Chinese Financial Conditions Loosening As Economy Slows

It does appear that the Chinese government is now loosening monetary conditions in the country in a bid to combat a slowing economy and heightened trade tensions with the United States. This comes as a deviation from Beijing's financial de-leveraging / de-risking campaign, which has been ongoing since late 2016.

The Chinese economy has been showing signs of fatigue as the first half of 2018 has come to a close.

Source: China National Bureau of Statistics

Investment in real-estate in China weakened for a third consecutive month to 9.7% growth in the year of 2018 through June. While this was above the 2017-through-June value of 8.5%, it marked a drop of 0.5 percentage points month-on-month, and the metric is now 0.7 percentage points lower from a peak of 10.4% growth in the first three months of the year, in annualized terms.

Source: China National Bureau of Statistics

In another concerning sign, the new orders portion of the China non-manufacturing purchasing managers' index (PMI) recorded its second consecutive fall in June to a value of 50.6. The 50.0 mark separates expanding activity (above 50) from contracting activity (below 50). In this instance, new orders are still expanding, but just barely as the metric floats above the threshold.

The drop-off in June appears to have been rather pronounced, with the new orders index falling 0.4 points to 50.6. It could be argued that Chinese companies and individuals became concerned with the escalating trade rhetoric from the United States in May and June, and therefore fewer new orders were submitted. The PMI data for July will be watched keenly for signs of continued falls in this new orders index, as early July marked the first implementation of U.S. tariffs on $34 billion of Chinese goods, with immediate Chinese retaliation of the same magnitude.

The Chinese economy has been heavily reliant on credit to maintain high growth rates since the global financial crisis, and this has left it with a substantial debt load.

Data from BIS

From the first quarter of 2015 to the first quarter of 2017, total private non-financial sector credit (all sectors) as a percentage of GDP jumped from roughly 190% of GDP to over 210% of GDP- quite an acceleration for the world's second-largest economy.

In late 2016, the Chinese government announced its intention to pursue a campaign of financial deleveraging and de-risking, an effort that authorities hoped would lower debt levels and close out opaque areas of financing, namely the shadow banking sector. As this campaign has plowed on, debt as a percent of GDP has fallen from a peak of 211.1% in the first quarter of 2017 to 189.8% in the first quarter of 2018.

That improvement, while still leaving the debt nearly double the annual output of the Chinese economy, is nothing to shake a stick at. This deleveraging campaign has put a dent in the credit-hungry habits of Chinese corporations and local governments (households maintain a debt-to-GDP ratio of less than 50%, per the BIS). This progress has come at the cost of economic growth, as the above data show. The side effect of a slowing economy was expected, as credit dried up and firms that truly relied on cheap credit to function began to struggle, but the slowing economy is now testing the resolve of the authorities. Beijing can either choose to continue tightening financial conditions and continue ahead with the deleveraging campaign, or the government may opt to pause the campaign and loosen monetary conditions to keep economic growth elevated, hoping that the stimulus does not destabilize the economy through asset price bubbles or other factors.

It now appears that Beijing has chosen to go with the latter option, as onshore financial conditions have undoubtedly eased during the first half of 2018. For evidence of this, we begin with interbank lending rates in China, benchmarked by the Shanghai Interbank Offered Rates or SHIBOR.

Source: Shibor.org

Traditionally, across global interbank lending markets, higher rates are a potential sign of stress, as banks may become less willing to lend to each other, thereby increasing the interest rates. Similarly, a flood of cheap credit may make banks rather lax about lending money, knowing their financial system is awash in liquidity (at least on the surface), and thus they reduce the interest rates at which they're willing to lend money.

The most-watched slice of the interbank rates is the overnight tenor, abbreviated above as O/N. This is the interest rate Chinese banks are charging each other to lend money simply for the overnight period. In the U.S., such overnight lending is primarily used for banks to maintain certain capital thresholds at the end of the day, for regulatory purposes. While I would assume the same can be said in China, I cannot say this for certain.

