Where are the Jobs?

Where are the Jobs?

Friday the Dow Jones opened down, falling as much as 258 points, to only then completely reverse direction and ended the day up 200 points for a more than 450-point swing!  This was the biggest one-day percentage reversal in about four years. What drove the crazy move? This wild move was based on the very disappointing jobs report released Friday morning. Yes, you read that right.  A market rally on a weak jobs report as we return to bad news is good news and wonder, where are the jobs?  Whoop whoop!

2015-10-05 Job Growth Slowing


  • Consensus estimate for new jobs was 201,000 but the actual was 142,000 – 30% below expectations.
  • On top of that grim number, about 60,000 jobs were removed from the prior two month’s estimates, making August’s not-so-bad 173,00 look pretty sad at a revised 136,000 new jobs.
  • This is also the sixth of the past eight reports to have had a downward revision – not a good trend.
  • To rub salt into that wound, the workweek also dropped from 34.6 to 34.5, which doesn’t at first glance look like that big of a deal, but when you put that number across the nation in aggregate… it means effectively an additional 348,000 in job losses!
  • No improvement in wages either, so don’t be waiting to see consumer spending to help out the economy here.
  • The steady unemployment rate is only because more and more people are leaving the workforce, such that the labor force participation rate has fallen to its lowest level since the grim days of 1977 at 62.4% from 62.7%.

2015-10-05 Labor Participation


I’ve been saying for most of this year that I think a rate hike is highly unlikely in 2015 and this market rally shows the market is coming around to my way of thinking.  After Friday’s report, I’d say not only is a rate hike unlikely, but another round of quantitative easing is becoming a real possibility if things continue on this trajectory.  That isn’t to say I think QE is useful, as a matter of fact I think it is quite harmful, but it is the only tune that central bankers seem to know how to sing when times get tough and the rest of the government has basically shrugged off any responsibility for providing a fertile environment for economic growth. Most seem to be more interested in tossing snappy sound bites at each other.  Good times.



I will also be watching very closely how the dollar is going to react as the strengthening we’ve seen could very well be affected by a belief that yet another round of QE is on the way, with the Fed once again joining the ranks of central bankers around the world trying to print their way into prosperity.

Looks like the refrain we’ve been singing for years of “Where are the jobs…. there ought to be jobs,” isn’t going to wrap up anytime soon. This cover is from over 4 1/2 years ago!   Oh and that Afghanistan thing… it’s sorted out right?

2015-10-05 Where are jobs


Neil Cavuto: Fed Policy is the Problem

Neil Cavuto: Fed Policy is the Problem

This morning I spoke with Neil Cavuto on Fox Business about the Fed’s decision to not raise rates earlier this week; my view, Fed policy is the problem!

An economy grows when good ideas are able to get funding, find talented people to work on them and are able to operate in an environment that is conducive to their success; that means limited laws, regulations, and a tax code that are all easy to understand and not costly to follow. 

All the QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) have kept interest rates super low. That forces people to put their money into riskier investments than they’d like. Riskier investments by definition have to generate higher rates of return to compensate for their higher level of risk. High levels of risk are also associated with ideas, that normally wouldn’t get funding, but manage to get it by promising really high rates of return. If investors are pushed into more higher risk/higher potential return investments than they’d normally like, that means more of these potentially bad ideas get funding.

This means the economy experiences a higher failure rate than would normally be the case. That means more investors lose their money and more resources get wasted, draining the economy. Add in that the U.S. economy is getting more and more complicated with respect to legislation, regulation and a tax code that even the IRS doesn’t understand and ever great ideas struggle under the burden of trying to jump through all those extra government hoops that just make it that much harder to be successful.

In my discussion with Neil I refer to how we have a record high level of job openings. The chart below is from the Federal Reserve, but can be researched in depth by looking up the JOLTS report from the Bureau of Labor Statistics.

2015-09-18 Cavuto - Job Openings

I also mentioned how the percent of the population actually employed is where it was nearly 40 years ago.  This data is also from the Federal Reserve.

2015-09-18 Cavuto Employment Population

ZIRP and QE are killing the economy

ZIRP and QE are killing the economy

Shocker! The Fed didn’t raise rates today.A Shocked Baby

I’ve been predicting the no-change decision for months!

It was pretty obvious, but that’s because I can see that ZIRP and QE are killing the economy.

The labor market is still relatively weak, regardless of what the seriously misleading unemployment rate statistic tries to tell us. Job openings are at record highs (companies can’t find the right talent) while the percentage of the population employed is at levels last seen nearly 40 years ago. The three-month moving average for retail sales is at a level only seen during the Great Recession. Second quarter revenues for companies in the S&P 500 were down 3.4% year-over-year.  Second quarter earnings were also down year-over-year.

So what does this mean?

