestic business investment. Among the downside risks cited were the possibility of additional appreciation of the foreign exchange value of the dollar, financial vulnerabilities in some foreign economies, and the proximity of the federal funds rate to the effective lower bound.


6. Several participants also commented on the uncertainty about the outlook for productivity growth or about the potential effects of tight labor markets on labor supply and inflation.


7. Some contacts thought that their businesses could benefit from possible changes in federal spending, tax, and regulatory policies, while others were uncertain about the outlook for significant government policy changes or were concerned that their businesses might be adversely affected by some of the proposals under discussion.


8. A few added that continued gradual strengthening in labor markets would help return inflation to the Committee’s 2 percent objective. But some other participants were uncertain that a period of tight labor utilization would yield lasting labor market benefits or were concerned that it risked a buildup of inflationary pressures.


9. A few participants noted the uncertainty surrounding real?time estimates of the longer-run normal rate of unemployment, and it was pointed out that geographic variation in labor market conditions contributed to that uncertainty.


10. Many participants expressed the need for caution in evaluating the implications of recent financial market developments for the economic outlook, in light of the uncertainty about how federal spending, tax, and regulatory policies might unfold and how global economic and financial conditions will evolve.


11. While viewing a gradual approach to policy firming as likely to be appropriate, participants emphasized the need to adjust the policy path as economic conditions evolved. They pointed to a number of risks that, if realized, might call for a different path of policy than they currently expected. Moreover, uncertainty regarding fiscal and other economic policies had increased.


12. Moreover, many participants emphasized that the greater uncertainty about these policies made it more challenging to communicate to the public about the likely path of the federal funds rate.


13. Participants noted that, in the circumstances of heightened uncertainty, it was especially important that the Committee continue to underscore in its communications that monetary policy would continue to be set to promote attainment of the Committee’s statutory objectives of maximum employment and price stability.


14. Members agreed that there was heightened uncertainty about possible changes in fiscal and other economic policies as well as their effects.

Uncertainty Scorecard

• 15 instances of derivations of “uncertainty”


• 2 instances of “heightened uncertainty“


• 2 instances of “uncertain“


• 1 instance of a sentence with with the word “uncertainty” used twice


• 1 instance of “greater uncertainty“


• 1 instance of “considerable uncertainty“


• 1 instance of “uncertainties” plural

FOMC Minutes Bingo

In FOMC Bingo you have to get every box filled. There were better cards. Wizard was a killer. Otherwise, I had a chance.

Fed Uncertainty Principle

Let’s review the Fed Uncertainty Principle and its corollaries  as I wrote them on April 3, 2008, before the crash.

Fed Uncertainty Principle:

The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:

The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:

Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:

The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Economists Predict Uncertainty to Clear Up

If and when the economists are ever “certain” about the economy, I am certain they will be wrong.

Back in August, I noted Economists Expect “Mount Everest” of Uncertainty to Clear Up by December

What happened?

Attempts by the Fed and economists to measure uncertainty are certainly ridiculous.