In any case, across tenors, interest rates have been falling. This trend has been most pronounced in the longer-term tenors, where rates are more stable. In particular, the interbank lending rates for periods exceeding 1 week (abbreviated as 1W above) really plunged around late-May or early-June, just eyeballing the graphs. I expect that these lower interbank interest rates surfacing around the time of escalating trade tensions with the United States is not a coincidence in the slightest, and instead is an effort by the Chinese government to cushion enterprises against any outsize effects from the U.S. tariffs.

Lending rates across all tenors, including overnight, have recently been falling yet again, with interest rates at the two-week period and beyond reaching >five month lows. This is another symptom of further monetary easing engineered by the Chinese government, which is now seeking to toe the line between supporting economic growth and deterring a resurgence of risk appetite as credit is re-introduced to the system. With trade tensions remaining elevated and the U.S. threatening tariffs on practically all of its imports from China, Beijing will likely continue keeping the deleveraging campaign in a holding pattern, instead preferring to support the economy via stimulus measures (both monetary and fiscal).

Source: AsianBondsOnline

Chinese local-currency sovereign bond yields have also recorded significant drops across the entire yield curve year-to-date, again a symptom of financial conditions easing instead of tightening. In an environment of tightening financial conditions, yields on bonds increase as credit in the financial system dries up, making money less readily available and thus placing a premium on attaining such money. This had been a feature of the Chinese financial system from late 2016 to early 2018, when the 10-year sovereign bond yield peaked at just over 4.00%, but since then yields on these bonds have fallen.

The yield curve can be used to determine the cause of these falling interest rates. Recall that interest rates in the longer-term end of the yield curve are primarily influenced by expectations for future economic growth, inflation and similar large-scale economic factors. In contrast, interest rates at the short-term end of the yield curve are more influenced by shorter-term economic and financial events; it is for this reason that the Italian 2-year sovereign bond yield exploded higher by a greater number of basis points than the 10-year yield did when political instability (a short-term factor, not a long-term factor like the business cycle) hit in May.

Year-to-date, the one-year Chinese local-currency sovereign bond yield has seen the steepest drop in basis points across the yield curve, falling 84 bps to stand at 2.98% as of the above image. In contrast, far tamer falls have been observed in the multi-year tenors, where the YTD basis points move has been confined to roughly 40.

Using the 'separation' of the yield curve explained in the second paragraph above, it is safe to determine that the significant fall in short-term yields relative to long-term yields stems from Chinese expectations and/or consequences of the government loosening financial conditions yet again to support the economy. It's the same situation as when short-term U.S. Treasury note yields rise in response to a Federal Reserve interest rate increase, but the 10-year and 30-year yields may barely budge; monetary policy primarily plays out in short-term interest rates.

Source: MarketWatch

Elsewhere in financial markets, the Chinese yuan (renminbi/Rmb) has rapidly depreciated against the U.S. dollar since mid-June, with the exchange rate jumping from Rmb 6.40 per US$ to Rmb 6.80. Much talk of the yuan has stemmed from U.S. President Donald Trump's accusation of currency manipulation by Beijing; whether or not that is the case is not to be decided in this post. Rather, the weakening of the yuan since April is another sign of easing financial conditions in China.

The gradual strengthening of the yuan throughout (at least) the second half of 2017 in the above image is not a fluke, but can be attributed to the tightening financial conditions observed in China throughout 2017 (for evidence, see the reduction of credit in the second half of 2017 from earlier in this post). In economic theory, the reduction of easily-available money in the Chinese financial system makes the remaining currency more valuable to hold, consequentially making that currency (the yuan) appreciate. This played out according to that script in 2017 as cheap credit dried up.

Now, as Beijing appears to relax financial conditions, the yuan has depreciated once again. It is necessary to consider that the depreciation in the yuan here may also be due to a variety of factors, such as trade tensions with the United States, a resurgent U.S. dollar amid U.S. economic outperformance relative to the world (especially the E.U.), overarching concerns about the slowing domestic economy, and even policy interest rate differentials with the U.S. No matter the amalgamation of factors that have contributed to the yuan's weakness in the second quarter of 2018, the easing of Chinese financial conditions has likely played a part.