Nearly a decade of ZIRP (Zero Interest Rate Policy) and trillions in Quantitative Easing and still, the economy can’t get off what the Fed believes is life support!

Why?  Because while playing in all their models they miss the big picture!

Economists often make understanding the economy unnecessarily complicated. Part of it is reasonable in that this stuff can be complicated and it takes a lot of time and effort to communicate these topics in a way that doesn’t use terminology that only “big brained” economists understand. They’re busy and most just aren’t interested in putting in the time. Part of it is probably job security – we all like to give the impression that what we do is really difficult!

An economy grows when good ideas are able to get funding, find talented people to work on them and are able to operate in an environment that is conducive to their success; that means limited laws, regulations, and a tax code that are all easy to understand and not costly to follow.  It is that simple.

All this QE and ZIRP have kept interest rates super low. That forces people to put their money into riskier investments than they’d prefer. By definition, riskier investments have to generate higher rates of return to compensate for their greater level of risk. High levels of risk are also associated with ideas that probably shouldn’t get funding, but manage to get it by promising really high rates of return; sometimes really high returns…I’m sure you’ve heard of the hockey stick effect. If investors are pushed into more “higher risk/higher potential return” investments than they’d normally like, that means more of these bad ideas get funding.

In an ideal world only good ideas get funded because when bad ideas get funded, investors lose their money and resources like people, time and raw materials get wasted.  There’s a net loss to society. (I’m simplifying here a bit for the sake of clear communication as some degree of bad ideas is a relative good because they serve as a warning and provide a place of learning what not to do or avoid).

Putting all that together, extra low interest rates mean investors are pushed into investing in more higher risk investments which means more bad ideas get funded than would otherwise be the case, so the economy experiences a higher failure rate than would normally be the case.  That means more investors lose their money and more resources get wasted, draining the economy. Add in that the U.S. economy is getting more and more complicated with respect to legislation, regulation and a tax code that even the IRS doesn’t understand. Even great ideas struggle under the burden of trying to jump through all those extra governmental hoops that just make it that much harder to be successful.

Where do we go from here?

With respect to interest rates, there is no easy solution. We need to normalize, but today that is a bit like dreaming of a bright future for a 17-year girl who’s 8 months pregnant, dropped out of school 4 years ago, ran away from home, and has covered her body covered with skeleton tattoos.  It’s possible – but it is going to take a hell of a lot to get from here to there!  That being said, reducing the regulatory, legislative and tax complexity would go along way towards helping all businesses, whether they be a great ideas, so-so, or even marginal be more likely to succeed, which means more jobs and more money available to invest in the next idea.




China and Emerging Markets – A tale of QE

China and Emerging Markets – A tale of QE

This week I sat down with Erin Ade on RT’s Boom Bust to discuss what is happening in China and emerging markets and how it may affect U.S. investors as well as our domestic economy.

When the Federal Reserve began its Quantitative Easing Programs, many feared that it woul16d lead to high levels of inflation. Today, after three rounds of quantitative easing, we have very little evidence of domestic inflation and with the dollar gaining strength against most all other currencies in the world, we are actually facing some deflationary forces.

First, what is Quantitative Easing and why do people say it is all about “printing money?”

Quantitative Easing refers to the process shown below wherein (1) the Treasury Department sells Treasuries to Banks in return for cash to fund the annual deficit. This money is then spent by the federal government. Banks then turn around and sell the Treasuries to the Federal Reserve in return for cash. This cash is typically in the form of a “ credit”  in their reserve account, but for all practical purposes it can be thought of as cash since these reserves can then be used to loan money to businesses and individuals, who then effectively have cash in hand.



So just how much of this did the Fed do?  The chart below from the Federal Reserves shows that it bought about $4.5 trillion dollars worth of Treasuries and mortgage-backed securities during the three rounds of quantitative easing.  To put that in context, that is over 25% of US GDP during that time.  With all that new money coming out into the economy, inflation was a very real concern, yet it didn’t happen.

2015-09-16 Fed Assets

So what did happen to all that “money printing?”  A lot of it went into emerging markets.

A recent working paper published by the Bank for International Settlements titled “Global dollar credit and carry trades” found that one of the unintended consequences of the Federal Reserve’s quantitative easing program, was the significant increase in issuance of dollar denominated corporate bonds by emerging market companies where the proceeds primarily fed into existing cash balances, a form of corporate dollar carry trade.  The paper cites a 2015 study that estimates that the outstanding USD-denominated debt of non-bank entities located outside the U.S was around $9.2 trillion at the end of September 2015, an over 50% increase from the beginning of 2010.

