Economy Archives - Page 33 of 134 - the patient investor

March 3, 2018

The Fed and Alice in Wonderland

In Lewis Carroll’s Alice in Wonderland a young Alice experiences a series of bizarre adventures after falling down a rabbit hole. The new Fed Chairman Jerome Powell will similarly have to lead global financial markets through a series of bizarre, unprecedented experiences.

Down the Rabbit Hole

In 2008, after the collapse of Lehman Bros, financial markets were in complete disarray and in danger of imploding. The Fed, under chairman Ben Bernanke, embarked on an unprecedented (and unproven) rescue attempt — now known as quantitative easing or QE for short — injecting more than $3.5 trillion into the financial system through purchase of long-term Treasuries and mortgage-backed securities (MBS).

Fed Total Assets

The Fed aimed to drive long-term interest rates down in the belief that this would encourage private sector borrowing and investment and revive the economy. Their efforts failed. Private sector borrowing did not revive. Most of the money injected ended up, unused by the private sector, as $2.5 trillion of excess commercial bank reserves on deposit at the Fed.

Fed Excess Reserves

Richard Koo pointed out that the private sector will under normal cirumstances respond to lower interest rates with increased borrowing but during a financial crisis, when their balance sheets have been destroyed and their liabilities exceed their assets, their sole focus is to restore their balance sheet, using surplus cash flow to pay down debt. The only way to prevent a collapse is for the government to step in and plug the gap, borrowing surplus capital and investing this in infrastructure.

One Pill Makes you Larger

Fortunately Bernanke got the message.

US and Euro Area Public Debt to GDP

… and spread the word.

Japan Public Debt to GDP

And One Pill Makes you Small

Unfortunately, other central banks also followed the Fed’s earlier lead, injecting vast sums into the financial system through quantitative easing (QE).

ECB and BOJ Total Assets

Driving long-term yields to levels even Lewis Carroll would have struggled to imagine.

10-Year Treasury Yields

The Pool of Tears

Then in 2014, another twist in the tale. Long-term yields continued to fall in Europe and Japan, while US rates stabilised as Fed eased off on QE. A large differential appeared between US and European/Japanese rates (observable since 2014 on the above chart), causing a flood of money into the US, in pursuit of higher yields.

….. with an unwanted side-effect. The Dollar strengthened. Capital inflows caused the trade-weighted value of the US Dollar to spike upwards beween 2014 and 2016, damaging US export industries and local manufacturers facing competition from foreign imports.

US Trade-Weighted Dollar Index

The Mad Hatter’s Tea Party

A jobless recovery in manufacturing and low wage growth in turn led to the election of Donald Trump in 2016 promising increased protectionism against global competition.

US Manufacturing Jobs

Then in 2017, to the consternation of many, despite rising interest rates the US Dollar began to fall.

US TW Dollar Index in 2017

Learned analysis followed, ascribing the weakening Dollar to rising commodity prices and a recovery in emerging markets. But something doesn’t quite add up.

International bond investors are a pretty smart bunch. When they look at US bond markets, what do they see? The new Fed Chairman has inherited a massive headache.

Donald Trump is determined to stimulate job growth through tax cuts and infrastructure spending. This will certainly create jobs. But when you stimulate an economy that is already at full employment you get inflation.

Who Stole the Tarts?

Jerome Powell is sitting on a powder keg. More than $2 trillion of excess reserves that commercial banks can withdraw without notice. Demand for bank credit is expected to rise as result of the Trump stimulus. Commercial banks, not known for their restraint, can make like Donkey Kong with their excess reserves provided by the Bernanke Fed.

Under Janet Yellen the Fed mapped out a program to withdraw excess reserves from the market by selling down Treasuries and MBS at the rate of $100 billion in 2018 and $200 billion each year thereafter. But at that rate it will take 10 years to remove the excess.

Bond markets are worried about what will happen to inflation in the mean time.

Off With His Head

The new Fed Chair has made all the right noises about being hawkish on inflation. But can he walk the talk? Especially with his $2 trillion headache.

….and the Red Queen, easily recognizable from Lewis Carroll’s tale, tweeting “off with his head” if a hawkish Fed threatens to spoil the party.