Source: MarketWatch

Lastly, the renewed easing of Chinese financial conditions recently (as per the new leg down in most SHIBOR interest rates) has likely played a non-trivial role in the rebound of Chinese equities. The Shanghai Composite closed out June by entering a technical bear market, defined as a 20% drop from a recent peak. The above chart shows this sudden drop in mid-June, before the bleeding finally stopped in early July.

Since that nadir, the Shanghai Composite has drifted upwards, gaining as much as 200 index points as of this typing. Again, a number of factors may have contributed to this rebound, but this time it's a little less opaque than analysis of the yuan's moves. On one hand, Chinese stocks rebounded despite no material improvements in U.S. / China trade tensions. It is plausible to consider that the higher stock prices reflect optimism from investors that domestic companies will be able to take advantage of the depreciated yuan and see a boost in exports, but this assumption is destabilized when considering the still-murky final impacts of the still-unfolding U.S. / China trade tensions.

The rebound in the Shanghai Composite came despite the release of rather pessimistic Chinese economic data in mid-July; a brief dip was seen, but the index has more than erased those losses. For these reasons, I'm led to believe that Chinese stocks have benefitted in a non-trivial way from the government easing financial conditions within the last several weeks.

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As the Chinese government continues its balancing act of supporting the economy but discouraging irrational investment activities, further gradual easing of domestic financial conditions are expected. The U.S. Federal Reserve is expected to continue increasing interest rates this year and next - in addition to continuing its balance sheet normalization program -, while the European Central Bank will end its asset purchase program at the end of this year. Both actions will see global liquidity continue to dry up, tightening global financial conditions in general.

With Beijing showing its desire to support economic growth at the expense of delaying further progress in the financial deleveraging / de-risking campaign, further easing of domestic financial conditions looks probable. Chinese stocks and bonds look set to benefit further, absent an unexpected deviation from the path.

Andrew

Turkey's Cooking: A Case of Intentional Overheating

Turkey is seen as one of the weakest links in emerging markets, with the Turkish Lira (TRY) falling substantially against the U.S. dollar, an impressive feat in itself given how the U.S. dollar has weakened substantially year-to-date as well. This post will review the foundation of how Turkey appears to be at risk of over-heating, and how this seems to be intentional at the hand of President Recep Tayyip Erdogan.

Source: Federal Reserve Bank of St. Louis

The Turkish Lira has followed up on a weak performance in 2017 with new record highs against the dollar in 2018, hitting 4.195 lira per US$ at its peak on April 11 of this year. The currency's decline has since taken a breather, and as of this posting it sits at roughly 4.06 lira per dollar, still down nearly 7.3% on the dollar year-to-date.

The rapid depreciation of the lira stems from growing anxieties over the state of Turkey, particularly with the increasing likelihood that the country's economy is being deliberately set to overheat.

Source: Federal Reserve Bank of St. Louis

Shown above is the consumer price index for Turkey, percent change from a year ago. After hitting nearly 13% in November 2017, the annual rate of inflation has slowed to "only" 10.2% in March 2018. At face value, one might be inclined to believe that inflation may finally be contained, and that the depreciating lira may not have as strong an effect as it's been made out to be.
However, the lower inflation rate looks to be a consequence of the base effect.

Source: Federal Reserve Bank of St. Louis

Indexed to October 1955, Turkey's CPI showed an acceleration around this time in 2017, as highlighted in the image above. Note, however, that the CPI seemed to then decelerate substantially for May through September 2017. In other words, what the base effect gives, the base effect may very well take away. The lira's depreciation that really kicked off in October 2016 (see top image) is already feeding through into the CPI, given the leg up in the index seen beginning around January 2017.

Continued depreciation of the lira since then, combined with the base effect reversing in 2018 Q2 and Q3, should result in upside surprises to Turkish inflation figures in the coming months, potentially intensifying the lira's depreciation and maybe even disrupting capital inflows to the country, though that may be more a consequence of global monetary policy tightening throughout the year, if it does happen.

