Ricardian Trade Theory and U.S. Total Factor Productivity

Total Factor Productivity which is defined as the economy-wide effects of innovation indirectly as the residual part of productivity growth that cannot be explained by other factors. Basically, the extra bit of efficiency that accumulates in an economy when  everybody is becoming more efficient. According to a February 2018 Federal Reserve Bank of San Francisco Economic Letter titled, "The Disappointing Recovery in U.S. Output after 2009", quarterly growth in Total Factor Productivity is beginning to slowdown. The Economic Letter also highlights that the slowdown began before the Great Recession and coincided with a peak in labor force participation.

What the analysis featured in the Economic Letter ignores is the fact that the U.S. economy has not been growing its Total Factor Productivity in a vacuum. When the U.S. economy began reaping the benefits of the shift from a manufacturing base to a services base by the early 1990s, Total Factor Productivity increases manifested. Being a high capital economy, able to take advantage of economies-of-scale, the U.S. economy had a comparative advantage over its trading partners in services. The advantage compounded through the 1990s and culminated with the bursting of the dot-com bubble. During the formation and inflation of the dot-com bubble the U.S. dollar appreciated as foreign investment capital flooded in and the U.S. grew the capital account surplus.

By the turn of the millennium, labor force participation was peaking as the baby boomers began their exit from the labor market. Within five years the slowdown in Total Factor Production became apparent, just in time for the Great Recession. But after pressing its advantage in services from about 1985 to about 2005, the U.S. economy began experiencing diminishing returns. Data moves more freely around the world now more than ever before and has been doing this for decades. Simply put, other countries have the internet now. Open trade has allowed other countries to buy, learn from, and develop upon U.S. services and technologies. They too can grow their Total Factor Productivities. The good news is if we keep trading with countries that are getting more and more efficient, it will keep import prices low which benefits consumers.

U.S. Yield Curve and Risk of a Liquidity Trap

The Fed, after its most recent meeting reiterated its plans for the front end of the yield curve for the remainder of the year and into next year. Barring some unforeseen disaster in one form of another, of course. Market participants can expect at most three interest rate increases this year. Since the unwind of Quantitative Easing began, the Fed has been loosening its grip on the longer end of the curve, which has allowed for a clearer dissemination of market expectations through pricing data. My regression analysis of the last year's price of the 10-Year U.S. Treasury Note Futures, suggests a period of stable to rising prices in the medium-term. Stable to rising prices for 10-Year U.S. Treasuries means stable to falling interest rates for that segment of the yield curve. Pair that with the raising interest rates on the very front end of the curve, the trend of yield curve flattening that has been unfolding in bond markets is set to accelerate.

When the Fed raises short-term interest rates in a healthy economy, with growth on its horizon represented by a steepening yield curve, the rate increase transmits throughout the entire curve and pushes down all bond prices. In normal financial markets, investment capital would flow out of bonds and into stocks, raising equity prices and further reflecting expected economic growth. Apparently, we don't have a healthy economy, with growth on its horizon, or normal financial markets. With the Quantitative Easing unwind well underway and the now-apparent fact that the U.S. economy cannot support equity prices at current levels on its own, stock markets around the world are revaluing. Now for a bit of normalcy, falling stock prices will result in investment capital flowing into bonds. More specifically, the 10-Year U.S. Treasury Note for its perceived safety and liquidity, which will push the price up and interest rates down.

As the Fed continues along its intended course of interest rate increases, inflation expectations of market participants and businesses will continue to remain subdued. This translates into lower prices of inflation hedges like gold, and even lower input costs starting with oil. From the position of businesses, even with shortages of qualified labor, they don't have enough of an incentive to raise wages because they don't anticipate significate or continuous price increases in the near future.

My expectation is that as losses mount in U.S. equity markets, investors will have to liquidate foreign holdings, putting continued pressure on global equity markets, both developed and developing. In addition to liquidating foreign holdings, U.S. investors will repatriate cash to cover margin calls and rebalance leverage ratios by selling foreign currencies and buying U.S. Dollars. Dollar inflows will become exacerbated if the selling in equity markets accelerates and triggers a flight-to-safety reaction in market participants. In this scenario, the Fed will be forced to divert the course of monetary policy. And, if as the flattening yield curve suggests, a slowdown in U.S. economic growth or even a recession is pending, then the Fed does not have very much room to maneuver before they're back to a Quantitative Easing policy. The real definition of a Liquidity Trap.