In an earlier post I pointed out just how much the USD has appreciated relative to most every other currency since the end of Quantitative Easing, making this carry trade increasingly untenable.  We’ve seen more and more slowing across the globe, with commodity-heavy countries like Australia, New Zealand and Canada, (who just reported that it is now in a recession after two quarters of negative GDP growth) engaging in pretty aggressive easing cycles, that will only further weaken their currencies relative to the dollar. What is even more concerning is that a rather large percentage of these firms are in mining, oil and gas sectors and we all know what has happened to prices for those commodities!  This means we have companies whose domestic currency is sliding further and further against the USD in sectors that have been utterly slammed, with outstanding USD denominated bonds, making those bonds more and more expensive every day – pushing an unwinding of this USD carry trade.  I suspect traders on Wall Street aren’t the only ones stocking up on Mylanta these days.

Our discussion begins at the 20 minute mark in the video below.


To Raise or Not to Raise

To Raise or Not to Raise

To Raise or Note to Raise – The big question that has the attention of markets all over the world is, “Will the U.S. Federal Reserve raise rates in September?” We’ve discussed in both our June newsletter and July newsletter that we believe it is unlikely that the Fed will raise rates and continue to believe so.  As the year goes by, the market has come around to our way of thinking.  In early August the odds on a rate hike in September were 48%.  By Thursday it had fallen to 32% and by the end of Friday at 27%.  At this start of this week, it was down to 22%. That being said there are compelling reasons for the Fed to raise rates, so we don’t have a particularly high conviction level on our call. The Fed is made up of a bunch of human beings, and you can never be too sure about what a group of folks might do when they get together and start talking, particularly when reputations may be on the line.

The first reason many may cite for a rate increase is the significantly upwardly revised second quarter U.S. GDP estimate, from 2.3% to 3.7%. Yours truly has some, ahem, concerns with the second estimates.  Without getting too wonky, remember that earlier this year, the GDP estimates for 2012 to 2014 were revised significantly lower.  Problem is, if they don’t lower the estimate for current GDP, the growth rates for 2015 would have to be much higher.  Think of it this way, I’ve always wanted to dunk, but at 5ft 7.5”, (don’t laugh, that 0.5 is important to me!) a hoop 10 feet high is challenging despite my orangutang-like arms, (I know mom, what can you do? I got Dad’s!). If I jump up onto a platform that is 3 feet high, I only have to reach 7 feet up to dunk.  But if I jump up onto a platform that is 2 feet high, I need to spring up and reach 8 feet into the air! By revising the 3 years from 2012-2014 down, I moved from the 3 foot platform to the 2 foot, so naturally I have to jump higher. We also note that about 12% of current GDP, which translates into $2 trillion of the roughly $18 trillion, comes from a “trend” estimate, the same trend that had previously been used for the 2012-2014 growth rates prior to the downward revision.  Errrh what?  So they overestimated back then, but now that same trend assumption is accurate.   Hmmmm… could be, but methinks it prudent to be cautiously skeptical.

We also find it ironic that various Fed Presidents have mentioned, while at the annual Jackson Hole meeting this past week,schrdi1 that they are concerned with raising rates during a period of heightened market volatility.  Really!? Come on! A good bit of the market’s volatility can be attributed directly to the mixed messages coming out from various members of the Fed with a rate hike both reportedly necessary and imminent while also increasingly unlikely given current conditions, depending on which official is speaking, in a bizarre monetary policy version of Schrödinger’s cat. Conventional wisdom believes that a rate hike will hurt stock prices, so naturally hearing contradictory statements like that will increase market volatility. There was a time when the Fed’s actions weren’t dependent on the stock market and vice versa – oh for a return to those simpler times!

To put the Fed’s fears in context, we’d like to point out that the S&P 500 is currently 6.7% off its all-time highs, yet some Fed officials are claiming they are uncertain about raising rates for the first time in a decade because they fear the equity markets may react negatively?  To give that even more context, the S&P 500 is up almost 200% from its March 2009 lows and nearly 30% above its 2007 highs. Is the Fed telling us that the bull market needs their support?  Hmmm….

What very few are talking about is what just happened with China’s devaluation of its currency and how it could affect the U.S. going forward. When China loosened its grip, its currency fell relative to the dollar more than China wanted.  To stop the slide, the government sold assets and bought yuan to support the currency (a reverse QE). What asset do they have a hell of a lot of?  U.S. Treasuries!

In an earlier blog post I mentioned that China had accumulated over $4 trillion in assets starting from 2003, more than all the Fed’s QE programs combined. So if/as China finds it needs to support its currency as the rest of the world sees its economy slowing and puts downward pressure on the yuan, it will need to sell more Treasuries to support its currency, and it has a lot of Treasuries along with other assets available for sale. That will increase the amount of Treasuries on the market, which will push prices down and yields up, again a reverse of what we saw in QE, as we are on the cusp of entering the era of Quantitative Tightening!  I’ll have a lot more on this in the months to come.

