Taper Talk

Interest rates are going up, let's face it. And it doesn't really matter where you look across the Capital Markets Universe, investors are preparing for price volatility.

The emerging market economies will be facing capital flights as investors seek better inflation adjusted yields, while the developed economies will be facing capital flights as investors seek rising yields and better growth prospects. The end effects being the same, currency depreciation against the dollar and all the macro-economic side-effects that result.

The countries with the smallest foreign exchange reserves will carry the extra risk of demand for dollars outstripping their ability to supply. But I think in the spirit of "First Do No Harm", the Fed shouldn't have too many arguments about swap agreements with the central banks in most need.

Europe relative to the U.S. is not so clear in the face of Taper Talk and beyond. High unemployment and soft real estate demand would seem to be pushing inflation expectations down, and if that leads to downward pressure on prices, the Euro might stand a chance of further appreciation against the dollar over the long term.

The Yen may be depreciating against the dollar now, and the Fed is going to be lending them a hand inadvertently. But the U.S. economy is going to stabilize and then normalize, and the Fed will finally be able to get back to sitting on its hands. Japan's birthrate more than likely wouldn't have increased in any meaningful way, and their immigration policies might still not be as open as may be needed. The fundamental demand for more, which pushes prices higher and drives investment is not being supported.

The Great Shake Out 2008 – 2012

Demographic re-balancing disguised as structural change in the US labor market. Of the occupational groups that the Bureau of Labor Statistics tracks, the top four with the highest projected employment change out to 2020 are all heavily technology driven industries. And as the millennials are slowly infiltrating the labor markets, whether as job creators or labor-for-hire, they are bringing in their incessant need to connect to and through technology.

The baby boomers on the other hand, who by the way seemed to have been affected by the Recession in their own special way, tend to not be so drawn to the cutting edge of human-machine interface. This macro shift to innately integrate technology into business functions automatically puts the boomers at a disadvantage, and will further drive their attrition out of the labor market.

As nothing good happens overnight, this demographic changing of the guard is a slow and drawn out process. But, on the upside, The Great Shake Out 2008 – 2012 acted as a catalyst in moving the theatrics along.

Don't F**k With The Prices

In The Road to Serfdom, Friedrich Hayek wrote: 

Any attempt to control prices or quantities of particular commodities deprives competition of its power of bringing about an effective co-ordination of individual efforts, because price changes then cease to register all the relevant changes in circumstances and no longer provide a reliable guide for the individual's actions.

First and foremost, Hayek was a Classical economist, but I am going to try to channel his philosophy on Price Controls, to ponder the work of a Monetarist Fed.

I'll be the first to admit that only monetary policy could have cleaned up the mess monetary policy created. It took about five years starting in 2001 for the housing market to ramp up in valuations to bubble status with the help of the Fed, and about two years to devastate the world economy despite the efforts of the Fed.

Five years into the recovery, I think it’s time to pull the morphine drip.

The first step on the road to normalization is acceptance. The smart folks at the Federal Reserve need to internalize the idea that somewhere mixed up in all the chaos of a global financial crisis, we might have experienced a structural shift in the labor markets, with regards to the natural rate of unemployment.

At this point, I think it’s safe to say that the scope of the (monetary induced) financial crisis has been exceeded. It’s time to let the economy be an economy again. Following Heyak’s logic, the Fed makes a habit of fixing the price of money, and has been exceptionally active as of recent with the Quantitative Easing programs.

As a result of being the buyer of last resort for so long, the Fed has unofficially taken on the role of chief underwriter of the US equity markets. Participants don’t seem to want to transact unless it’s with the Fed’s money. Added to that, a recent annual report by the Financial Stability Oversight Council warned that “a sudden spike in yields and volatilities could trigger a disorderly adjustment, and potentially create outsized risk.” From my vantage point, this seems to put the decision makers at the Fed in a bit of a pickle. Their presence in the market is the sole source of confidence and liquidity that has been keeping yields and volatilities low. The same low yields that make government and household borrowing costs lower and low volatilities that make investors feel wealthier and more inclined to further invest have been supporting the economic recovery.

