Monday, August 5, 2019

Round 3 of the tariff wars

The stock market hit an air pocket today, buffeted late last week by news that Trump had threatened to unleash a new round of tariffs on Chinese imports, and news today that the Chinese yuan had fallen below 7 to the dollar. For good measure, the Chinese government also announced it would retaliate by restricting imports of US agricultural products.

Yikes, thought the market, maybe this is going to turn into a full-fledged tariff war after all! Better sell now before the sh*t hits the fan!

I've mentioned before that if Trump's tariffs are going to have their intended effect, namely forcing China to lower its trade barriers and respect intellectual property rights, then the Chinese are going to have to be very worried that bad things are going to happen to their economy if they don't make a deal with Trump. It's also true that for the Chinese to take Trump seriously, just about everyone needs to be worried that Trump is out of control and the global economy is headed for a fall. If we aren't scared, the Chinese never will be.

Well, it's looking like we're getting closer to that point.

Chart #1

Chart #1 compares the level of China's forex reserves to the value of the yuan vis a vis the dollar. What this says is that the huge rise in the yuan's value leading up to 2014 was largely due to a huge influx of capital. The Bank of China was actively trying to suppress the yuan's value, since if it hadn't bought more dollars and sold more yuan, the yuan would have risen even further. But from mid-2014 to mid-2017, capital began to flee China. This forced the Bank of China to sell its forex reserves and buy yuan, otherwise the yuan would have depreciated even more against the dollar. Until recently, it seems that the Bank of China has been targeting a fixed level of reserves, and allowing the yuan to fluctuate with the winds of capital flows. The recent drop in the yuan virtually guarantees that capital is desperate to abandon China. At the same time, China's economy has been slowing. China is far more dependent on trade with the US than the US is with China. Trade disruptions are disrupting China's economy meaningfully, and that is putting increasing pressure on Chinas' leadership to make a deal. Further declines in the yuan's value will put tremendous pressure on China to make a deal, otherwise their economy could be crippled.

Chart #2

Chart #2 shows that the market's level of fear, uncertainty and doubt (as proxied by the ratio of the Vix Index to the 10-yr Treasury yield) is today as high as it has been in many years. We are in Panic Territory. Yet I note that the selloff in stocks has not been very deep so far. This could mean that the market is not really terrified, because the market realizes that although things look really bad today, they can be fixed with a simple Trump tweet or a Chinese capitulation. In any event, it's worth noting that FUD is high but stocks have not really suffered very much. But does that imply the market is over-confident? Not necessarily.

Chart #3

Chart #3 shows that the real yield curve today has inverted even more. The market is expecting the Fed to be forced into deep cuts, since otherwise an escalating trade war with China could cause serious damage to the Chinese economy, and that would inevitably be felt here at home as well. In any event, the market is sending a strong signal to the Fed that monetary conditions are too tight right now. That in turn is due to a sharp rise in risk aversion and a sharp increase in the demand for money and other safe havens, both of which have not been alleviated by offsetting Fed actions (e.g., lower rates, which have the effect of making cash and money less attractive).

Chart #4

Chart #4 shows the implied rate on Fed funds futures contracts that mature next June. The market fully expects the funds rate at that time to trade at around 1.6%, which would further imply three more 25 bps cuts to the current funds rate of 2.25%. That in turn means the market thinks the economy is going to be sucking pondwater pretty soon.

Correction: (9;28 pm PST) I need better reading glasses. This chart says that the market expects the funds rate to be 1.2% by next summer, not 1.6%. That implies four more 25 bps cuts to the current funds rate. HT: Mike Churchill

Chart #5

Chart #5 compares the price of gold to the price of 5-yr TIPS (proxied here by the inverse of their real yield). Both tend to rise in periods of uncertainty. Moreover, the recent rise could be attributed to the market thinking that the Fed has fallen so far "behind the curve" that in the end it will be forced to ease too much, and that will ignite an unwelcome rise in future inflation (gold and TIPS both promise protection from rising inflation). The market is getting pretty worried about the future, it's safe to say.

Chart #6

Chart #6 shows the spread between 10- and 30-yr Treasury bond yields. The long end of the Treasury curve has been steepening, even as the front end has been inverting. This reinforces the view that eventually the Fed is going to be forced to "reflate," and that would be bad for long-dated bond prices.

Chart #7

Chart #7 shows the yield on 10-yr Treasury bonds. Late last year it looked like bond yields had broken out of their long-term downtrend. Now it looks like that downtrend is still intact. I'm not a technical chart devotee, but there are a lot them out there, and this chart has gotten their attention, you can be sure. That US yields have fallen this low implies 1) great demand for equity hedges (which in turn implies a lot of bearish sentiment), 2 very low inflation expectations, and/or 3) a belief that the Fed is at risk of making a deflationary mistake.