Source: Federal Reserve Bank of St. Louis

This inflation surge has been accompanied by a surging economy, as Turkey's gross domestic product spiked to nearly 7.5% in 2017, about double the growth rate seen in 2016 and the highest print since 2013. The combination of surging economic output and inflation is what's leading to the fears of an overheating economy, fears that will only intensify if 2018 Q2 - Q3 inflation figures do accelerate again and/or the lira continues to depreciate.

Interestingly enough, the overheating economy has been not only welcomed but instigated by the administration of Turkey's President Recep Tayyip Erdogan. Erdogan has announced snap elections for June 24, well ahead of the expected dates of late 2019. It's believed the elections may be to capitalize on the current strength of the economy, rather than waiting until 2019 when the overheating may take its toll and hurt Erdogan's chances at re-election. Whether Erdogan allows the economy to return to a more normal state after elections (assuming he does win) remains to be seen, although the announcement of a $30+ billion investment project to create jobs and further boost the economy makes that possibility seem rather remote.

The economy will likely be left to overheat, particularly given the lowered credibility and independence of the Turkish central bank. Although the central bank raised its late-liquidity lending window lending rate by 75 basis points this week, President Erdogan has repeatedly called for interest rates to be lowered, holding the view that lower interest rates will lower inflation. Current economic theory states that lower interest rates increase the availability of credit and money, increasing spending and boosting inflation. The interest rate increase this week is a sign that the central bank is at least attempting to retain some independence and credibility in preventing the economy from truly going off the rails, but so long as President Erdogan continues attacking the central bank for not cutting interest rates and the fiscal policy side remains extremely stimulative, the central bank's policy will likely have only minimal effects.

The country of Turkey looks to be enticing a textbook case of an overheating economy, with high inflation poised to jump higher in coming months, a currency continuing to depreciate, and economic output still growing strongly. The country's heavy reliance on capital inflows makes it a candidate for an economic crisis (whether FX-based or current-account based), although for now this remains only a possibility, not a certainty. What is certain, though, is Turkey is heading down an unsustainable economic path, and if concerted efforts aren't made to guide the economy back towards a more stable level, things could end quite badly, for the country and perhaps emerging markets in a broader sense.

Andrew

Venezuela Projected To Begin 2018 With Under $5.3 Billion in Forex Reserves

Using a linear forecast of Venezuela foreign exchange reserves, and accounting for roughly $3.8 billion in debt payments through the government and state-owned PDVSA through December 2017, I am projecting the level of foreign exchange reserves to end up at just under the $5.3 billion mark on 1/1/2018.

Data source: Central Bank of Venezuela
Chart source: Author's creation

As of July 22, 2017, Venezuela's foreign exchange reserves stood at $9.971 billion, the lowest level of reserves seen during the current crisis. As the chart above shows, the country's foreign exchange reserves have been broadly falling since the start of 2017, from a few ticks under $11 billion at the beginning of the year to the $9.971 billion level we are at now.

I took these two data points and, to satisfy my own curiosity, used the data points to create a linear projection of foreign exchange reserves for each day through the end of 2017. Using these data points, the linear equation was calculated to be:

Y = -7.75x + 10,995

where Y is the level of foreign exchange reserves in millions of USD, and X is the date in basic number format. For example, July 21, 2017 was assigned the number 134, as it was the 134th data point in the foreign exchange reserves data set as provided by the Central Bank of Venezuela. I have filtered out all weekend dates, so the linear projection does not create an artificially-low ending forex reserve level by incorrectly lowering reserves on weekends. It should be noted that this model does not account for holidays or other days off during the workweek.

January 1st, 2018 was the 250th data point in this data set, so the projection was calculated to be Y = (-7.75*250) + 10,995. This resulted in $9.055 billion of foreign exchange reserves to start 2018. When we account for sovereign and PDVSA debt that will be paid from August 2017 through December, however, we subtract $3.8 billion to receive an estimated foreign exchange reserves level of $5.26 billion on January 1st.

There are many caveats to this forecasting methodology, of course, a primary flaw being that the world of finance (and the world as a whole) generally does not move linearly. If it did, we wouldn't need posts like this trying to make predictions, because everything would be so linear we could forecast decades and decades into the future. An additional threat to the integrity of this model is that Venezuela could strike further bond deals, as it did controversially with Goldman Sachs earlier this year.