One pill makes you larger
And one pill makes you small
And the ones that mother gives you
Don’t do anything at all
Go ask Alice
When she’s ten feet tall

….When the men on the chessboard
Get up and tell you where to go
And you’ve just had some kind of mushroom
And your mind is moving low….

When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen’s off with her head
Remember what the dormouse said
Feed your head
Feed your head

~ White Rabbit by Grace Slick from Jefferson Airplane (1967)

Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.

February 26, 2018February 26, 2018

Richard Koo: Surviving in the Intellectually Bankrupt Monetary Policy Environment

Richard C. Koo, Chief Economist, Nomura Research Institute, at the ACATIS Value Konferenz 2016 in Frankfurt

Why QE doesn’t work.

I have the greatest respect for Richard Koo and his unconventional, balance-sheet-recession approach to economics.

It strikes me is that if central banks lower interest rates to stimulate borrowing and borrowing does not rise because borrowers are repaying debt to restore solvency, then it will backfire and hurt GDP. Households reliant on income from investments, especially in financial assets, will experience a significant loss of income from lower interest rates and will reduce their consumption accordingly. Falling consumption will cause a drop in GDP.

Investments in financial assets consist not only of household bank deposits and bonds, but also insurance sector and pension fund investments in financial assets (mainly bonds) which will raise insurance premiums and lower pensions as a result.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

February 23, 2018

Why is the Dollar falling?

The broad, trade-weighted US Dollar index has been declining since early 2017.

US Dollar Index - Broad and Major Trading Partners

This is the best explanation I have found for current US Dollar weakness. From Bank of Montreal, BMO Nesbitt Burns:

The relationship isn’t perfect, but as a general rule of thumb, the USD declines in years when global growth is above potential. In such years, strong global growth causes commodity prices to rise, which lifts commodity currencies. In addition, strong global growth normally triggers a flood of investment out of developed economies and into emerging economies. As emerging central banks intervene to slow the appreciation of their currencies from these two factors, they sell the USD against EUR and other alternative reserve currencies, thereby causing the USD to decline against both developed and emerging currencies. That dynamic helps explains the USD depreciation in 2017 as well as the 2004-2007 period. The 10Y average of the IMF’s World GDP growth rate is 3.4% and we think that is roughly potential growth. The IMF estimates that global growth will come in at about 3.6% for 2017 and accelerate to 3.7% in 2018.

In addition, the US’s twin deficit fundamental (sum of the current account deficit and fiscal or federal budget deficit as shares of GDP) is another factor that is negative for the USD. Turns in the twin deficit normally precede turns in the USD by 1-2 years and then trends match thereafter. The US’s twin deficit fundamental has been deteriorating for the past two years and is likely to deteriorate further in 2018 and beyond due in part to the tax cuts. When looking at all these factors together with the fact that USD phases tend to last 5-7 years, we feel that we have to forecast a continuation of broad USD weakness—albeit at a slower pace. We project that the broad USD index will fall 1.5% in Q1 and then 1.0% per quarter in each of the remaining three quarters of 2018.

Hat tip to David Llewellyn-Smith at Macrobusiness.

The fall in the Dollar may also be self-reinforcing, as Enda Curran at Bloomberg highlights:

…..On top of the boost already coming from robust global GDP growth, the dollar’s fall over the past year may add over 3 percent to the level of world trade, according to Gabriel Sterne, global head of macro research at Oxford Economics Ltd. Tipping further dollar weakness, the risks are skewed to the upside for Oxford’s baseline forecast for 5 percent growth in world trade in 2018.

“Falls in the value of the dollar oil the wheels of the global financial system, boosting global liquidity by strengthening balance sheets and alleviating currency mismatches,” Sterne wrote in a note. “One important channel is variation in the differential between the cost of raising dollars onshore and offshore. Dollar weakness reduces the cross-currency basis, increases cross-border lending and boosts bank equities.”

The biggest winners will likely be emerging economies given the weaker dollar will lower the value of their dollar-denominated debt, taking pressure off their balance sheets and from credit conditions more generally…..