Chart #8

Yet despite all the doom and gloom priced into the Treasury market, Chart #8 shows that the corporate market is only a tiny bit concerned about the outlook for corporate profits. Spreads on generic 5-yr Credit Default Swaps have only risen modestly from very low levels. Similarly, I note that swap spreads are extremely low (2-yr swap spreads have fallen to -7 bps), both here and in the Eurozone. This suggests both a dearth of safe-haven assets, and strong liquidity conditions. Investors are buying swap spreads instead of other high-quality bonds because they are trying to hedge their exposure to stocks and other risk assets—not because they are afraid the economy will collapse. As I argued in my last post, the low level of real yields and the abundance of bank reserves imply that financial conditions in the US are not deteriorating; money is not hard to come by, and therefore the economy is not at great risk of a Fed mistake.

This further suggests that the carnage being priced into assets today is still in the minds of investors, and is not yet to be found in the physical world.

Chart #9

With the rush to safe-haven assets, the PE ratio on the S&P 500 has fallen to 18.6, which gives the stock market an earnings yield of 5.4%, which is a whopping 370 bps above the yield on 10-yr Treasuries (see Chart #9). You have to go back to the scary days of the late 1970s to find an equity risk premium that high. One thing this chart says for sure: the market is quite pessimistic about the risks that the future holds.

If Trump and China figure out how to make a face-saving deal, the upside potential out there could be very impressive indeed.


Illuninati said...

I'd like to thank you for your insightful posts. I realize that as a retiree, you could be playing instead. Thank-you.

Scott Grannis said...

Thanks, but in my defense (why am I doing this for free?), I'd note that an important reason I take the time to do these charts and posts is that the discipline helps me stay focused on the economy and the market, and that in turn guides my investing. So I do it for myself as much as for others. It's a way of "giving back" some of the knowledge that I've acquired over the past four decades.

LetUsHavePeace said...

As always, much appreciated. Could it be that President Trump is using tariffs and the threat of tariffs as his solution to the Federal government's debt dilemma. A dollar whose exchange rate is expected to rise is the only reliable guarantee of continuing foreign investment in U.S. Treasury debt. But, a "strong dollar" shifts the terms of trade against domestic employment. American consumers benefit, but American workers and their higher wage rates find themselves becoming even more uncompetitive. The post-Civil War solution to this dilemma was to expand trade with the world but tax imports. The protectionists favorite tool - import quotas - were abolished; but tariff rates were increased. By 1870 average tariff rates had doubled from the Civil War level of 15%. They stayed at 30% for the next two decades, even as the Civil War debt was reduced by a third.
I doubt very much that President Trump is consciously following the policies of Ulysses Grant, and it is impossible to imagine the Federal government operating without continuing deficits. But, in terms of managing the enormous overhang of Treasury IOUs and assuring future funding, Trump's actions are remarkably similar to the policy Grant's Administration adopted.

Frozen in the North said...

Part of the problem is that Trump rarely sticks to his trading guns. Really, Europe, Canada, China, and Mexico, in all cases he backed most trade partners assume that he's going to keep on doing the same thing again here. More worriseome is the shift away from US agricultural products, these are hard to turn back, once systems have been created.

Finally, and this is the big one, if China starts buying fuel from Iran, then all bets are off, oil will probably fall on that piece of news -- that's going to hurt part of the US economy, and its unclear how far the impact of that shift would be.

The problem is an escalation, it was the problem with the risk of nuclear war in the 1980s and its now the same game theory problem with trade. First, Trump always backs down, he has historically always backed down...until he doesn't.

China's economy is not doing great with massive issues such as Zombie companies

Then again, Trump could back down, and the market, once again, recover

Who knows!

Scott Grannis said...

Trump will almost certainly ¨back down,¨ provided China offers him a ¨good¨ deal. China will almost certainly do something to alleviate the pressures which its economy is facing, which are not insignificant. Nobody is going to ride the trade rocket to oblivion.

The fact that everyone is worried that this won’t end is good evidence that Trump is an aggressive negotiator. The Chinese won’t budge unless they are really feeling the pain, and that’s got to be happening. China’s currency is down over 10%, stocks have given up all recent gains, and capital flight is ongoing. Companies are shifting manufacturing away from China. A weaker exchange rate helps domestic manufacturers to some extent, but a weaker currency and capital flight erode Chinese fundamentals in a big way. Inflation is likely to rise with a weaker currency (because imports cost more).

The solution is finding the “deal” that gives something worthwhile to all parties.

Cabodog said...

Great post Scott, along with the comments. Thanks again for your insight and sharing.

steve said...

Wow Scott, I am plainly shocked that you think there is anything beyond bullying and inanity behind Trumps tariff wars with China. You ascribe way too much insight to POTUS. It is well known that he is unread and lazy. Every one of his obsequious advisers except the inept Navarro recommended against the recent escalation.

This will not end well and the worst part? Almost all of the crazy dems agree with him!

Yesterday, the entire yield curve of German bunds went negative. The 10 year is trading at -.5%! WHAT!!

Could the US 10 year go negative? Anything is possible and Trump will continue his insanity and regardless of who wins in 2020 (Trump, unless of course there is widespread election rigging....) we'll see more trade wars.

And you wonder why growth is sub par and bonds are trading at 1.75%

LetUsHavePeace said...

