Fed Changes the Script, But Not the Ending…

24th September 2013

“I am perplexed and baffled. I do this for a living. I shouldn’t be so confused and confounded.” Strategist at a leading investment bank last week, after the Fed ‘shocked’ markets

Maybe he should book some therapy or a career break, but his dismay is a reminder of the remarkable faith investors still have in the elaborate general equilibrium macroeconomic models that drive central bank policies, despite proving hopelessly inaccurate both pre and post crisis. Macro forecasting, particularly at economic inflection points, is as much art as (pseudo) science. Of course, investors understandably crave certainty and predictability, but as I highlighted last week looking at the employment market, there are huge uncertainties which generate confusion even among Fed researchers. Regardless of which month a Fed exit begins, higher yields largely reflect a reduction in perceived global tail risks and related inflows to ‘safe haven’ assets. The broad dynamic is similar to that which has seen gold plummet this year. It seems inevitable that central bankers will squander hard won credibility if they fumble the exit from this period of extraordinary intervention and/or attempt to reverse underlying market forces driving higher yields higher from unsustainably negative real terms back in May.

With TIPS break-evens suggesting long term inflation expectations in the order of 2.4%, it is clear that a 10-yr bond yield sub 3% reflects extraordinarily low implied risk premiums. Implied long-term bond yields are so low partly because of the Fed’s dominance of incremental Treasury issuance, but also by very bearish medium term growth expectations and hence inflation risks, both reflected in portfolio positioning and net flows. Most observers assume that interest rates were abnormally low until May because of QE, but investor liquidity preference/risk aversion reflected in $1.2trn in bond fund inflows from 2008-12 was a bigger factor. As I’ve highlighted, the US labour market is not as strong as the headline number suggests and the fall in the unemployment rate has probably surprised most Fed members, who would have expected the participation rate to start picking up by now. Ahead of last week’s Fed meeting, the average rate for a 30-year fixed mortgage had risen to 4.5% from 3.4% in May so the market has already tightened credit conditions meaningfully. Overall, the endless tapering speculation by investors has usefully reduced the froth that had developed in risk assets like EM debt and HY credit/MBS over the first half of 2013, and highlighted structural GEM vulnerabilities to tighter policy.

I went to a lunch last week with a very prominent central banker, who expressed the frustration of his peers that bond markets have simply refused to follow the script in recent months and from the UK to US, efforts to manage medium term interest rate expectations via ‘forward guidance’ are meeting growing scepticism. We’re seeing a very gradual asset reallocation shift from ‘safe haven’ precious metals/government paper i.e. this year’s bond sell-off largely reflects normalizing bond risk premia rather than a change in central bank rate or inflation expectations and there is little central banks can (or should) do about it. The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation and the Fed will be unable to stop that ultimately healthy process with further QE over the next couple of years, so may as well make a virtue of an inevitability and wind down the current stimulus program in an orderly fashion.

US Productivity Growth a Double Edged Sword for Labour Market…

In this US recovery, total payroll employment has only risen by 1.9%, versus over 8% on average in recoveries since 1961. Productivity has rebounded above its 2% LT trend, while real median income has been negative since the recession. That more than any Fed action explains why equities have performed so well in such a lackluster macro environment, as margins have swiftly rebounded on technology enabled cost-cutting, but that is also driving extreme income inequality and weak aggregate demand. The non-farm payrolls report on Friday showed unemployment declining to 7.8% in September after holding between 8.1% and 8.3% during the first eight months of the year. This is the lowest unemployment rate in more than four years. Employers added a seasonally adjusted 114k jobs, accompanied by upward data revisions indicating that 181k jobs were added in July and 142k in August, and Q3 job growth was far higher than in the spring, amid yet another US growth panic.

Despite gasoline prices flirting with $4/gallon and the pervasive uncertainty over 2013 tax levels, the jobs market has returned to its recent trend. Since the start of 2011, payrolls have grown by a pretty consistent average of 169k jobs a month. Payrolls have risen by more than 250k only three times since the start of 2011, and by less than 50k only once. The labour force rose by 418k in September and the participation rate rose, although it remains historically low (see chart below). In addition, the long term unemployment level has moved down to 40.1% from 41.9% in June. Naturally, the surprisingly low unemployment rate and large upward revisions to prior months drove Republican conspiracy theorists needlessly into overdrive.