Finally, from Deutsche Bank (again hat tip to David):

How can it be that US yields are rising sharply, yet the dollar is so weak at the same time? The answer is simple: the dollar is not going down despite higher yields but because of them. Higher yields mean lower bond prices and US bonds are lower because investors don’t want to buy them. This is an entirely different regime to previous years.

Dollar weakness ultimately goes back to two major problems for the greenback this year. First, US asset valuations are extremely stretched. As we argued in our 2018 FX outlook a combined measure of P/E ratios for equities and term premia for bonds is at its highest levels since the 1960s. Simply put, US bond and equity prices cannot continue going up at the same time. This correlation breakdown is structurally bearish for the dollar because it inhibits sustained inflows into US bond and equity markets.

The second dollar problem is that irrespective of asset valuations the US twin deficit (the sum of the current account and fiscal balance) is set to deteriorate dramatically in coming years. Not only does the additional fiscal stimulus recently agreed by Congress push the fair value of bonds even lower via higher issuance and inflation risk premia effects, but the current account that also needs to be financed will widen via import multiplier effects. When an economy is stimulated at full employment the only way to absorb domestic demand is higher imports. Under conservative assumptions the US twin deficit is set to deteriorate by well over 3% of GDP over the next two years.

US Current Account Deficit

In summary:

Rising global growth boosts commodity prices and emerging markets
Central banks in emerging markets then sell Dollars to slow appreciation of their local currency
Fiscal stimulus, such as US tax cuts and infrastructure spending, lifts inflation
Higher inflation causes a bond bear market
Fiscal stimulus also widens the current account deficit
Central bank selling, higher inflation, a bond bear market and wider current account deficits all cause a weaker Dollar

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

January 25, 2018April 16, 2018

How QE reversal will impact on financial markets

The Federal Reserve last year announced plans to shrink its balance sheet which had grown to $4.5 trillion under the quantitative easing (QE) program.

According to its June 2017 Normalization Plan, the Fed will scale back reinvestment at the rate of $10 billion per month and step this up every 3 months by a further $10 billion per month until it reaches a total of $50 billion per month in 2019. That means that $100 billion will be withheld in the first year and $200 billion each year thereafter.

How will this impact on financial markets? Here are a few clues.

First, from the Nikkei Asian Review on January 11:

The yield on the benchmark 10-year U.S. Treasury note shot to a 10-month high of 2.59% in London, before retreating later in the day and ending roughly unchanged in New York. Yields rise when bonds are sold.

The selling was sparked by reports that China may halt or slow down its purchases of U.S. Treasury holdings. China has the world’s largest foreign exchange reserves — holding $3.1 trillion, about 40% of which is in U.S. government notes, according to Brad Setser, senior fellow at the Council on Foreign Relations.

Chinese officials, as expected, denied the reports. But they would have to be pondering what to do with more than a trillion dollars of US Treasuries during a bond bear market.

Treasury yields are rising, with the 10-year yield breaking through resistance at 2.60%, signaling a primary up-trend.

On the quarterly chart, 10-year yields have broken clear of the long-term trend channel drawn at 2 standard deviations, warning of reversal of the three-decade-long secular trend. But final confirmation will only come from a breakout above 3.0%, completing a large double-bottom.

Withdrawal or a slow-down of US Treasury purchases by foreign buyers (let’s not call them investors – they have other motives) would cause the Dollar to weaken. The Dollar Index recently broke support at 91, signaling another primary decline.

The falling Dollar has created a bull market for gold which is likely to continue while interest rates are low.

US equities are likely to benefit from the falling Dollar. Domestic manufacturers can compete more effectively in both local and export markets, while the weaker Dollar will boost offshore earnings of multinationals.

The S&P 500 is headed for a test of its long-term target at 3000*.

Target: 1500 x 2 = 3000

Emerging market borrowers may also benefit from lower domestic servicing costs on Dollar-denominated loans.

Bridgewater CEO Ray Dalio at Davos:

We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws…

If there is a downside, it is likely to be higher US inflation as employment surges and commodity prices rise. Which would force the Fed to raise interest rates faster than the market expects.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

November 19, 2017

Leading Index gives early warning

One of the better composite indicators in the US, the Leading Index from the Philadelphia Fed, points to a slow-down in the US economy. A dip below 1.0% is often early, as in July 2000 and May 2006, but serves as a reliable warning of an economic slow-down.