However, using duct tape to fix a crumbling building can only do so much, per se. Venezuela will continue to struggle amidst this economic, political, social and broadly-humanitarian crisis. With the Venezuelan bolivar recording a 750%+ depreciation over the last year as of this typing, a currency crisis appears to be blooming. This is quite ominous, as currency crises historically have been seen to precede sovereign debt crises. Investors appear to be baking such a potential credit event into their investments, with the Venezuela five-year credit default swap spread reaching levels not seen since 2016 this past Thursday (Figure 1 below).

Figure 1: Venezuela's 5-year CDS spread.
Chart from http://www.boursorama.com/bourse/cours/graphiques/historique.phtml?symbole=3xVENZ

The vultures continue to circle around Venezuela, and while a credit event may not occur for some time, it's quite apparent that the economic & financial situation, much less the social and political situation, is unsustainable.

Andrew

Yield Curve Continues to Flatten

The yield curve for U.S. Treasuries continues to flatten, reflecting a dimming of expectations on significant economic boosts from President Trump's proposed reforms, continued thirst for yield globally, the Federal Reserve moving to tighten monetary policy, and some investor anxiety about the apparent separation of stock market prices from underlying fundamentals.

A comparison of the yield curves from May 1, 2017 (lighter blue line) and June 23, 2017 (darker blue line) shows the flattening process that began earlier this year and has continued into the summer. The flatter yield curve can be attributed to four primary causes:

I. Dimming of Expectations of Pro-Growth Reforms
After his election as president and through the first couple months of his presidency, Donald Trump advocated an agenda heavy with reforms that, if implemented as promised, would likely give a substantial short- to medium-term boost to the languishing economy. Some of his most notable campaign ideas included repealing and replacing the Affordable Care Act passed under President Barack Obama, significant tax reform, and substantially relaxing regulations on financial institutions (namely the Dodd-Frank Act). Market participants saw the potential bounty of economic growth that these reforms could bring, and have sent all four major stock market indexes skyrocketing in the time since the November 2016 election.

Stock Index Performance since the 2016 Presidential Election (11/8/2016 to 6/23/2017).
From top to bottom: Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000
Chart from stockcharts.com

Roughly five months since President Trump's inauguration, these reforms have not been fully realized as investors had hoped. Some progress has been made on easing regulations on financial institutions, but a significant defeat of the initial new health care bill a couple months back, paired with the newly-released health care bill this past week still garnering skepticism from within the Republican Party shows that any significant health care reform will take some time. Tax reform, another potential Congressional flashpoint, has yet to be proposed as legislation. As the year has gone on it has become apparent to many investors that if Trump's reforms are to be fully implemented as promised (still a very big "if"), it will take notably longer than they had expected. As such, any significant economic boost is still a ways off, and thus inflation expectations have dimmed to levels not seen since just before the 2016 presidential election. Bonds then become more attractive to investors, one reason why the yield curve has once again begun flattening.

II. Continued Global Thirst for Yield
This factor is much more long-term than the first factor we discussed. The search for yield has been intense for years now, amidst this global low-interest-rate environment, and while the global economy is beginning to pick up steam, American long-term debt remains much more attractive to foreign investors than those investors' own domestic sovereign debt.

Worldgovernmentbonds.com

Above is a list of major countries' 10-year bond yields. There are countries like Japan, France, Germany and the U.K., all with easy access to the global financial markets but with sovereign debt yields well below the United States' 10-year yield. Consequentially, as we have seen for a few years now, foreign investors are plowing money into long-term U.S. debt to get those higher yields. In turn, this is also helping keep the long end of the yield curve flat.

