Thursday, December 25, 2014

Greater Expectations

What Did You Expect?

The lack of inflation in the US economy, and by extent the rest of the developed world has been [and still is] one of the most discussed topics in macroeconomics of recent. The timing of the macroeconomic pendulum swinging from a period of high inflation to one of low inflation, is more interesting relative to the Global Financial Crisis, than is the fact that the economy is growing slowly, and inflation is low. The labor market is transforming to facilitate a different "take" on an adult working life, that will come to dominate as Baby Boomers exit stage left, and millennials take the reins to the US economy.

As the demographics of consumption change, the Baby Boomers, who came of age at a time when inflation was growing, built expectations of rising inflation that carried them through to the early 1980s. At which point, Congress deemed inflation to be worth the full-time attention of the Federal Reserve System. And so, for the last 30 plus years, the Fed has been actively targeting inflation expectations. They have been working on building credibility for their policies and policy targets. Now it seems their efforts have been rewarded with the macroeconomic reality of today being in-line with the long-held expectations they have been cultivating, unintended consequences included.

Another point of interest has been the amount of inflation risk premium demanded by investors. Inflation risk premium has been fairly flat for the duration of the Fed's inflation targeting. This indicates that market participants have placed a high degree of confidence in the Fed's ability to actively manage inflation over the long-term.
While the US economy has been shifting focus from manufacturing to services, from about the same time the Fed received its dual mandate, real interest rates have been on the decline. The services sector, tending to be more capital intensive relative to manufacturing, attracted investment capital from around the world, as represented by the Trade Weighted U.S. Dollar Index: Broad.

Interestingly, the upward trend in the dollar that prevailed during the 1980s and through to the 1990s, reversed in proximity with the bursting of the dot-com bubble and the introduction of the euro currency at the turn of the millennium.
Effectively, global speculative capital 1) saw an apparent end to the US tech dominance, and 2) had a seemingly viable dollar alternative in the newly minted euro currency. Simultaneously, emerging market economies started becoming developing economies on the back of globalization accelerated by the telecommunications infrastructure that spawned from the dot-com bubble. Investors worldwide had credible (some more so than others) alternatives to investing in the US economy when seeking sensible capital appreciation.
Meanwhile, in the US, the investment capital that was not diverted outward found its way into the real estate market. When that investment reached critical mass, money moved into energy commodities and some softs. When that investment reached critical mass, and the money markets were in disarray, money moved into gold out of fear.
The Fed Effect
Monetary policy that supports positive inflationary pressures in the face of falling nominal interest rates will drive down real interest rates (rates of return) down.
Since the early 1980s, as actual inflation fell in line with expected inflation, the FOMC managed its interest rate targets lower, taking market rates with them. Through times of economic uncertainty and financial instability, the Fed followed conventional monetary policy and lowered short-term interest rates to provide liquidity. Any additional liquidity however, provided by the Fed is supportive of positive inflationary pressures in the short-term, which counteracts with long-term expectations of falling inflation.

Looking at real interest rates going back to the early 1980s, there have been brief periods, usually coinciding with a recession, in which real interest rates where actually negative. By contrast, the last two recessions have seen real interest rates go negative for longer and longer periods of time. Since the Global Financial Crisis and the ensuing recession of 2008 - 2009, real interest rates have spent only a few brief periods positive, compared to the majority of the time being spent negative.
This has many fundamental implications for investors, as they tend to hold assets over time, their financial assets are losing value in real terms. This is conducive to an environment where the financial markets place a premium on liquidity.
Both US equities and debt appear to be over-priced at current levels, when compared to the real macroeconomic environment. Due in part to banks choosing to hold liquid assets in the form of financial securities, instead of making loans and extending credit out of precaution from uncertainty
and negative real interest rates. As long as an air of uncertainty persists, equity and bond markets will be buoyed by the liquidity preference in the banking system.
On the flipside, it's a borrower's market. With the amount of liquidity being created by near-universal easy monetary policy, corporations and governments have a rare opportunity to borrow vast amounts of money for long periods of time, and take comfort in knowing that they're getting a deal.
What to Expect When You're Expecting
Looking forward, the Fed now has to get inflation expectations and eventually inflation up to and above their current 2% target, after thirty-plus years of trying to push it lower. Looking at the evolution of an Expected Inflation Yield Curve, market participants do not seem to expect inflation to be back at or above the Fed's current 2% target for another ten-plus years.