China has to use American dollars to pay for its own imports. Unlike the U.S. it cannot use its own currency; no one will take it. So, the exchange rate is largely irrelevant for the pricing of China'sternational trade. What it pays out is a function of its inventory of U.S. currency and its expectations for future sales to holders of readily exchangeable FX. Its pricing of exports depends far more on the need for FX than on any profit margins. In that sense Trump is right about who is paying the tariffs. The net bill to U.S. importers remains unchanged, as the "inflation" figures in our economy confirm.

Fred said...

I'm afraid Steve is right. Look back at Trump's interviews over the past 30 years and you will see that the one thing he believes in is tariffs. He thought we should impose tariffs on the Japanese in the 80s when everyone thought their economy would crush ours.

Francis Scotland said...

Hi Scott
Very interesting analysis. You mention that the market is telegraphing to the Fed via the yield curve that monetary conditions are too tight, which would normally signal building economic risk. Later on you interpret modest 5yr CDS and low swap spreads as a sign of strong liquidity conditions. Financial conditions are not deteriorating, money not hard to come by and that the economy is not at great risk---you wrote. I see the same thing--monetary data says too tight; but financial liquidity conditions look ok. Is this just a sequencing issue and time lags in your opinion---if the Fed does not ease and if the economy deteriorates, only then will financial conditions erode?

Rich said...

I still think the smart play would have been to confront China with our allies and postponing trade tiffs with them until that was complete.

Anyway, your work is invaluable, Scott.

Johnny Bee Dawg said...

Spot on post.
Thanks for those charts and your insight.

Jeff said...

I wish Trump would build some form of Coalition in this effort to bring China to the table, make them accountable for their actions and truly set up a new deal that is more fair to all involved. However, I don't think he has tried or has an interest in doing this. However, the more world pressure against the Chinese and their trade practices the better chance to get a deal that could be truly impactful....I believe.

Mnjoe123gobears said...

Thanks Scott!

I do wonder if there are intentions to resolve the trade war. It's bigger than Trump and may be an economic attack on China with full intent to damage it's economy long term and disrupt the party's ten year plan which is an impressive long term strategy and a threat to US world power.

steve said...

"threat to US world power"

I have no idea what the hell this means but wouldn't be at all surprised if that was largely Trumps insane motivation.

randy said...

There was an article recently that attempted to clarify - should we approach China as a competitor, or an enemy. If they are an enemy, then using economic pressure to undermine their stability MIGHT make sense. It also might not makes sense if the resulting civil unrest causes the leadership to more severe domestic and foreign tactics. If this is really more about being a competitor, the strategy should not be to undermine their stability. JBD says a lot of things, sometimes clearly in jest or goading, so this is not a swat at him. But when he comments that Trump is succeeding because China is in the crapper, I wouldn't agree that China in the crapper is a good thing for the world. When playing long games with those that aren't your enemy, it's smart to win but not so badly the other player can't continue to play the game you've agreed to. Right now we seem to be making them the enemy. I don't think that was necessary or a good strategy for US interests.

Also agree that Trump deserves zero benefit of the doubt for some masterful long-term strategy. He's just a bully and using bully tactics because that's all he knows.

Charlie said...

Could Trump be trusted to follow through on any deal the US made with China, even if China thought it was in their interest? I think China would be crazy to make a significant concession now. Better to hunker down and ride it out as best they can.

Benjamin Cole said...

In any event, it's worth noting that FUD is high but stocks have not really suffered very much. But does that imply the market is over-confident? Not necessarily.---Scott Grannis

Great post, and ditto on the reading glasses. I need reading binoculars.

But I have to confess, I do not know what is "FUD".

The good news is, the market recovered yesterday. I think the real problem is not trade tensions between the US and China, but that major central banks have been too tight.

People are confusing low interest rates with EZ Money. But you do not get to chronically low interest rates through EZ Money. Only decades and decades of tight money can result in such low interest rates.

Al said...

Great post.

Scott Grannis said...

FUD = Fear, Uncertainty, and Doubt

Carl said...

Thank you for the publications.
In 2014, you posted the following:

To make a long story short, basically, my understanding of the narrative described is that interest rates and related expectations, which had diverged down, would eventually catch up with growing growth. In fact, it seems that the bond market was not gloomy enough if one looks at how 2019 is unfolding.
Interesting times but I submit that equity downside risk is not priced adequately as the kinds of animal spirits which are being dismissed now are not visible because they have been suppressed.

“The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.” G.K. Chesterton

Rob said...

Hi Scott. I've asked you before and your answer always was that you weren't that worried but I just wanted an update please: does the extraordinary level of debt in the world concern you, both national and individual? Isn't this the kind of debt that can only truly be solved by an extraordinary event ? Thanks very much.

steve said...

Rob, the bond markets certainly don't think that debt is a problem. Worldwide, there is some $15 trillion with negative returns! Not to mention the US 10 year trading at 1.7% or so. One would think that if debt were problematic yields would CLIMB not fall.

John said...

Regarding the $1 trillion (or whatever it is) in U.S. Treasuries held by the Chinese. How big of a stick is that for them to swing if they choose to?

Rob said...

Thanks Steve, interesting.

Flying Robot said...