The table below itemizes the primary arguments for and against.



What we do know is that looking over the history of the Fed, it does pay attention to the world around it. Combining current conditions with past behavior under similar circumstances, a rate hike looks unlikely.  The rising U.S. dollar will likely hurt export-oriented sectors without causing the overall equity market to be harmed as importers will conversely benefit and the Fed is more likely to hold its hand.  Lower bond yields coupled with a strong U.S. dollar will keep upward pressure on price to earnings ratio, (i.e. upward stock price pressures) and the drop in U.S. bond yields will help credit-sensitive sectors like housing and autos.  With around 70% of the U.S. economy being driven by consumer spending, the country is better positioned to withstand the ongoing global slowdown than those economies that are more dependent on exports.

Strong Economy, Really?

Strong Economy, Really?

Last week I pointed out that the data coming in wasn’t exactly painting a picture of an increasingly robust economy that would warrant the Fed tightening rates.

Last Thursday we learned that initial jobless claims rose again the last week of February to 320,000, significantly above expectations of 295,000. We also learned that US Factory orders fell 0.2% versus an expected increase of 0.2%. Friday we received impressive headline jobs data, but it didn’t exactly jive with much of the rest of what we are seeing in the economy and upon a closer look, the fall in the unemployment rate was driven more by people leaving the workforce than by new jobs, and those newly filled jobs were skewed towards lower paying industries.

Today we learned that retail sales fell for the third consecutive month in February as a mix of bad weather and consumer caution outweighed an improving labor market and cheap gasoline prices.  Sales at retailers and restaurants decreased 0.6% last month to a seasonally adjusted $437 billion, the Commerce Department said Thursday. Retail sales fell 0.8% in January and 0.9% in December.  We also learned that business inventories growth was flat in January versus expectations for 0.1% increase… but what is even more concerning is the sales to inventory ratio, which is back to where it was back in the depths of the financial crisis!

Inventory to Sales

So much for the economy getting back on track.

In fact, Tuesday the Wall Street Journal ran an article entitled “Recession’s Impact Lingers for Many States,” which pointed out that 30 states are still below their peak, pre-recession tax revenue receipts. The states that are actually above their last peak include North Dakota and Texas, which are likely to suffer going forward with the impact of plummeting oil prices. We’ve also seen US GDP expectations for Q1 tanking, (today’s retail numbers reinforcing this) with many forecasting in the 1.5% range, which given the increasingly soft data coming in, seems wise. Prior forecasts were north of 2% at the beginning of the year.

Additionally, inflation expectations remain firmly muted with yields indicating that investors expect US consumer prices to rise in the neighborhood of 1.7% a year for the next 10 years, dropping from 1.9% just last week – more of that dropping price thing. In addition, consumer credit growth is moderating, auto sales appear to be topping out and the Case-Shiller 20 city price index shows home price inflation has slowed to 4.5% year-over-year from 13.4% last year. So far, nothing screams out a need for tightening, particularly in light of the defacto tightening resulting from the rising dollar. In fact, if the Fed did tighten in June, it would be the first time in the past 30 years that it has done so with a rising dollar. We do see tightening also occurring on the fiscal side where the federal deficit is shrinking significantly.

The Euro has now dropped below $1.05 for the first time in about 12 years and is down around 33% from its highs against the dollar, last seen in April 2008 and down around 12% since the beginning of the year.


Tale of QE


As the ECB gets cranking on its 10-year sovereign debt purchases, yields have once again hit record lows yesterday in Germany, Belgium, the Netherlands, Italy, Ireland and Spain. The 10-year US Treasury rate at 2.2% is over 9.5x the 10-year bund, a phenomenon never before seen. With the US one of the few places to get any kind of yield on sovereign debt, it is unlikely that dollar strengthening will cease. So not only do foreign investors get better yields in the US, the dollar is most likely strengthening against your currency, jacking up returns even more.


Diverging monetary policies are continuing to affect domestic equity markets as we see the US materially underperforming Europe and Japan in 2015, which is a complete reversal from 2014. Monetary policy clearly continues to dominate equity markets post-financial crisis. We believe this is likely to continue further into 2015, making international market indices more attractive. Investors can access these market easily through ETFs such as the relatively new Recon Capital DAX Germany (DAX), iShares MSCI France Index (EWQ) or MAXIS Nikkei 225 Index ETF (NKY).




Impact of share repurchases

Impact of share repurchases

I’ve discussed before on this blog the trend for companies to issue debt then use the proceeds to buy back their own shares.  Today I’m going to look at the impact of share repurchases on equity markets.  The chart at right shows the increase in share repurchases.2015-02 Share Repurchase

When the interest rate paid on the bonds is lower than the dividend yield on the shares being repurchased, this is a cash-flow positive strategy. Here’s the math, using small numbers just to keep it simple.