III. The Federal Reserve Tightening Monetary Policy
The federal funds rate now stands at a range of 1.00% to 1.25% after three rate increases, each by a quarter of a percentage point, over the last six months by the Federal Open Market Committee. Let's first be clear in recognizing that even despite these increases, a 1.25% federal funds rate is still quite accommodative. It is not the 0.25% that this range ceiling reached at the nadir of this cycle, but a range of 1.00% to 1.25% remains quite accommodative by historic monetary policy standards. The St. Louis Federal Reserve branch's Financial Stress Index also portrays how loose monetary policy remains:

Intriguingly enough, this index has been falling even amidst the FOMC's rate hikes, but that's another discussion for another post. For now, the focus is on the Federal Reserve's tightening of monetary policy (through rate hikes and reducing its $4.5 trillion portfolio of Treasury bonds and mortgage-backed securities, set to begin later this year) sending short-term U.S. Treasury debt yields higher, as typically happens in tightening monetary policy.

It is worth noting that when the Federal Reserve begins allowing its Treasuries to mature and not re-invest to maintain the size of the $4.5 trillion portfolio, longer-term Treasury debt yields are expected to rise somewhat as supply increases in the market without a clear replacement buyer as the FOMC steps away. But again, this is another discussion for another post.

IV. Some Investor Anxiety
Let me first start off and assuage you that this discussion will not be about the CBOE's Volatility Index, or VIX. We are all well aware that the VIX continues to remain incredibly subdued, whether due to complacency or genuine investor confidence in the economy or even a side effect of massive central bank stimulus. There is likely a degree of all three present in where the VIX lies today, but that's not relevant to this section.

Rather, there is some investor anxiety over a culmination of the uncertainty in President Trump's promised reforms from above, weaker economic data as of late that raises questions of if the Federal Reserve may accidentally tighten monetary policy too much and cut off economic growth, very high stock price valuations even in the face of improved corporate earnings, geopolitical tensions (which seem to rise every other day in some aspect), and more. To me, it comes down to substantial risks to the market being at least partially offset by continued strongly accommodative monetary policy by central banks worldwide. I say partially because we have seen some rattled nerves in recent months following bouts of increased uncertainty or tension, but overall this has not been enough to persuade investors to fully dive into haven assets like U.S. Treasuries or gold. Gold is up over $100/ounce from the start of 2017 to 6/23, and the U.S. 10-year Treasury yield has dropped 30 basis points in that same timeframe. Again, these signal some investor anxiety, but not enough to make the stock markets or other riskier assets notably less attractive.

So what's the outlook? Unless Congress can force the most recent health care bill through in the near term, it looks to be more of the same: A gradually flattening yield curve as uncertainty over Trump's promised reforms, tightening monetary policy, an insatiable global thirst for yield, and hints of investor anxiety amidst heightened geopolitical tensions.

Andrew

Yellen's 'High-Pressure Economy' May Pressure Stocks

Janet Yellen laid out her take on current monetary policy in Boston on Friday at a luncheon, describing how a "high-pressure" economy may be necessary in order to boost growth. The speech comes at a time when the Federal Reserve is divided on whether to raise benchmark interest rates this year, or keep them steady at their historically-low levels. (More information on her speech can be found in this link from Reuters).

I have a few concerns about letting inflation run temporarily hot.

FRED - Federal Reserve Bank of St. Louis

Shown above is the civilian unemployment from January 1948 to the most recent data point, September 2016. Shaded gray areas indicate economic recessions. There are two main take aways from this graph:

1. When looking at past economic expansions, a common signal that the expansion is coming to an end is when we start to see the slope of the unemployment rate line go to zero. This was seen prior to the recessions of 1970, somewhat in 1973-1975, again in ~1979 and ~1981, and notably just before the early 1990s recession, the early 2000s recession, and a bit before the Great Recession back in 2008. While one could nitpick and say the slope never did get to zero, merely eyeballing it shows that before recessions, the unemployment curve generally becomes flat, if not close to flat, as the economy reaches full employment.
Taking a look at our current position on the curve, we're right around (if not at) that point where the unemployment line's slope hits zero-ish. The table below illustrates this quite well:

