Monday, June 24, 2013 - Hog Wild

Hog Wild

by Sinclair Noe

DOW – 139 = 14,659
SPX – 19 = 1573
NAS – 36 = 3320
10 YR YLD + .03 = 2.55%
OIL + 1.26 = 94.95
GOLD – 16.00 = 1283.60
SILV - .43 = 19.79

On Friday's show we had a call near the end of the hour and the caller posed a good question: “has the Fed started tapering?” The answer is technically “no”. But I had a chance to reflect over the weekend and I think what the Fed has done is started the process of gauging market reaction to an eventual exit from QE. It's like dipping a toe in the water.

Or as Richard Fisher, president of the Dallas Fed, told the Financial Times today, “Markets tend to test things. We haven’t forgotten what happened to the Bank of England [on Black Wednesday]. I don’t think anyone can break the Fed . . . But I do believe that big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”

Fisher said the exit has not started but last week's hints by Fed Chairman Bernanke were part of a process to prepare the markets for the end of central bank support; or as Mr. Fisher put it: “I don't want to go from Wild Turkey to Cold Turkey overnight.”

The People's Bank of China seems to be taking the Cold Turkey approach; they are telling the country's largest banks to rein in risky loans and improve their balance sheets, a warning that sent a jolt through already unsettled equity markets. Last week, China experienced a bit of a credit crunch as short-term borrowing rates jumped; the overnight lending rate hit a record high of more than 13% and another measure of cash in the banking system , the 7-day repo rate peaked at 25%.

The official state media reported that the central bank was targeting the shadow banking system, saying: “It's not that there's no money. It's that the money is not in the right places.” And so the People's Bank of China said the banks must prudently manage liquidity risks that have resulted from rapid credit expansion. This seems to be a clear indication that the Chinese government has no plans to loosen policies or inject liquidity to bring down interest rates. The likely result is Chinese economic growth will slow this year, with most estimates ranging about 7.5% growth – only 7.5%.

The Federal Reserve expects the US economy to grow at a 2.6% pace this year; right now, the economy is growing at about a 2% clip. It will take some more time to see if the Fed's rosy outlook is justified; the Fed is typically bad at forecasts. If you don't get more job creation and higher incomes, there won't be a meaningful increase in consumer spending or economic growth.

It's hard to get blood out of a turnip.

The turnip is the American consumer. A new report from Bankrate says 76% of Americans are living paycheck to paycheck, with next to nothing in savings; 50% of those surveyed have less than a 3-month cushion of savings and 27% had no savings at all. And the savings rate has barely changed over the past 3 years. And a new poll from the Murdoch Street Journal finds 58% of Americans think the US is in a recession even though the recession officially ended 4 years ago.

The reality is that most of America is still living through a small “d” depression and the Fed's testing the waters or measuring the aggressive nature of the bond market feral hogs does nothing to get us out of the depression. Talk of taper does nothing to improve the employment picture, but then QE hasn't done much to help the employment picture. Unemployment is down, but employment is not up; in other words, we've seen a drop in the number of people looking for a job, not an increase in job availability. The US has 2.4 million fewer jobs today than when the recession began. Adjusting for population growth, it will take more than nine years at the current rate of hiring to return to pre-recession employment levels.

There is a durable belief that much of today’s unemployment is rooted in a skills gap, in which good jobs go unfilled for lack of qualified applicants. This is mostly a corporate fiction. A Labor Department report last week showed 3.8 million job openings in the United States in April — proof, to some, that there would be fewer unemployed if more people had a better education and better skills. But both academic research and a closer look at the numbers in the department’s Job Openings and Labor Turnover Survey show that unemployment has little to do with the quality of the applicant pool.

In a healthy economy, job openings are plentiful and unemployment is low. April’s tally of 3.8 million openings might sound like a lot, but it is still well below the prerecession average, in 2007, of 4.5 million openings a month. It is also far lower than the record high of 5.2 million openings in December 2000, when the survey was started near the peak of a long economic expansion.

Unemployment is also stubbornly high — 7.5 percent in April, or 11.7 million people, a ratio of 3.1 job seekers for every opening. No category has been spared: unemployed workers outnumber openings in all of the 17 major sectors covered by the survey. The biggest problem in the labor market is not a skills shortage; rather, it is a persistently weak economy where businesses do not have sufficient demand to justify adding employees.

 In addition, when there are many more applicants than jobs, employers tend to impose overexacting criteria and then wait for the perfect match. They also offer tightfisted pay packages. What employers describe as talent shortages are often failures to agree on salary.

If a business really needed workers, it would pay up. That is not happening, which calls into question the existence of a skills gap as well as the urgency on the part of employers to fill their openings. Research from the National Bureau of Economic Research found that “recruiting intensity” — that is, business efforts to fill job openings — has been low in this recovery. Employers may be posting openings, but they are not trying all that hard to fill them, say, by increasing job ads or offering better pay packages.

Corporate executives have valuable perspectives on the economy, but they also have an interest in promoting the notion of a skills gap. They want schools and, by extension, the government to take on more of the costs of training workers that used to be covered by companies as part of on-the-job employee development. They also want more immigration, both low and high skilled, because immigrants may be willing to work for less than their American counterparts.

So, we have a problem with the Fed not accomplishing its mandate of full employment; what about the mandate for price stability? Well, there is very little inflation. There is a near zero chance of domestically generated inflation while wages are falling, and contractionary fiscal policy is depressing real incomes, and banks are not lending, and corporations are failing to invest. Externally driven inflation is possible and we are seeing some inflation in asset prices as a consequence of QE, but the core trend is disinflation in developed countries.

What the taper talk has accomplished is to push rates higher. Two months ago, the benchmark interest rate on the 10-year Treasury Note was about 1.62%; today it hit 2.62%. Higher rates will surely mean a slower recovery than we would have had if the Fed had avoided taper talk.

Right now, the feral bond hogs are winning. This bloodbath represents a 62% increase in borrowing costs for the federal government. Meanwhile, the average going rate for a 30-year fixed-rate mortgage has also risen by a full percentage point, to about 4.4 percent.

Today, the Bank of International Settlements, which is basically the central bank of the global central banks published its annual report on the state of the global economy. And they included a chapter on “Fiscal sustainability”, concluding: "While progress has been made towards reducing fiscal deficits, many economies still need to increase their primary balances significantly to put their debt on safer, downward trajectories." The BIS does not explain how rising interest rates might lower debt; and that is a major problem; rising rates means higher debt, just as slow growth leads to higher debt.

Instead, the BIS explains in its annual report, just how bad the losses might be if rates rise: “losses on US Treasury securities alone will reach $1 trillion if average yields rise by 300 basis points, with even greater damage in a string of other countries. The loss could range from 15% to 35% in France, Italy, Japan, and the UK. Such an upward move can happen relatively fast.” So says the BIS with a reference to the 1994 bond crash.

Monetary stimulus comes and goes; the idea is to try and time it so that it leaves when the economy is strong and can better handle the loss of stimulus. That's not what we saw this past week. Instead, we saw the Fed testing the waters, looking to withdraw stimulus based upon the markets' reaction. And that is entirely the wrong reasoning.