Leading Index for the United States

The Leading Index predicts the six-month growth rate of the Philadelphia Fed Coincident Index. In addition to the Coincident Index, it includes variables that lead the economy: housing permits (1 to 4 units), initial unemployment insurance claims, delivery times from the ISM manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.

The Coincident Index combines four indicators: nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing and wages and salaries.

Coincident Index for the United States

The Leading Index signal does seem early. Low corporate bond spreads and VIX near record lows continue to indicate low market risk, typical of a bull market.

Corporate Bond Spreads and VIX

Monetary policy remains accomodative, with money stock growing at close to 5% p.a. (MZM = cash in circulation, travelers checks, money market funds and deposits with zero maturity).

MZM and Yield Differential

The yield curve has flattened, with the spread between 10-year and 3-month Treasuries falling to 1.0% on the above graph. That is what one would expect when the Fed hikes interest rates in a low inflation environment: short-term rates will rise faster than long-term rates. But a negative yield curve, where short-term rates are higher than long-term rates, is a reliable predictor of recessions in the US economy. Each time the yield differential on the above graph crossed below zero in the last 50 years, a recession has followed within 12 months.

Underlying inflation remains low, with average hourly earnings growth below 2.5% p.a., and the Fed should be careful about single-mindedly raising interest rates without considering the yield curve.

Annual Growth in Average Hourly Earnings

The bull market continues but investors need to keep a weather eye on interest rates and the yield curve.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

October 23, 2017October 23, 2017

Should we Worry that Velocity of Money is plunging?

Some writers have attributed slow GDP growth in the US to the plunging velocity of money.

In layman’s terms, the velocity of money is the ratio between your bank balance and the amount you spend. For the economy as a whole, it is measured as the ratio of GDP (or national income) against the total stock of money (or money supply).

When the economy is hot, consumers have a higher propensity to spend — or invest in the latest hot stock — and the ratio normally rises. When the economy cools, the ratio falls.

If the ratio was fixed, the job of central bankers would be simple: print more money and GDP would rise.

M1 Money Supply and GDP Growth

Unfortunately that is not the case. GDP growth has remained slow, post-2007, despite a sharp boost in the money supply.

M1 is a narrow definition of money: cash in circulation plus travelers checks, demand deposits (at call) and check account balances.

The ratio of GDP to M1 money (or M1 Velocity) has almost halved, from a 2007 high of 10.7 to a current low of 5.5.

M1 Money Supply and GDP Growth

Does this mean that consumers are feverishly stuffing cash into mattresses as the economy goes into a death-dive or is there a more rational explanation?

Examine the above chart more closely and you will see a clear relationship until 1980 between the velocity of money and interest rates (in this case the Fed funds rate). When interest rates rise, the velocity of money rises. So when interest rates fall, as they have post-2007, to near zero, the velocity of money should fall. As it has done.

The anomaly is not the current fall in the velocity of money but the rise in velocity of money between 1990 and 2000, when interest rates were falling. There are two explanations that I can think of. One is the digital revolution, with the advent of online bank accounts and automated clearing of business checking accounts which enabled depositors to minimize balances in non-interest bearing accounts. Second, is the rapid growth of money market funds which fall outside the ambit of M1 and M2.

Velocity of money measured as GDP/MZM gives a clearer picture, with velocity rising when rates rise and falling when rates fall. MZM is M1 plus all savings deposits and money market funds that are redeemable (at par) on demand.

M1 Money Supply and GDP Growth

We should expect to see the velocity of money recover as interest rates rise. If that doesn’t happen, then it will be time to worry.

Strange as it may seem, we could witness something really unusual: if higher interest rates stimulate GDP.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

October 23, 2017

Fed flunks econ 101?

Caroline Baum’s opinion on the Fed’s approach to inflation:

For all the sturm und drang about the Fed debasing the dollar and sowing the seeds of the next great inflation, the public’s demand for money has increased. The increased desire to hold cash and checkable deposits has risen to meet the increased supply. Velocity, or the rate at which money turns over, has plummeted.