Large revisions are a long-standing pattern, whether there’s an election looming or not. Almost all the revisions, however, came from an upward revision of 101,000 to local government education in August before seasonal adjustment – a repeated anomaly at this time of year. It’s likely something is wrong in the BLS collection process as there shouldn’t be a recurrent pattern of error like this. The real issue is less the quantity than quality of the jobs being created; the vast majority were part-time, continuing the general trend since 2009. After accounting for population growth the economy is on balance shedding full-time positions with benefits, offset by part-time positions at lower pay and no benefits. We need to see median real household income rising on a consistent basis to drive a stronger and less volatile recovery, rather than simply cheaper consumer financing as prescribed by the Fed.

The  gain  in  hourly  earnings  was  solid  in  September  at  1.8%  y/y  and  suggests  a corresponding increase in personal income, which would imply support for consumer spending, and further employment gains (the relationship as shown in the chart is that personal income/consumption leads employment by about 3 months). The minutes of the September FOMC meeting released last week point to a vigorous discussion about employment conditions. Those wondering when the Fed’s QE measures might end did not get the definitive decision rule they were hoping for, as the current US recovery is historically well past middle age, at 13 quarters, but has been a very weak one on almost every metric, making traditional policy short hand rules such as the capacity utilization rate dubious.

Stepping back from the data noise, the proportion of 16 to 64-year-olds who are employed fell sharply in the recession and has barely recovered since; while the unemployment rate has steadily fallen back towards its historic levels, labour force participation has fallen, keeping the employment-population ratio constant. One hypothesis is that the recovery has been so weak because of underlying adverse trends in the US labour market. In an academic paper entitled “Manufacturing Busts, Housing Booms, and Declining Employment: A Structural Explanation”, the authors show how the ongoing decline in the demand for men with no more than a high school education in increasingly IT intensive manufacturing has generated an increasingly negative employment trend for these workers for three decades.

This trend continued unabated during the years after the 2001 recession but was masked by the housing boom, which lifted employment for less-skilled workers for another five years. If we view the housing boom (when residential investment doubled from its long-term average at about 3% of GDP) as an aberration that is unlikely to resume, it is misleading to compare the current labour market with that just preceding the onset of the 2008 crash, just as output gap analysis is similarly misleading. In both cases, the starting level of activity was artificially boosted by an historic credit boom, flattering the apparent strength of the US economy at every level back in 2007. The decline in the employment to population and male workforce participation ratios has been a long-term structural trend, pre-dating the 2008/9 recession but accelerated by it.

 

The recent auto sales data, alongside the ISM surveys (particularly on services) suggest that we’re still stuck in that 2% or so growth zone. Whether the recent mediocre but steady performance of the jobs market and overall economy can be sustained into Q1 or even accelerate, depends increasingly on political events in Washington. As both the Presidential election and ‘fiscal cliff’ loom, there seems to be bipartisan agreement emerging in a couple of areas. Defense spending is slated to come in for $600 billion in cuts over nine years, which might compromise national security and would certainly eliminate thousands of jobs. It seems likely that at least some of that will be restored. In addition, there is bipartisan support for allowing the temporary payroll tax reduction to expire; this will help restore cash flow into Social Security and Medicare, but will cost the average household about $1,000 annually. The uncertainty has been a deterrent to economic activity, as reflected in weakening corporate investment trends, for example.

The  two  sides  have  been  in  meaningful  discussions,  which  are  encouraging;  Treasury Secretary Tim Geithner recently met with Congressional leadership and the Congressional Ways and Means Committee has stepped up its deliberations, but there remains fundamental ideological disagreement on the future course of tax policy and entitlement spending. Without a compromise in these two areas, a long-term budget agreement will remain difficult to achieve. Some observers suggest that a deal will be reached that postpones the crunch point on the debt ceiling, deferring hard discussions until later in 2013, or even that we will go over the cliff to avoid the Republicans breaking their bizarre but sacred principle of no tax rises, and then some taxes get cut again in January.