FIFO Monetary Policy and the Business Cycle

With all the talk of Yield Curve flattening and recession forecasting in the U.S., see U.S. Yield Curve and Risk of a Liquidity Trap ; it occurred to me to consider the interest rate structure of other developed economies and also juxtapose the economic narratives. Developed economies are generally experiencing low unemployment rates paired with low wage growth, healthy housing markets paired with available credit, and overpriced equity markets paired with geo-political uncertainty.

The common theme of shrinking spreads between long-term interest rates and short-term interest rates suggests that many developed economies are on similar positions on their business cycle. It stands to reason as Central Banks synchronized their response to the Great Recession, and monetary policy accommodation during the recovery and expansion stages of the business cycle. When the Federal Reserve embarked on its current monetary policy tightening cycle, they all but ensured that the U.S. economy would once again lead the world economy into its next recessionary cycle and out the other side.

By tightening monetary policy, which is inherently short-term, the Federal Reserve is accelerating the pace of yield curve flattening. As they drain liquidity from financial markets by selling short-term bonds, the Fed pushes up short-term interest rates. The loss of liquidity means less money is available to keep pushing up the price of equities so stock markets fall too. And finally, as stock prices fall investors buy long-term bonds for safety, pushing prices up and long-term interest rates down. This shift represents a change in market participants expectations about the trend in economic growth over the duration of the yield curve. Long-term rates falling relative to short-term rates is interpreted as future growth is expected to fall.

Central Bank policy and crisis response is generally backward-looking, so they only respond to  recession after it is underway even if they are the technical cause. That being said, the first economy to go into a recession will have its Central Bank modify policy, and will be the first to cycle out of recession and onto recovery and expansion. First In First Out (FIFO).

Baby Boomers + Labor Market = Low Wage Growth

The one thing that has been consistently missing from this otherwise textbook recovery that was engineered by the US Federal Reserve is sustained wage growth. The one thing that has been consistently ignored in the narrative of the recovery has been labor force participation. The trend has been one of declining participation ratios, and this can only be expected to accelerate. The acceleration in the rate of decline of labor force participation is predominantly driven by the Baby-boomer exit from the labor market.

In terms of a lack of sustained growth in real wages in the last almost two decades, again the burden lies with the Baby-boomers. Wages grew while the Baby-boomers entered and matured in the workforce, including the macro-introduction of women into the labor market. Now we are at a point where Baby-boomer wages have increased for decades and now on aggregate are at their caps. Paired with Fed-backed low inflation expectations, employers on average have no reason to increase wages. However, as the Baby-boomer retirement trend accelerates, and their share of the labor pool shrinks, employers would have to increase wages on aggregate to keep or attract younger talent.

All-in-all things seem to work themselves out. Millennials get to experience sustained wage growth over some period congruent with experience and education, and long-term employers see their average wages fall as the boomers retire. Now let's take this slice of relative tranquility on the labor side of the Fed Mandate and overlay it with the pricing side of that same mandate.

The unwind of the Fed's Quantitative Easing  policy and effective tightening of monetary policy, along with similar positions being adopted by other Central Banks means financial and other inflation sensitive assets will continue to reprice lower.  Simultaneously, President Donald Trump is pursuing a trade policy that in one way or another will lead to higher consumer prices in the U.S. through higher import prices. U.S. households look to be caught in a full pincer maneuver. From one side they will be hit with falling financial asset prices which reduces the value of their savings, from the other side they will be hit by increasing consumer prices stemming from trade disputes, and finally from above with demographic pressures keeping wage growth subdued.

Long story short, when U.S. discretionary spending starts contracting a recession will soon follow.

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.

What The US Dollar is Telling Me About the Global Business Cycle

As of December 28, 2017 the one-day, one-week, one-month, one-quarter, and one-year regression slopes of the Dollar Index are all negative. Looking further back, the five-year and ten-year regression slopes are positive, but this reflects the recovery from the Great Recession over the past decade.  Because the one-year regression slope is the longest of the short-term measures that has turned negative, tells me that the almost decade long rally in the US dollar came to an end in 2017. The apparent reversal in the mid-term trend of the US dollar is a signal of a return to normalcy in global financial markets, and international capital flow.  

When searching for context, I like to look at my longer-term charts out to twenty-years. What stands out is the period from mid-2001 to mid-2008, and the economic narrative of the day.  From the early 1990s through to the early 2000s the US economy, and by extent the global economy was is a long-term expansionary period. The growth that was experienced resulted from the US economy going through the finally stages of transitioning from a manufacturing dominant economy to a services dominant economy. A process which started in the late 1970s, and manifested as stagflation in the 1980s.