Scott, everytime I've read your summaries over the past 6 years or so I have had to do a confirmation bias check w/r/t your conclusions, because it jives so closely with my perceptions.... but I'm nowhere near knowledgeable enough to do this kind of analysis, so I want to say thanks for sharing your thought process and insights.

Regarding the China Tariffs, I have had the thought that from Trumps pov, a year from now would be mighty propitious time for Tariffs to disappear. Anyways, it seems to me that the two elements that need to be present are a face-saving victory on some important issue for China (& they will trumpet in their state newspaper/outlets that rarely get reported in the US), but also concessions that Trump can use to claim success at home (that don't have to be of much actual value, he frequently claims substance-less victories and everyone seems to shrug.) Thus I suspect an end to the trade wars really isn't that difficult, and the considerations may be more about political timing than economic substance, but that the odds of it going away this year are low. Maybe I'm being facil, but that's my pet theory anyways.

Unknown said...

Insightful comments as ever, Scott. I wonder if the main reason for the inverted short end/positive long end curve pattern is because negative real yields in Europe means that the only demand for 30 year bonds is for US$ assets? Meanwhile, US$ 10 year yields are highly influenced by the spread versus Euro 10Y which are also negative. Could it be that the inversion is simply a function of active flows into US equivalent bonds from other 10y assets for a yield pick up? - that the US 10y simply offers a yield premium for the same risk and, with a rising US$ it is simply a no brainer trade for international fund flows?

randy said...

Good commentary by WSJ, at least it seems to me.

(fantasy letter from Xi to Trump)

"Then you and I can say we settled matters without relying on our advisers. I’ll say you offered China very good terms for fine American products. You also agreed to withdraw your tariffs, and you agreed to crack open your market to equipment made by our great, privately owned success story, Huawei.

On this latter point, I know your advisers worry about spying. Mine also worry about spying. Countries will spy on each other! But if we have a choice of being poorer together and rivals, or richer together and rivals, I know which I would pick.

And then we can go on as before without greater unpleasantness developing between us. You can declare a big win for your trade strategy. I will be able to declare that I turned a dangerous situation to China’s advantage."

Johnny Bee Dawg said...

Inverted 2s and 10s now.
Jay Powell keeps on giving.
He wouldn't listen to the short end inversion. so let's see if he can hear this one?

Fed Funds rate is now higher than every govt bond yield on the planet except for the irrelevant Italian 15 and 30 year.
Fed Funds higher than every single US Treasury bond along the curve.
Has that ever happened before??

Amazing incompetence. Or is it on purpose?

steve said...

As of 0800 futures down 1.4% and 10 year trading under 1.6% again. Johnny is right that the markets will force the feds hand now. Perhaps an emergency rate drop? Starting to feel "panicky".

steve said...

Randy, I just read the WSJ piece. Did you read any of he comments? Could have been written by Johhny. Rabid DT fans and view China as an adversary not a trading partner. This is problematic. As long as we view China as the enemy (as long as DT is POTUS) we will never come to any agreement with them and this WAR will fester. In the meantime US consumers are losers and our markets are in turmoil. Yes, I know JBD, China is probably hurting more than we are so are we supposed to feel better that on a relative scale we're in less pain than they are?

Just crazy stupidity and arrogance and you know damn well that Xi won't back off either. This is an economic war with dire repercussions that could escalate to something even worse.

Johnny Bee Dawg said...

What do you call a trading partner who steals from you, and hacks into your computers to plant spyware and viruses?
And sends in the army to put down protestors?

randy said...

Steve, I did read the comments and agree. I try to read comments both in the NYT and the WSJ. Geez, it's flabbergasting with both sides. Heck it's damn near civil war in my own house with my wife who told me she'd leave me if I voted for Trump. I don't think she meant it, but not entirely sure. I asked her to pray that Dems don't choose Liz Warren. I blame it all on social media influence. JBD - absolutely the security risks are very serious. Just doesn't seem tariffs are a realistic tool. More for show but will cause a lot of collateral damage. I don't know the answer, but I'd guess there are technical solutions that can mitigate the spying / theft risks better than dreaming that tariffs will force Xi to.. do what? He can dictate official spying but he can't dictate commercial spying activity.

steve said...

JBD, I hear you on that point. Honestly, I do. I simply don't think economic war is in our best interests. And as I've said, ad nauseam, DT has a history even before being POTUS of damn near hating anything imported. I actually believe he's sort of an isolationist.

Randy, I hear you on familial civil war. We have five kids aged 23-34 and they're all over the map politically although even my oldest son who is somewhere right of Genghis Khan disdains Trump. He and I both believe he is literally ruining the GOP and anything that may be considered "conservative".

Scott Grannis said...