A company’s stock is trading at $100. The current stock dividend is 4% on an annual basis, which means it is paying $4.00 in dividends on every share per year.

The company issues $1,000 worth of bonds yielding 2.5%. This means that if you bought $100 of this bond, you would receive $2.50 a year in interest payments. The company uses the proceeds of the bond issuance, (the $1,000) to repurchase 10 shares of its own stock (10 * $100/share = $1,000). Now the company is paying only $25 a year in interest versus the $40 it was paying previously.

Looking at those equations one can see how low interest rates, (a la Federal Reserve Quantitative Easing) could make it more attractive for companies to buyback their shares and would put downward pressure on dividend yields. So let’s look at the magnitude of share buybacks.

2015-02 Biggest Repurchasers

Well that sure seems like a lot of money going into share buybacks, and that is just the top 12 by volume (number of shares).   Let’s look at the top 10 companies by dollar-value and their share returns.

Repurchasers by dollar

Looks like overall, this proved to be a strategy that is at the very least, correlated to shareholder-pleasing stock price gains. (Keep in mind that executives often have their compensation tied to improvements in share price.) How could these share buybacks affect share prices and not just reduce the amount of money companies pay out in dividends?

The price of a stock on any given day is just a function of supply and demand. The greater the demand (buyers) the more the stock price is pushed up until no more buyers are interested at the higher price. The converse is also true, the more that want to sell, the lower the price will go until no more sellers are interested in selling. (Real world example – when home prices are high, lots of people consider selling their homes, but when home fall, more people are happy to stay just where they are.)

So how big of an impact do these share buybacks have on demand? We can answer this buy looking at fund flows, meaning money going into and coming out the markets.

2015-02 Equity flows

The chart above shows that the single largest source of funds going into the equity markets came from corporations.   Households on the other hand were net sellers. This chart shows that in 2014, household took $183 billion out of the stock market while corporations put $415 into the equities market. If no corporations had purchased equities, there would have been a net outflow of $237 billion dollars! Talk about a reduction in overall demand.

Now let’s go back to the company making the decision to issue bonds, (borrow money) and use the proceeds to buyback shares of their own stock. There are a few things to keep in mind:

  • This is not a sustainable process. Companies cannot endlessly issue debt then use the proceeds to buyback shares – rather intuitive, but something to keep in mind as it is not a long-term way for a company to generate returns for shareholders.
  • If stock prices fall, then the entire equation we did above falls apart. How’s that? Well I left out the impact of share price and the company’s balance sheet in that analysis. (Tricky aren’t I!)   So let’s revisit that equation taking share price into account.

The company issues $1,000 worth of bonds and immediately buys $1,000 worth of stock, or 10 shares since the stock was trading at $100/share. So on the company’s balance sheet there is now a liability worth $1,000, but an asset that is worth $1,000 counters it.

If the company’s stock were to decline by say 15%, then those shares would be worth $850. The company now has a liability worth $1,000 that is countered by an asset worth only $850. This negative change in the company’s net worth makes it less attractive than before the share price decline, so now it has a double hit. Its shares have been falling and now its balance sheet looks less attractive. That can put further downward pressure on the company’s share price, which results in an even less attractive balance sheet and so on. This is another example of how debt can exacerbate problems when asset prices fall.

Now that I’ve mentioned asset prices… well that brings up the Fed and for that matter, most all central banks these days. The goal of loose monetary policy is to induce borrowing which is intended to generate economic activity and drive asset prices up, so if there is a material decline in asset prices, we wouldn’t be surprised to see the Fed step in to try and push prices back up… that is if/until monetary policy is no longer capable of doing so. As the saying goes, “We live in interesting times.”

One more little bit to contemplate is the relationship between company profits and the growth of the economy.  The chart at right shows how the six-month change in 12-month forward earnings per share is closely correlated with changes in real GDP. Notice how most every time the change in EPS goes negative, the economy contracts – again we work with probabilities, not certainties, but one must always keep an eye on the data and the correlations.

2015-02 EPS to GDP

December Market Update

December Market Update

Last week was a tough one in the markets as taper fears, once again, in that tired refrain, pushed the indices down. The markets are still in decidedly heady territory for the year, up 27% as of Friday’s close.

Given the holiday season, we thought we’d try to express our concerns a little more festively this month.


Dashing through the Dow

In a market oh so gay

O’er the highs we go

Laughing all the way.

New records Fed does bring

Claiming policies right

What fun it is to see records ring

A surging market alright!

Ohhhh, Taper talk, taper talk,

Bernanke goes away.

Oh what fun it is to ride

the S&P today, hey!

Taper talk, taper talk,

Yellen saves the day!