Extreme monetary price fixing was needed, for a time, but that time is past. In short, there’s no obvious way to avoid the withdrawal that is going to result. We have to expect higher yields and higher volatilities. The question is, how much of the shock can Fed dissipate around market participants, and how are they going to do it?


http://www.economist.com/blogs/analects/2013/05/hayek-prize
http://www.economist.com/blogs/freeexchange/2013/05/federal-reserve-speaks

A Simple Reason Why Gold Prices Will Keep Falling

Over the past couple days, the price of Gold has been the headline (or at least received honorable mention) for most of the major financial news reporting organizations. Everyone seems to have a different and in some cases arcane rationale behind the move. The most sober offering was by Professor Campbell Harvey of Duke University. He suggests that the price of Gold normalized for the CPI puts fair value somewhere below $800 per Oz. As Gold is currently trading with a $1300 handle, the good professor's work suggests much more room for prices to fall.

Just because something is overvalued, certainly does not mean that the financial markets cannot rationalize the price higher. In this case, however, I think what we're looking at is a slow shift of speculative money out of Gold, as the most recent Fed minutes are suggesting that Quantitative Easing may be loosing its appeal, and the conversation has begun about a Fed exit.

Gold bugs are still going to buy the metal in the event that the world comes to an end and they have to buy groceries the following day, and industrial demand should be fairly stable as global economic growth really isn't worth writing home about. But speculators really don't have a fundamental reason for being net long if the easy money might start slowing and inflation expectations start easing.

Gold should have at least two more downward corrections before it gets back on track with its long term average. The first should be when the Fed finally stops buying Treasuries, the second should be when the Fed starts its rate raising campaign, which I think should take prices down towards where professor Harvey suggests (which I concur with).

Entrepreneurship and the Small Business is going to be the Saving Grace of the US Economy

Big business at this point is waiting for the world economy to pick up, which is in turn waiting for the US economy to pick up. Bad news is, the growth trajectory is low slow and gradual for at least the next three-to-five.  No new growth means no new jobs, no new jobs means no demand. Big business lives and dies on new demand.

In the meantime people still have to get shit done. Every day, day after day, people still have to get shit done. Good news, you're in America.

How Immigration Can Make You More Money

I'm watching my USD/JPY trades and thinking about the last 15 years of Japan's economic history. The Japanese went through a similar issue to what we experienced here in the US in 2008, back in the early 90s. Their crash was followed by what is affectionately know as the lost decade. Interest rates were pushed as low as they could go, and still no growth (as measured by inflation). After years of little to no price increases, prices started falling as consumers put-off spending and deflation set in leaving Japan in a Keynesian liquidity trap.

We're not there yet, but we could actually see the economic situation in the US go a similar route but for one thing. Foreign migrants and non-restrictive immigration policies can be the catalyst that can jump-start real long-term economic growth. Japan didn't think so, and restricted migrant access to the country and made it very difficult for them to get jobs. As a result, there was no outside stimulus to population growth coupled with one of the lowest birthrates in the world, Japan went from second largest economy in the world to a far third behind China and being forced to competitively devalue its currency just to spur exports. It only has to do this because there isn't much new internal demands from the quickly retiring Japanese workforce.

Who's Concerned?

As posted on the Federal Reserve Bank of Chicago website, in 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Fast forward to 2013, and the Fed has explicitly linked the timing of future interest rate increases to the rate of unemployment, and more recently, has expressed concern about the effects that early increases to interest rates could have on the Federal Government’s budget deficit targets. I’m concerned that the Fed isn’t concerned about price inflation.

Before the Fed started truly intervening in the financial economy in late 2008, their balance sheet and by extent the amount of “money” in the economy was around $800 billion, at the end of 2012 after four years of quantitative easing and special lending programs the Fed’s balance sheet was close to $3 trillion. Of all that new money, $1.5 trillion are bank reserves just sitting.

My finance background has exposed me to the idea the money does not like to sit still for very long. When the financial economy shifts from de-leveraging to investing, that money is going to be put in motion, and when it is, upward price-pressure will be exerted on the economy.

Inflation is not yet a concern, but I think that by the time it is, the horse would have already left the barn and closing the door would be fruitless pursuit.