FUD is increasing, and the market is ratcheting down its expectations for real growth and inflation. The market now expects the Fed to cut rates by 100 bps over the next 12 months. The Fed can't wait too much longer to follow the market's lead. Global nerves are frayed. Interest rates everywhere (except in Argentina) are falling as nearly everyone girds up for slower growth and lower inflation. But there is still time to fix things. Swap spreads remain very low, and credit spreads are only modestly above very low levels. Small business optimism remains very high. The US economy continues to grow. Real yields on 5-yr TIPS are priced to the assumption that the economy is going to grow a bit less than 2%. Safe-haven assets (gold, TIPS, government bonds) are in high demand, mainly because risk-aversion is quite strong. Lots of risk aversion doesn't necessarily translate into a recession. In fact, recessions more often than not occur when the market is not very worried about the future.

The next FOMC meeting is schedule for September 18, but I seriously doubt the Fed will wait that long to cut rates again. Sept 18th is almost an eternity when nerves are frazzled like they are today. Inflation is not a problem, since inflation expectations have been falling and are now well below the Fed's 2% target. Lots of risk aversion means the demand for money is very strong, and the Fed must offset that by lowering interest rates significantly. (Lower rates make money less attractive, offsetting the market's increased demand for money).

John said...

I suspect POTUS will post a good-news tweet from the crapper tomorrow morning and the market will take off like a rocket.

Mnjoe123gobears said...

Lol John!

Benjamin Cole said...

Call me Mr. FUD.

Egads, Trump was right.

The Fed is, and has been, too tight.

That a vulgarian reality TV host is better at monetary policy than our central banks speaks volumes—no, encyclopedias and libraries—about our central banks. If you want to ossify an organization, make it public. If you want to embalm the ossification, make that public agency independent. Then you can freeze the ossified, embalmed carcass by making that public independent agency self-financing. Voila! The Fed!

Trumps tariffs are debatable, but minute in relation to the US, let alone the global economy.

A general global GDP slowing, in combination with sinking interest rates and dead inflation, can only be explained by global central bank tightness.

Sadly, in general, the US orthodox macroeconomics profession has been barking up the wrong trees—actually derelict in their duties—by constantly defining the Fed as “easy” and howling in righteous indignation about the Trump tariffs as the cause of economic maladies.

The Fed is too tight. Trump tariffs are a thorn in the side, but hardly fundamental, to a large economy.

How the Sinocentric multinationals stole the macroeconomic narrative is another great story.....

WealthMony said...

Benj, I've really enjoyed reading your comments over the past years. You have consistently called for lower interest rates from a Fed you've said has been tight. I just don't get it. With over $1.5 Trillion in excess reserves and very low interest rates and steady M2 growth, I don't understand how you can say the Fed is tight. If you've got the time and inclination, please explain. Thanks.

steve said...

Yeah, Benjamin I agree the Fed is too tight but seriously disagree that tariffs are not problematic. In fact, POTUS is problematic. A president should not be castigating a fed chair. But since our POTUS is a petulant child, he does. Could be that we're just going to have a slowing economy and because we live in an instantaneous social media world everything is amped up and magnified. Trump as POTUS while we enter a slowing or recessing economy? just imagine the tweets!

John said...

I agree with WealthMoney. Don't get it. How is it we had strong economies in the mid 80s and 90s with interest rates 3 or 4 times higher than what they are now? It seems there is no incentive to save anymore and soon we will be paying banks to store our money like household junk at Lock-it-Up.

I think the problem may be more basic, i.e., there is more global competition, more supply, and slowing demand.

steve said...

Spot on piece in the journal:

Best comment was that Navarro was the only economist who fit DT's nonsense trade narrative. Two idiots driving China and the world (US along with them) into recession. And we're blaming the Fed?

randy said...

Fair or not, the history books will remember Trumps Tariff War. They will likely not think much about Fed monetary

Johnny Bee Dawg said...

Market has shrugged off Trump's tariff weapons in China negotiations, ever since he's started them. The problem is glaringly that the Fed is too tight.
When Trump announced he was backing off on China tariffs, the market made a pop that had no umph. However, the 10 year didn't budge one bit. Then the big 800 point crash the next day. Tariffs did nothing. It was once again the Yield Curve.

Wal-Mart earnings and revenues show that China tariffs are being managed just fine for the American consumer. Shrieks of doom and soaring prices have been greatly exaggerated.

Its the Fed. Its always been the Fed, ever since Janet Yellin shocked markets with her abrupt and unnecessary rate hike in Jan 2018 (to get the House Intel Committee report about DOJ and FBI corruption off the front page). She caused the fastest 10% drop from all-time highs in US history that day.

Powell crashed markets again in 4th quarter with his idiotic rate hikes that he made AFTER oil & copper had just plummeted 30% each. Fighting deflation with rate hikes...BRILLIANT!

And 2 weeks ago his "mid-cycle adjustment" one-and-done blabber crashed stocks, inverted the curve worse, and pushed UP the dollar. The EXACT opposite of his "task". Hmmmm.
Its the Fed. Its always been the Fed.

Time for Jay to at least PRETEND he is trying to help America instead of squashing prosperity.
Jay needs to make a speech and apologize again, or just go ahead and cut 50bp NOW.
Fed Funds rates is highest on earth. That is absurd and a screaming policy mistake.

Fred said...