The attached table shows civilian unemployment data from FRED, compared year-over-year for September of each year during the current economic expansion. We began the economic expansion in September 2009 with a change of -0.3% from then until September 2010. The YoY change in the unemployment rate from September 2015 to September 2016 was the smallest change throughout the entire economic expansion when looking at September YoY changes. I haven't run the data for all the months' YoY change, but going through a few more data points, it appears this could very well be the smallest YoY change throughout the entire expansion, including all months' YoY changes.
What does that tell us? Right now, the only thing we can plausibly assert is that the labor market is near full employment, based on how the slope of the unemployment line is getting closer and closer to zero. I don't believe this shows that a recession is barreling our way, primarily because the Fed is keeping monetary policy extremely accommodative and investor sentiment remains more-or-less high, though we saw an unexpected drop on the Consumer Sentiment Index on Friday. However, given the Consumer Sentiment Index is a lagging indicator, and by most other measures the domestic economy is still chugging along, I don't believe a recession is pending in the short-term.

2. Despite claims that the labor market is not yet at full employment, recent recessions indicate it could be. Referring back to the FRED unemployment rate chart, note how the minimum unemployment rate, or at least the point when the slope of the curve begins to flatten to zero, has been creeping up ever since April 2000, when it hit an expansion-low of 3.8%. The expansion-low prior to the Great Recession was 4.4%, hit multiple times from Fall 2006 to Summer 2007. Our expansion-low in our current economic expansion is 4.7%, from May 2016. The gradual uptick in apparent minima with respect to the unemployment rate could be a signal that our labor market is at full employment, in addition to the signal from the flattening slope of the curve.

                    ______________________________________________________________

My other main concern resides in the fact that the stock market is already near record highs, and broke record highs this past summer. Allowing inflation to run hot could create a bubble, if one hasn't already been formed.

Big Charts - Marketwatch

The chart above reflects the DJIA's history through early 1988 or so, on a weekly scale. Note how we are currently just below record highs reached earlier in the summer. Record stock prices generally come about around the peak of a bull market, and it's been my belief for some time that we are either at the peak or just past the peak of this current expansion's bull market. But that's not my primary point of discussion relating to the stock market.

Extraordinarily-accomodative monetary policy in the U.S. for the last many years, and expectations of continued accommodative policy, has led to prolonged risk-on sentiment, as reflected in the record highs for all three major equity indices this past summer, and the near-record-high valuations at present date. Many financial analysts promote the idea that this accommodative policy has led to the 'Central Bankers' Bubble', named after central banks' continued enforcement of such monetary policy that some believe has blown a bubble in more than just one specific asset. To be sure, this is by no means a prevailing opinion, as far as I can tell, and the theory that we are mid-bubble does not stand for all financial analysts. However, I do personally believe that this is the case, at least to some degree, and this is where my concerns over a 'high-pressure economy' come to light again.

In a general sense, inflation is bearish for the stock market. When inflation begins to ramp up, typically the Federal Reserve will act to tighten monetary policy by hiking interest rates, thus placing a more risk-off sentiment across financial markets as investors leave stocks and seek safer investments, like bonds. However, if the Federal Reserve were to maintain low interest rates while allowing inflation to rise, the 'lower-for-longer' concept (the idea that interest rates will stay lower for a longer period of time) that has boosted stock prices over the last few years would persist. Inflation would begin to eat away at the stock market, and at that point the Fed would begin tightening monetary policy, but until then it would be a continuation of low interest rates and more-or-less tepid inflation, until the 'high-pressure economy' kicks in and inflation rises.
Why the worry? With inflation expectations so low, we could be talking about a number of years in a low interest rate, low inflation environment, which would almost certainly blow an equities bubble, if one hasn't already begun forming. Consequentially, if/when inflation reaches a point that the Fed deems as conducive to hiking interest rates, the pullback in stock markets would be far sharper than it would be if the Fed were to hike rates today.

In my eyes, the Fed has dug itself into a hole by maintaining interest rates for so low. To be fair, this was a good choice when you see how steadily the unemployment rate fell. However, good cases could have been made for a rate hike in the last few FOMC meetings, particularly after some FOMC members began taking far more hawkish viewpoints. Then, when they didn't hike, the Fed began losing credibility, but that topic is for another write-up. By allowing a low-inflation, low-interest rate environment to persist, possibly for a prolonged time period (longer than Ms. Yellen believes, as the FOMC is notorious in recent history for being too aggressive in their inflationary expectations), equities would almost certainly enter into a bubble, and if other assets also enter into bubbles as ultra-accommodative monetary policy continues, the pullback if/when tightening occurs could be nasty.