Oh what fun it is to ride

the Russell 2000 today, hey!


So can the Fed pull it off? Taper without market tantrums? To answer that, let’s look at one of their most important tools, forecasting. Economists are often expected to answer the seemingly simple question, “What will happen to the economy in X period of time if we do Y?” Much fun was had post financial crisis mocking anyone with a title even remotely resembling an economist, as conventional wisdom declared the profession all but dead due to its reported failure to see the impending doom. First, it is absolutely false to say that no economist predicted the financial crisis. Many economists and those in financial services predicted the crisis years in advance. They were typically mocked as fools and in the case of Dr. Michael Burry, sued by investors in his fund Scion Capital, until the inevitable collapse occurred and his remaining clients enjoyed incredible gains, making him the stuff of legends, (hat tip to Chris Brown of Aristides Capital for reminding me of this story). Second, those who got it right were ridiculed or worse because they were unable to predict when the crash was going to occur.

To think that any economist or organization, like the Federal Reserve, can predict with any degree of accuracy the how and when of economic events and manipulations is fool’s wish. I am going to paraphrase the best description of why this is from Russ Roberts, of Stanford University’s Hoover Institute. An economy is a living thing, much like a complex ecosystem where competition and emergent order create a complex interaction of organisms and their environment. We do not expect a biologist to forecast how many squirrels will be alive in ten years if we increase the number of trees in the United States by 20%. A biologist would laugh at you. But that is what people ask of economists all the time. Economists should be honest and say that the tasks they are often asked to do are outside the scope of economics as we know it and perhaps outside the scope of economics as it will ever be known.


Bottom Line: While assuring the markets they know what they are doing, the Fed’s track record, (like most of economics) of foreseeing problems and being able to prevent disasters is unimpressive. Investors be warned.

100 Years of the Federal Reserve

100 Years of the Federal Reserve

There was a time when no one, outside perhaps the most esoteric economic geek circles, could name the current Chairman of the Federal Reserve. Those days are now long gone as the Fed has taken a much more active role in the economy and the various Fed Presidents and Chairman have evolved into media cult figures, perhaps less riveting than the latest Kardashian marriage collapse, but financially far more provocative.


The Fed’s current focus is clearly helping Uncle Sam reflate out of the government’s enormous mountain of debt. The chart on the next page shows the mountain of debt that has been created by impressive levels of spending from both sides of the aisle for a truly bi-partisan mess. The deficit is now almost three times what it was seven years ago, while debt service costs are at about the same level, thanks to Fed sponsored suppression of interest rates. The Fed effectively has complete control of the market for longer-dated Treasuries, with its holdings of bonds with a maturity greater than 10 years increasing by $154 billion through June of this year, (latest data available from the Fed) to a total of over $500 billion. Meanwhile the total outstanding level of such debt, privately held interest-bearing, grew a measly $9.6 billion for a total of $809 billion.

For those of you who enjoy a monetary policy geek-fest, the following summary of comments from the various speakers at the Cato Institute’s Monetary Policy Conference on November 14th, including current Philadelphia Fed President Charles Plosser may be of great interest. I’ll do my best to keep it lively.


Charles Plosser opened the conference with a discussion of how many of the both implicit and explicit limits on central banks around the world have been challenged over the past few decades and most dramatically since the financial crisis. He believes the Fed entered into the realm of fiscal policy when it began purchasing non-Treasury securities such as mortgage-backed securities and referenced Milton Friedman’s warning in 1967 that, “We are in danger of assigning to Monetary Policy a greater task than it can accomplish.” Over the past 40 years, it is clear that we have failed to heed Friedman’s warning, with the Fed doing a poor job of aligning expectations with what it is actually capable of accomplishing. Plosser warned that increasing the scope of the Fed’s mandate opens the door for highly discretionary policies, acknowledging that a rules-based approach is unattractive for the majority of policy makers as it ties their hands.,Discretion is the antithesis of commitment, something most politicians loathe. If the Fed gave itself less discretion, it would be held more accountable. He pointed out that the current climate of guess-my-mood communication on the Fed’s part leads investors to make unwise gambles, as they try to read the mysterious tea leaves of Fed speak, such as the recent market tumult over taper talk.