As Scott has said many times on this blog, it's all about confidence in the economy. My construction industry clients are seeing less new activity. This is reflected in the AIA billings index for new projects. We're also seeing contractors demand tariff escalation clauses in contracts. All of this points to FUD due to the tariff wars which will have a big impact on the economy if business pulls back and decides not to invest its capital. You can cite to Walmart earnings all you want but I'm seeing the impact of tariffs real time where it matters. Perhaps the FED does need to lower interest rates but that is only part of the problem.

WealthMony said...

JBD, I take it you do not like Powell as Fed chairman? It seems to me that the Fed has always been the problem (as you stated); however, it does appear the FOMC has improved post-Carter with recessions being less frequent. What do I know, but I did not think any rate hikes were warranted in 2019. Let's keep the economy growing. It is not roaring and I, for one, would like to see such. But I'm just not sure it is correct to characterize the Fed as "tight." I know Benji has been frustrated with the Fed and BOJ since I've been reading Calafia Beach Pundit, and he comes across to me as a thinking and informed individual. That's the reason I would like to hear from him as to how he sees the Fed as tight. It can't be just the nominal level of interest rates.

I personally like low interest rates, but it is the very low level of interest rates that has caused the nominal level of debt to rise over the past 35 years. To me it makes a lot of sense to borrow money at 0%-3% rates. That's almost free money that can be used to invest.

Producer prices are up +1.7% over the past year and the CPI is up +1.8%, so there's not much inflation to fight. Both the ISM Manufacturing and non-Manufacturing Indices have been declining over the past 12 months plus.

I am thankful President Trump has taken on China, a COMMUNIST nation, and I wish him well. Are tariffs the way to go about it? Heck, I don't know. China's economy is slowing. According to the WSJ a Chinese recession would mean a European recession. I don't wish a recession on China, but I do want the US, not China, to lead the world. I do want China to play fair. Any efforts by previous presidents, if there were any, failed with regard to China. At least President Trump's methods might be succeeding. We haven't crossed the finish line yet.

So, JBD, I think you make some insightful points. I'd love to hear from Benj reference Fed being tight. And then we can all move on to American progress and prosperity for all who are able and willing to work and produce.

Grechster said...

John and WealthMoney:

Whether the Fed is too tight or not is NOT based on the Fed Funds rate relative to history. Rather, it's based on the relationship of the total money supply versus the demand for money. As it turns out, we live in extreme times in that the demand for money is unusually high (and has been for most of the last 11 years). The Fed and its defenders keep insisting that because the Fed Funds rate is low relative to history that it is "easy." Or, others say that because the unemployment rate is historically low that, again, it isn't too tight. But invoking employment in determining monetary policy is pure idiocy. It's just wrong. (I know full employment is part of the Fed's mandate but this part of the mandate was added far after the Fed was formed and it was done for political reasons.) And history isn't instructive here given the extreme nature of our times. Of course rates are low by historical standards... and they need to be even lower.

It doesn't matter why the demand for dollars is as high as it is.

Also, focus in on the chart that Scott puts out from time to time: The real Fed Funds rate versus five-year TIPS. It shows in graphic form that the Fed is too tight (by about 75 basis points). Also, note what the markets have done after a sustained period of too-tightness.

The question of WHY the Fed is in fact failing to meet the extreme demand for dollars despite historically low Fed Funds is a complicated one. But let me suggest to you that one of the prime reasons is that the borrowing/lending/investment function that has dominated our country's history is meaningfully changed. This can be seen in the now decade long fact that despite super low interest rates, borrowing and investing (in things like factories) isn't taking place to nearly the extent one would expect based on history. And because that function has been changed so much we can conclude that the relationship between the money stock and the money supply has been changed.

Another consideration is that the menu of investment choices (for big money) is permanently changed. Consider: Throughout almost all of American history investors in the 10-year govt bond have insisted on roughly 200 bps of real return. Now? About zero. This tells us that something is meaningfully changed. (And this dynamic has been in play for a very long time, many years now.)

To those who keep resisting what the markets are telling us I would ask the following rhetorical question: 1) What do YOU think the ten year breakevens are telling us? A corollary to this: Wouldn't it be wonderful if the Fed came out and said, "We live in extreme times. Despite our many PhDs and some genuinely brilliant minds, we're quite confused. But we're going to rely on what the markets are telling us, and particularly on deep, liquid markets like the Treasury markets. And it's saying we're too tight. So we're going to act accordingly. Also, going forward, in an effort to reduce FUD, we're going to target the ten-year breakevens. We want this at 2% and will act accordingly." Imagine what that would do for planning, both in corporate America and in the markets.

randy said...

"To those who keep resisting"

I'm not sure how much resistance there is to the need for the FED to react. What you say makes perfect sense, thanks for explaining it so clearly. What Scott said on August 1st makes sense - and when he characterized it as a non-fatal mistake. What's a little frustrating is the monetarists fixation that it's just monetary policy - it's always the Fed and only the Fed. Trade policy has nothing to do with *creating* the conditions where more liquidity is needed. That POTUS has generally been creating massive anxiety whether you love him or hate him as nothing to do with increasing uncertainty and the need for liquidity. The rising likelihood that backlash to POTUS will get us Liz Warren has nothing do with risking anxiety and need for liquidity. The fate of the world rests singularly on a few pointy heads at the Fed. That's frustrating.