Lucky for us, all of this is hypothetical, and assuming the FOMC goes along with Yellen's ideals. While she posed the high-pressure economy as a 'question that needs more research', it's quite frank that she is looking for every excuse to not hike interest rates, and it's entirely plausible that the chairwoman is able to convince the FOMC to follow suit.

Andrew

Central Banks at Center Stage

I'm typing this post with a case of strep throat, so forgive me if my thoughts seem a bit disjointed or otherwise incomprehensible at times. It just so happens that this past weekend was the much-anticipated Oklahoma vs Ohio State football game, which I had the honor to attend. While the main show was indeed the football game, a number of other factors played an equally important role in the experience. This included nearly coming to blows with a very drunken fellow student, an intense storm just prior to the game's original start time, among other things. This week, while central bank decisions are taking center stage, there are a number of factors working on the exterior of the stage still playing a big role in our current economy.

Let's begin with the latest FOMC forecast for the long-term.

Federal Reserve

The infamous dot plot above shows many FOMC members wishing to hike the benchmark interest rate from 0.25-0.50 percentage points to an average 1.25-or-so percentage point interest rate in 2017, a rather ambitious goal given the global struggles to see stronger economic growth. By 2019, most FOMC members would prefer to see the benchmark interest rate somewhere around 2.50 percentage points, again a rather ambitious outlook and one I'm personally wary of, as we're already in/near year 8 of this economic expansion, making it one of the longest on record. A bull can't run forever.

The vote to maintain the current interest rate of 0.25 to 0.50 percentage points landed at 7-3, a pretty strong signal that some members inside the Fed are getting a little antsy with respect to keeping interest rates low, and I agree. The Fed almost seems scared these days, worried that even a minimal jolt to the economy could bring everything crashing down, and thus the best way to keep things steady is to keep interest rates steady. This mindset has created a whole other level of problems alone, but that's a post for another day.

Federal Reserve

Another interesting graph from the Fed's decision yesterday, and one of those exterior factors dancing around central banks, was the projected PCE inflation. I don't have my protractor on me at the moment, but that's nearly a 90-degree angle from observed PCE inflation through 2015 to projected PCE inflation through 2016. The FOMC is essentially expecting inflation to reverse course and start chugging its way back up at this very moment in time. Unfortunately, the FOMC is notorious for being too optimistic on the future of the economy, particularly in the current expansion. When accounting for this, it becomes difficult to see a 2% PCE inflation mark earlier than 2018.

The Federal Reserve isn't the only central bank that had their monetary policy meeting this week; the Bank of Japan also met up.

At their previous meeting, the Bank of Japan announced it would re-evaluate its current monetary policy, which set off concerns amongst investors if this was a warning shot, if the BoJ might stop pushing ahead with negative interest rates and QE. This week, the Bank of Japan came out and modified their policy slightly, now to a yield-curve based goal. The BoJ will now aim to keep 10-year Japanese government bonds around 0%, and while this is still very accommodative monetary policy, it's also a cessation that plunging further into negative interest rates right now, when the benefits are beginning to be questioned, is not the right move. It's part of a larger cessation that the Bank of Japan is running out of tools, something we've all known for a while, but no one really knew when the Bank would begin realizing that. One could effectively argue that this realization moment came at their last meeting, when the BoJ opted to re-evaluate its policy, but carrying through with that re-evaluation into this week's meeting reaffirms that more than incredibly accommodative monetary policy is needed to stimulate the economy.

Central banks will continue taking center stage, perhaps the Romeo and Juliet of this monetary policy opera. However, Mercutio, Tybalt, and Benvolio are also on stage, and while they aren't the main focus right now, you can bet that what they do will influence what the two main characters do. In our case, inflation, equity pricing, bonds, and more play our 'secondary characters', but their influence down the road will prove anything but.

Andrew