The Fed has two choices. It can adopt the Dr. Strangelove approach and learn to stop worrying and live with low inflation and low unemployment. Or it can do something about it, which runs counter to its stated intention to raise the funds rate and reduce the size of its balance sheet.

Option #1 involves learning to live with a low, stable inflation rate about 0.5 percentage point below the Fed’s explicit 2% target.

Not only has the Fed has achieved price stability in objective terms, but it has also fulfilled former Fed Chairman Alan Greenspan’s subjective definition of price stability: a rate of inflation low enough that it is not a factor in business or household decision-making.

Option #2 means taking some additional actions to increase the money supply by lowering interest rates or resuming bond purchases. The Fed is taking the opposite approach. It began its balance sheet normalization this month, allowing $10 billion of securities to mature each month and gradually increasing the amount every quarter. And it has guided markets to expect another 25-basis-point rate increase in December….

The Fed faces a delicate balancing act. Unemployment is low but capacity utilization is also low, indicating an absence of inflationary pressure.

Capacity Utilization

Janet Yellen understandably wants to normalize interest rates ahead of the next recession but she can afford to take her time. The economy is unlikely to tip into recession unless the Fed hikes rates too quickly, causing a monetary contraction.

I believe the Fed chair is relying on the outflow from more than $2 trillion of excess reserves held by banks on deposit with the Fed to offset the contractionary effect of any rate hikes.

Capacity Utilization

If pushed, the Fed could lower the interest rate paid on excess reserves in order to encourage banks to withdraw excess deposits. But so far this hasn’t been necessary. The attraction of higher interest rates in financial markets has been sufficient to encourage a steady outflow from excess reserves, keeping the monetary base (net of reserves) growing at a steady clip of close to 7.5% p.a. despite rate hikes so far.

Capacity Utilization

Makes you wonder why Donald Trump would even consider replacing the Fed chair when she is doing a great job of managing the recovery.

Source: Fed flunks econ 101: understanding inflation – MarketWatch

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

October 19, 2017

Australia: Employment data points to recovery

Total hours worked grew at an annual rate of 2.7 percent in September, suggesting an up-turn in GDP growth after the 2011 to 2015 slump.

Australia: Hours Worked and GDP

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

October 9, 2017October 9, 2017

How long will the bull market last?

US markets are clearly in a bull phase, with the Dow, S&P 500 and Nasdaq making strong gains. A rising Freight Transport Index highlights the broad up-turn in economic activity.

Freight Transport Index

Low corporate bond spreads — lowest investment grade (Baa) minus 10-year Treasury yield — and VIX below 15 both reflect bull market conditions.

Bond Spreads

Real GDP is growing around a modest 2 percent a year. Low figures are likely to continue, with annual change in hours worked (total payroll * average weekly hours) falling to 1.2 percent in September.

Real GDP

Money supply (M1) growth recovered to a balmy 7 percent (p.a.) after a worrying dip below 5 in early 2016.

M1 Money Stock

The Fed may be reluctant to tighten monetary conditions but will be forced to act if inflation starts to accelerate. Annual growth in hourly wage rates turned above 2.5 percent in September, signaling underlying inflationary pressure.

Average Hourly Wage Rate - Annual Growth

Another dip in M1 below 5 percent growth would warn that monetary conditions are tightening. From there, it normally takes 12 months to impact on the broad market indices.

M1 Money Stock and Fed Funds Rate

At this stage it looks like another 2 years of sunshine before the storm. But one false tweet and we could face an early winter.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.

October 6, 2017

Australian banks under selling pressure

The ASX 300 Banks index are a major drag on the broad market index. Having respected resistance at 8500, a test of primary support at 8000 is likely. Twiggs Trend Index peaks below zero warn of strong selling pressure.

ASX 300 Banks

Return on equity is falling.

Australian Banks Return on Equity

A combination of narrow interest margins.

Bank Net Interest Margins

Soaring household debt.

Bank Net Interest Margins

And rising capital requirements as APRA desperately tries to protect their glass jaw.

Bank Capital Ratios

Don’t let the ratios fool you. They are based on risk-weighted assets. Common Equity Tier 1 (CET1) leverage ratio for at least one of the majors is as low as 4.0 percent.

Colin Twiggs

Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.