From the position of the banking system, until inflation increases due to sustainable economic growth and expansion, the liquidity and market depth of simple stocks and bonds will remain appealing. The banking system plays a pivotal role in ensuring that any inflation that manifests is based on real world supply-demand shifts and not monetarist accounting. The liquidity preference substitutes market securities for loans, and so diminishes the fractional reserve banking system's ability to get money into the hands (or accounts) of everyday people. Instead, the banking system is expanding on its ability to get money into the hands (or accounts) of corporations and governments via the financial markets.

Monday, December 1, 2014

Deflation, or Something to that Effect

The Age of Uncertainty

Deflation: a fall in the general price level or a contraction of credit and available money. This is the simple definition provided by; from there it only gets more complicated.

In one form or another, from Asia, to Europe, and on to the Americas, the specter of deflation is present. Usually, in order for general price levels to fall, there also needs to be a drop in wages. Workers earn less relative to before, so they spend less relative to before, which puts downward pressures on prices. During the boom times leading up to the Great Recession, low wage growth was offset by borrowing. The borrowed money was consumed, and put upward pressure on prices, which resulted in inflation, and hence more production to capitalize on higher prices.

Now, in the age of uncertainty, driven by household deleveraging (in developed economies at least), borrowed money is not being used to offset low wage growth. Household consumption is therefore subdued, producing very little inflationary pressure on prices.

Another driver of inflationary pressures which is no longer present in the global macro environment is government spending. Again, in the boom times leading up to the Great Recession, governments around the world competed to attract multinational business by lowering tax rates, while in most cases increasing the services that they offered, with shortfalls being covered with borrowed money.

But, in the age of uncertainty, the fiscal sustainability of many governments is being questioned. In many cases fiscal consolidation, and even austerity programs are being pursued. Services are being watered down, reduced, or cut all together. The next step in the fiscal consolidation march is to start raising tax rates.

The third leg in the borrow-and-spend trifecta are corporations. Of the three, they tend to be the most logical, and in many cases realistic with spending borrowed money. In the boom times leading up to the Great Recession, corporations invested in expanding capacity and territory to capitalize on global economic growth, as well as reshuffling addresses to capitalize on competing tax regions.

Post crisis, in the age of uncertainty, corporations have been spending 10s of billions at a time. But at this point the spending is more defensive in nature. Mergers and Acquisitions have been occurring in record numbers and with record price tags. Money is being spent to combine efforts and abilities instead of in outright competition. This has the overall effect of putting upward pressures on equity prices, but not much else, and of course synergies reduce the need for as much labor.

Who Really Benefits?

With easy monetary policy being the prevailing trend around the world, the idea being to entice households in particular to borrow more and spend to stimulate growth. But, since the bursting of the dotcom bubble, households around the world had ramped up borrowing to unsustainable levels, in tune with governments. The households, governments and even some corporations that were over-leveraged have been foreclosed, bailed out, or bankrupted in that order (with a few exceptions). Since then the macro environment has had an air of debt aversion, especially among households, as they are the last to receive assistance in times of crisis. 
Governments have been an obvious benefactor of the easy monetary policy trend, as the use of their debt instruments as collateral for central bank lending has helped to keep borrowing costs low.
The search for yield resulting from the low returns on government debt has spilled over into the corporate debt market, allowing corporations to borrow at relatively lower rates as well to fund the rash of Mergers and Acquisition transactions in recent years.

Households have seen their main source of collateral; real estate, struggle to regain values lost during the Great Recession. Uncertainty in the labor markets have receded from crisis levels, but a residual uncertainty still remains as corporate employers and governments continue to consolidate in one form or another. Debt also has to be repaid with money that is worth a little more in the now low-inflation environment, than when it was borrowed during the previous higher-inflation environment.

By the time households have paid down their debt (or GDP has caught up) to levels that allow a reintroduction of an appetite for more (hopefully sustainable) borrowing, it would be time to start tightening monetary policy. Governments would have had the opportunity to refinance mountains of debt at lower rates, corporations would have had the opportunity to strategically invest for competing in a low growth environment, and household would get to borrow again at higher rates. Hopefully, and I do mean hopefully on top of higher tax rates to hasten the fiscal healing that is needed in most (if not all) developed economies.