Jerry Jordan, the former President of the Cleveland Federal Reserve expanded on Plosser’s comments, pointing out that the existence of a Central Bank with discretionary power essentially guarantees the emergence of moral hazard with the resulting power to grant permission and regulate with discretion, opening the door to crony capitalism. To large banks, their PACs, (Political Action Committees) are often more impactful on their bottom line than their own management. (Shocker, businesses as well as individuals respond to incentives!) He referenced the Fed’s recent report on the impact of quantitative easing on the economy stating that if there is any relationship between economic growth and quantitative easing, it is a remarkably well kept secret, instigating a round of chuckles from the audience. He pointed out that most economists understand that monetary policy cannot correct the mistakes of the rest of government, even though the Fed is currently doing its best to defy that assessment. He argued that central bank independence is a myth, at least during a financial crisis, because once a central bank takes its first steps to support the economy, there is no way out that does not involve collateral damage. That, by definition, prompts pressure from bureaucrats. He believes that exiting the current zero interest rate regime will be exceedingly complex and it will be impossible to escape without considerable financial market volatility. He seconded Plosser’s assessment of the Fed’s move into fiscal policy, asserting that traditional views of monetary policy and its impact are no longer useful as monetary policy has become fiscal policy. This move into fiscal policy has served to increase market volatility as no one can say with certainty, which entities will receive support during a crisis and for how long. Once again, discretion comes at a price.


Cato President and CEO John Allison, (former CEO of BB&T Corp, a U.S bank with over $180 billion in assets) discussed the impact he saw of government actions on his former bank. He pointed out that the Patriot Act and the federal privacy policy are in conflict with each other, leading to discretionary enforcement and application by regulators, which opens the door for corruption. He observed one of the great fallacies of current conventional wisdom is that there was financial deregulation under President George W. Bush which led to the crisis. Instead, Allison stated that there was actually a net increase in regulation if you look at the quantity and complexity of the regulations before and after his term. He believes that regulators greatly exacerbated the panic that hit the markets during the financial crisis by effectively suspending the rule of law and greatly increasing their level of discretion. No one had confidence in just what were the rules of the game, nor was there any clarity on who would be bailed out, who wouldn’t, and at what cost and for how long.


Kevin Dowd, Professor of Finance and Economics, Durham University, reinforced John Allison’s assertions, pointing out that the original Federal Reserve Act is about 32 pages long. The Glass-Steagall Act is under 40 pages long. The Volker Rule is just under 550 pages. Dodd-Frank, so far, is nearly 850 pages with most expecting it to total around 20,000 pages or more when all the discretionary bits are worked out. Notice a trend in the timeline here? The more complex the regulations, the more costly it is to enforce them, and to comply with them, creating a bias towards ever larger financial institutions, and increasing the opportunity for corruption.


For those of you who’d like a bit more, aside from suggesting you look into therapy as my family reiterates every holiday, I recommend going to this site to watch clips of some of the presentations. Despite the gloomy potential, there were frequent rounds of boisterous laughter, albeit the geeky economist style which I enjoy more than I ought to admit.

Tapering Taunts Tells of Tenuous Times

Tapering Taunts Tells of Tenuous Times

Starting in late May the Federal Reserve diligently prepared the markets for the dreaded tapering of quantitative easing, based on their assessment of an improving economy. By the time the September meeting of the FOMC (Federal Open Market Committee) occurred, the markets had been thoroughly primed and conventional wisdom considered a $10 – $15 billion a month reduction in the Fed’s current $85 billion/month rate of purchases of Treasuries and MBS a done deal. To put this amount into historical perspective, consider a few pivotal events.

In 1998 Long Term Capital Management (LTCM) was the first organization to receive the Too-Big-To-Fail treatment, requiring a $3.6 billion bailout after losing $4.6 billion in less than four months when the Russian debt crisis threw a massive monkey wrench into its carefully crafted models. At the time I was with JP Morgan with a front row seat to the stock market drama and witnessed the terror running rampant. Conventional wisdom declared loudly that the global financial system would implode unless LTCM was somehow saved. It is interesting to note that the year before LTCM nearly brought global finance to its knees, two members of its Board of Directors, Myron Scholes and Robert Merton, were recipients of the Nobel Prize in Economics. Just for fun, check out the Board of Directors for Dimensional Fund Advisors.

In 2008, Bear Stearns required an infusion of $25 billion from the Federal Reserve to prevent its collapse, an amount that was considered astronomical. This evolved into a $30 billion loan to JP Morgan in order to fund its takeover of Bear to once again, stave off the specter of global financial collapse.

Later on in September of 2008, Lehman went bust without the support Bear had received and global liquidity froze, prompting the TARP bailout package of $787 billion. Ignoring the impact of inflation for simplicity, let’s look at the relative size of the monthly QE program compared to these bailouts.

Current QE program =     $85 billion/month

23.6 times the entire bailout for LTCM

2.8 times the one-time loan for Bear Stearns

1.3 times TARP on an annual basis




As the chart at left from the Wall Street Journal illustrates, by September 2/3rds of all economists though it was a done deal. The Fed managed to have the markets fully primed for a reduction in the level of stimulus, and had instilled an increase in uncertainty to somewhat reduce the level of risk-taking, but not enough to cause the markets to get overly skittish. This was the Fed’s master soufflé, cooked to perfection and ready to serve… then Ben sneezed.