Grechster said...

Randy: Putting aside the silly employment part of its mandate, the sole role of the Fed is to match up the money supply with the demand for money. This is harder than it sounds because they only control the very front end of the yield curve. But it's also a problem of measurement. Who gets to define how inflation is measured? It's more than an academic question. CPI tells a different story than PCE which tells a different story than the bond market. (Since the late 90's we've had the TIPS market which, since I almost always defer to freely traded markets, tells a very accurate story of what the world expects in inflation over the relevant time frame.)

The Fed has demonstrated over the years that it is essentially incompetent in determining the right amount of liquidity for the markets. This would be bad enough but it also has made incredible mistakes over the years in explaining what it looks at. (The Philips Curve is nuts! And that's just one example of their muddled thinking.) Most of the time the Fed's mistake of providing too little or too much liquidity isn't egregious enough to bring on massive problems. But sometimes it is. We may be in one of those periods now.

But this isn't to say the Fed is everything. It's almost always the most important factor but it isn't everything. Even if they got the liquidity question perfectly right, we'd all have to contend with fiscal issues (as you point out when you raise the issue of trade, the policies of our pres, the prospect of Dems winning, etc).

steve said...

One thing is certain and I think we all agree on: the Fed needs to cut-and soon. the problem is the Fed has a nasty reputation of doing the wrong thing a lot.

The Cliff Claven of Finance said...

The FED cutting interest rates did not "save" the economy from a recession in 2001 and 2007.

I suppose it's different this time?

Johnny Bee Dawg said...

We don’t have high valuations and Mark-to-Market accounting this time.
Corporate balance sheets have never been stronger, especially their liquidity.
We also have record cash on the sidelines, cowering in fear.

So, yes, Cliff...this time it’s different.

Inversion on the short end of the curve has been signaling Powell that he’s too tight for months now. It’s as simple as that. Yesterday’s 2/10 was trying to wake him up.

There’s no reason for the “riskless” US to be yielding so much more than the rest of the world. Our yields want to fall to be in line with planet Earth. Nobody needs a PhD or an economics degree to see this. The one rate he can control is waaaay too high.

The only person not listening to the market signals is Jay Powell. Same with Yellin on her way out the door.
Why is that?

Markets down 3% yesterday, but high beta stuff stayed in line. Things that would have fallen 8% in last 4th quarter’s environment fell less than the market yesterday. That tells be the market doesn’t really want to fall apart because it knows Powell is going to have to react. SURELY he will. Surely.

S&P Low Vol index is now 95 cents from all time highs, beating SPY YTD by 535 bp.
Market HQ All Points Bulletin: be on lookout for mousy little man with horn rim glasses and slide rule. Answers to Jay. Jay, where are you?! (I kid Jay.)

Benjamin Cole said...

WealthMony: well, I say the Fed is too tight for the same reason I say major global central banks are too tight. And I am happy to quote Milton Friedman. You do not get to negative interest rates and dead inflation after decades of easy money.

Beginning around 1980, major central banks in general became more independent and were justifiably concerned with reining in inflation.

Since then, interest rates and inflation have indeed retreated until now we see interest rates that are negative, and inflation that is dead in Europe in Japan and barely surviving in the US.

But as public agencies, central banks remain devoted to their founding principles and are committed to fighting the last war. Central bankers keep jibber-jabbering about inflation, and the Fed Beige Books are obsessed with "labor shortages".

At this point, I am even open to money-financed fiscal programs, AKA helicopter drops. It may be that the tools of lower interest rates and quantitative easing are pop-guns. The financial world has changed.

Trump may be a boor (maybe I have been at times also). That does not explain why the global economy is slowing, why we have 16 trillion dollars of negative interes-rate bonds in circulation, and why inflation is dead almost everywhere on the planet.

Do not confuse a distaste for Trump's personality with macroeconomic policy necessities.

randy said...
This comment has been removed by the author.
randy said...

Long time readers may remember Mark Gerber, and his steadfast thesis that demographics would lead to something like we see now. Maybe that's bearing out.

steve said...

Really good piece in The American conservative re the inverted yield curve and the prospects for recession;

"The FOMC’s attempt to artificially raise short-term interest rates when there was no compelling reason to do so gave us the inverted yield curve. Now, under Jerome Powell, the FOMC must figure out a way to back out of this mistake without completely destroying what remains of the Fed’s credibility. In fact, the FOMC is probably the single biggest threat to the U.S. economy."

The take is that the author argues that the yield curve is NOT a harbinger for a recession as short rates are artificially high (it's different this time).

Color me skeptical but open minded...

Read entire piece here:

Johnny Bee Dawg said...

Jackson Hole gives Powell and other Fed Governors the perfect opportunity to issue yet another mea culpa.
Bonds and stocks know he "has" to.

Also, millions of people peacefully marching in Hong Kong (singing the US National Anthem) are showing that Liberty is not going down easy. The pictures from the weekend are astounding, and encouraging.

The Cliff Claven of Finance said...