For the duration of the expansion during the 1990s, the US dollar appreciated against wide baskets of it trading partners. This appreciation reflected international investment capital flowing into the US to participate in the tech bubble and the broader US equities market. By mid-2002 the Dollar Index was making lower lows in conjunction with lower highs, which signaled the start of a downward trend. The trend in the dollar continued until mid-2008, by which time global financial markets had become aware of an underlying problem with the US financial system. During that same period, the US consumer was left to do what they do best, which is borrow and spend, and that they did. There was economic growth driven by appreciating housing prices and deepening household debt, and even a recovery in the US equities markets after the dot-com crash. The US dollar depreciated from 2002 through to 2008 for the same reason why it will depreciate from 2017 through to 2022 and maybe into 2023.

There have been trillions of dollars in value created in US equities since the lows of 2009. For the recovery part of the business cycle, the US economy was the biggest and safest game in town, while the rest of the world ‘sorted through their financial affairs’. Now that we are in the expansion part of the business cycle, risk appetite is returning to global financial markets. With (tepid) growth ensured in the US, market participants can move their profits from the US equities market into international markets to better leverage the synchronized expansion we are currently experiencing around the world.

If global economies keep expanding in sync with each other, monetary policy will remain on a path of tightening around the world. However, consumer price inflation will not return in a synchronized manner, which means US interest rates should rise relatively slower than world averages. This should lead to further dollar depreciation in the face of further economic expansion, which should continue to support the US equities market.

US Housing Market

For at least a decade leading up to the Great Recession multi-family housing starts were trending with single-family housing starts (in rate-of-change not magnitude). The 2009-2010 recession and the protracted recovery coincided with a compositional shift in the US population by age. The baby boomers are transitioning out of the labor force and their demand for housing is reshaping the residential real estate market. By the end of 2014, multi-family housing starts had matched or by some measures surpassed its pre-crisis levels. The recovery in single-family housing starts on the other hand has been tepid.

In the years leading up to, and proceeding the Great Recession, baby boomer demand for multi-family housing remained fairly consistent. With this as a base to support the market, the post-recession increases in demand from millennials and the elderly was enough to spur the recovery in multi-family housing units. The shift in preferences away from single-family housing units towards multi-family units, which is being influenced by many factors, is incentivizing home builders to construct more units. At the core of the shift is housing preferences is the baby boomer generation transitioning from the workforce, and wanting less living space.

The home builders with the projects in the regions where baby boomers are migrating for the climate are positioned to immediately take advantage of the new trend. Next up are the builders who are securing land for new construction in those same regions. The good news is that the upward trend in multi-family housing starts, which is being supported predominantly by the demands of the baby boomer generation is in its nascent stage. This potential tailwind can support a selective real estate portfolio over the next decade. 

Lemonade (Limonada)

Puerto Rico just had its entire electrical infrastructure decimated by hurricane Maria. It is estimated that the entire island could be without power for up to six months. This being a conservative estimate, means realistically we're talking twelve to eighteen months. But, as the adage goes, 'When life gives you lemons, you make lemonade'. Or in this case limonada. Puerto Rico's electrical infrastructure needed improving and modernizing, but those types of projects to a backseat to the debt issues the US territory was entangled in with private institutional investors.

In the wake of the destruction inflicted by hurricane Maria across the island, the International Monetary Fund (IMF) can step in to help the people of Puerto Rico rebuild after this humanitarian disaster. The IMF will of course insist on some measure of fiscal austerity in exchange for the loan, which in all honesty the timing would be ideal {I'll explain later}. Puerto Rico would be able to build a completely modern electrical infrastructure system. A system with built-in safeguards against natural disasters, especially hurricanes as the strength of the storms positively correlate to the temperature of the oceans where they form. Whether it's from natural oscillations in ocean temperatures over the long-term, or human activity exaggerating natural oscillations in ocean temperature over the medium-term, ocean temperatures are trending higher.

As for the ideal timing of IMF imposed austerity measures, the best time to raise taxes while cutting government spending is when (almost) everyone has a job. On a slightly smaller, much more efficient model of how the Federal Emergency Management Agency (FEMA) allocates funds and reimburses businesses and local governments, Puerto Rico can tap large swathes of its labor pool. Puerto Ricans can be put to work modernizing Puerto Rico's electrical and information infrastructure. From manual labor, to administrative, to finance, to legal, there will be hundreds of thousands of roles that will need to be filled to make a project of this magnitude a success. The net effect on the national economy should be a jump-start in personal consumption from the fiscal stimulus being dampened by higher tax rates.

Hurricane Maria has presented Puerto Rico with an opportunity to make it-self more competitive in the long-term, more attractive to businesses that depend on frontier level information and logistic infrastructure to develop and commercialize new technologies and processes. Simultaneous investments in the education system will need to be made, or Puerto Rico risks having a local workforce not equipped to compete globally for local jobs.