The world was stunned to have seen the Fed put in all that hard work to prime the markets, only to have the Fed bow its head with a plaintive, “Just kidding,” at the last moment.

“The Fed shocked markets across the world by leaving its $85bn-a-month asset purchase scheme unchanged on Wednesday, despite guiding traders to believe that so-called “tapering” would begin this month. Most Fed followers had expected the stimulus programme to be reduced by between $5bn and $15bn a month.”  UK Daily Telegraph, September 19, 2013

After the Fed’s superb job of convincing most market participants that tapering was a fait accompli, this reversal comes at a high cost.

“This FOMC edition feels less dovish than it does outright scared. Confidence in the outlook has dimmed. That Bernanke had a free pass to begin that tapering process and chose not to follow is telling. The Fed had the market precisely where it needed to be. The delay today has the effect of raising the benchmark to tapering and ultimately makes that first step harder to achieve.” Eric Green, Global Head of Rates, FX and Commodity Research at TD Securities.

“The US Federal Reserve has damaged its credibility and sown confusion about central banks’ communication strategies by surprising markets with its decision to keep quantitative easing on hold, economists have warned.”  The UK Daily Telegraph

“Well, as I said in my remarks, I’m a very big believer, the Fed Reserve is a very big believer in transparency and communication. I think transparency in central banking is kind of like truth-telling in everyday life. You got to be consistent about it. You can’t be opportunistic about it.” Federal Reserve Chairman Ben Bernanke in July 11th, 2013 interview with the Wall Street Journal.


The Fed is giving the markets some confusing mixed signals, with Bernanke repeatedly announcing a desire for increased transparency, and for clear communication, and then does this about- face on a reduction that was relatively small in any case, as the chart at right courtesy of ZeroHedge illustrates. The market is now less inclined to believe what the Fed says. Why would the Fed damage its credibility, a valuable asset, over such a trivial change in policy that would arguably have had a negligible impact?

Bear in mind also, according to a recent research report by the San Francisco Fed, all that the Fed has accomplished with its intervention has been a net contribution of 0.13% per year to annual real GDP growth. So what else could it be? If we look to the headlines, the two biggest topics in recovery-talk are getting people back to work and a recovery in housing.

If we delve into the drivers of employment, we see that according to a study by the Kauffman Foundation, between 1996 and 2009 virtually all new jobs come from companies less than five years old. According to the SBA, small firms accounted for 65% of the 15 million net new jobs created between 1993 and 2009. Small businesses produced 46% of private nonfarm GDP in 2008. Small firms are also more intensely innovating. They produce 16.5 times more patents per employee than larger firms. Thus we can easily deduce that new and small businesses are critical to economic growth, but their ranks are dwindling. The level of entrepreneurship in the U.S. is declining. The number of incorporated, self-employed fell from 5.78 million in 2008 to 5.12 million in 2011. The number of unincorporated self-employed declined from 10.59 million in 2006 to 9.45 million in 2011. While incorporated data only go back to 2000, unincorporated self-employed numbers date back decades: the 2011 number was the lowest in a quarter century! The ways to address this depend largely on your economic and political ideology, but there is no denying that small and new businesses depend considerably on personal savings, small loans, and tapping into home equity.

This brings us to the housing recovery. Homes are typically bought using a significant percentage of debt, thus the price of debt, interest rates, will have a material impact on home prices.

The chart at left makes it a bit clearer. The 10 year Treasury yield rose almost 50% in less than 4 months on the tapering talk. That kind of enormous jump in rates cannot help but have an impact on mortgages and financing options for new and small businesses. The Fed has used quantitative easing to artificially lower interest rates, which helps the housing market recover and helps small businesses get moving. If it decreases or stops its bond buying, interest rates rise, the housing recovery stumbles and small businesses have a tougher time getting funding. The hope is that given enough time, the economy will become strong enough under its own steam and no longer need the Fed’s support. The risk is that the economy and the markets will continue to need the Fed’s support indefinitely, meaning it cannot stop its QE programs. Obviously quantitative easing is something that cannot go on forever, and a forceful ending would likely be very painful.

The chart below gives another hint as to what might have the Fed more concerned. Banks have been scaling back their loan portfolio growth rates and now, the year-over-year growth in bank securities holdings is at its lowest level since the financial crisis. While banks are cutting back, the Fed keeps on buying, so much so that now the Fed’s holding of securities exceeds that of all US banks combined! Previously banks owned about 2.5x the Fed’s holdings.

Bottom Line:
Without being privy to the Fed’s inner communications, we can’t know for certain its rationale behind the tapering delay, but we can deduce that the Fed’s assessment of the potential damage from starting the taper in September was worth the damage to the Fed’s credibility. This warrants careful attention.