Mr. (Trump lap) DAWG wrote:

"So, yes, Cliff...this time it’s different."
My response:
"This time is different" is exactly what the losers said in early 2000, and in mid-2008, before the stock market fell 50%. I guess you believe there will never be another bear market, or another recession? ... A lot of Dumbocrats want a recession in 2020, to get rid of Trump, and they can say and do things to encourage one. They called Trump a Russian. That didn't work. Now they call Trump a racist and white supremacist. That won't work. Next they'll try to encourage a recession in 2020. Dumbocrats act like they hate this country, at least when Trump is president -- perhaps all the time?
"We don’t have high valuations ..."
My Response:
The median stock, which emphasizes small and medium capitalization stocks, was more highly valued in July 2019, than at any time in stock market history.

For the average stock, which emphasizes large capitalization stocks, almost all valuation metrics were above average in July 2019.

For the valuation metrics that have been most accurate for predicting stock market returns over the next 8 to 12 years (the P/E Ratio is not one of them), the average stock is very overvalued.

Here are two examples of over-valuation,
using proven valuation indicators:
Warren Buffett's favorite stock valuation metric,
U.S. Stock Market Capitalization
as a Percentage of U.S. GDP
See the chart at the link below:

For my favorite stock valuation metric,
the S&P 500 Price to Sales Ratio:
Record Low Month --------- March 2009 = 0.80x
Record High Month --- September 2018 = 2.20x
Price to Sales Ratio on August 16, 2019 = 2.12x
See the chart at the link below:

"Corporate balance sheets have never been stronger"
My Response:
Corporate balance sheets are overloaded with debt.
"We also have record cash on the sidelines, cowering in fear."
My Response:
This is silly talk:
For "cash on the sidelines" to buy stocks, someone who owns stocks has to sell them, and take their cash ! The only exception is buying new issues of stock, which accounts for a tiny portion of all stock trades each week.

Mutual funds have small cash balances.

Warren Buffet had an unusually large cash balance at the end of 2Q 2019, suggesting he can't find undervalued stocks to buy. Mr. Buffett's cash balance has been a good contrary stock market valuation indicator over the decades.

Mr. Dawg:
Say "hi" to your motorcycle gang !

Johnny Bee Dawg said...

ALL valuations were astronomical back in 2000 and 2007. That was different.
They are definitely mixed today.
Every relative strength measure was screaming to get out of stocks by June 2000, and Jan 2008 (I did).
Only a few are saying that now, and they are close to reversing back up. That was different.

Mark to market accounting changes turned a housing bubble into a near Depression. That was different.

Mr. Buffett is very VERY wise, but he really has nothing to do with normal investing. He cant own the companies I do, as they would have no effect on his massive portfolio. He wouldn't even bother buying the entire company. And he has massive cash flows (insurance premiums) into his portfolios every single month that dictate a totally different approach.
And other people have 100% autonomy to run most of his portfolio, so you really dont know if CASH is his own opinion or not.

And Berkshire Hathaway stock is DOWN this year while the market is up 17%. So he’s not always right.
Buffett has underperformed the market over the most recent 1,3,5,10 year periods. I dont think many people realize that.

Whether we go into recession or not is completely up to Jay Powell, at this point. What does Jay want??
Bonds and stocks are signaling that he will correct his constant policy mistakes soon. We shall see.
We are in trouble if he botches things again.

John said...

Maybe expectations have changed. I'm 64 and my dad would be 100 if he were still alive. I remember his advice about investing. He said never feel bad about taking a profit. Never beat yourself up for getting out too early. Don't look back. Lots of guys lose their shirts. If you can make 10 percent a year, that's GOOD. Now, it seems if you aren't making 30 you're a "loser." Are valuations reliable? Do we really know what anything's worth anymore?

WealthMony said...

Thank you to Benj and Grechster for your comments regarding Fed tightness. JBD, you've really hit the nail on the head regarding mark-to-market accounting (I believe) as a significant contributor to the 2008 financial crisis. There are lots of good posts in this current discussion.

steve said...

Delusional thinking to believe that the Fed has our future in their hands if they do NOT cut 50 bps. Crazy talk. Agreed, they SHOULD cut but recession if they don't when rates are already
at 2% ish? C'mon. There are obviously other factors involved here not he least of which is DT's trade war (even the WSJ says he's losing according to a piece today).

steve said...

That trump needed to be schooled by Tim Cook with literally eco 101 principles proves his absolute stupidity. That said, I doubt he'll follow his advice.

Johnny Bee Dawg said...

When the Fed ignores bond market signals, bad things happen. Every single time. For 100 years.
Its not "delusional" to recognize history, and realize the enormous power the Fed has to put a lid on prosperity...or worse.

Powell's Fed Funds rate is highest on Earth. Out of sync with everything.
Inverted yields on the short end are going to hurt business funding if allowed to persist.

Even just in recent history, every lid on the stock market and GDP has been Fed induced: Jan '18 (Janet), Oct '18, and 3 weeks ago.
Markets are pricing in 1.2%. Powell is at 2.25%
That's a massive dislocation.

Lets see how he does in Jackson Hole.

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