Intersection of real economy, monetary tightening and credit froth means volatility
- Money supply and LEI in the US are pointing down
- Fed hawkishness is increasing
- Credit excesses continue in high yield
This week’s multi-theme Friday post is going to pull together threads on the real economy, monetary policy and credit markets. My thoughts follow below.
When I discussed the economy in the US yesterday, I left out a big piece of the data puzzle. If you look at the OECD’s Leading indicators for the US, they have trended down since Q3 2013, the point I am calling peak growth at this point.
The OECD looks at the PMI, consumer sentiment, housing starts, net new orders, durable goods, the yield curve’s steepness, hours worked and share prices as components that it aggregates into a composite LEI. For the US, this time series peaked at 100.7 in August – October 2013 and has been declining since. The last data point for March 2014 was 100.4. By comparison, Spain where I am bullish has an LEI vaulting to a new high of 102.8 in March. Same for Greece at 102.7.
So the aggregate leading indicators for the US are trending down.
Ambrose-Evans Pritchard also notes that money growth in the US has trended down as well.
Data from the Centre for Financial Stability in New York show that growth of the “Divisia M4” money supply slowed abruptly to 1.6pc in April, down from 6pc in early 2013.
Divisia M4 is a dynamic measure that aims to capture shifting uses of money. It is has been one of the best weather vanes over recent years, signalling economic health a few months ahead.
Professor William Barnett, a former Fed official now at the University of Kansas, said the weak M4 figures are a sign that the US is not recovering properly, leaving the Fed with a grim choice as it tries to wean the economy off emergency policies that are themselves causing havoc. “The Fed faces a ‘Catch 22’ decision. I am glad I am no longer on the Board’s staff,” he said.
When you look at today’s weak April consumer spending figure showing a 0.1% contraction, you have yet more data showing that the US real economy is not vaulting to new highs at all, unlike the chatter you hear in markets.
At the same time, as Barnett correctly argues, the Fed is boxed in to a corner now because of froth in credit markets and the rapid decrease in unemployment in the US. The unemployment has already blown through the Evans Rule barrier of 6.5% and we may end up surprised at how quickly it declines from here.
Many Fed officials are talking in hawkish terms as a result. For example, Richmond Fed President Jeffrey Lacker told Kathleen Hays at Bloomberg yesterday that he is ready to raise rates early in 2015. His view: “We’ve seen inflation bottom out; I think it’s pretty conclusive it’s bottomed out in the last couple of quarters. And there’s some tentative signs that a move back towards, a gradual move back towards 2 percent is in train, and I’m hopeful that that will play out over the year.” When asked directly by Hays, “can the Fed start raising the key rate if it hasn’t even reached the inflation target?”, his answer was, “”I don’t see why not.”
Then we see comments from Esther George of Kansas City. She is so keen to hike rates that she has joined the voices of more dovish members of the Fed like Williams and Dudley, saying that she would support not reducing the size of the Fed’s balance sheet before the Fed starts to raise rates.
And St. Louis’ Bullard has said that rate hikes could come in late Q1 of 2015, according to the Wall Street Journal. The clear implication here is that the reason the Fed led the discussion in April – as outlined in the Fed minutes – with a whole discussion on how to raise rates is because they are looking to raise rates. Again, I remind you that tapering IS tightening and that the Fed now has a tightening bias. They want to hike.
The question then is how they do so. The April minutes state, “A staff presentation outlined several approaches to raising short-term interest rates when it becomes appropriate to do so, and to controlling the level of short-term interest rates once they are above the effective lower bound, during a period when the Federal Reserve will have a very large balance sheet.” Atlanta Fed chair Dennis Lockhart expects the Fed to use reverse repos during the stimulus exit. But there are other tools that will come to bear on the process. I suggest you read Peter Stella’s piece on “Exit-path implications for collateral chains” that I carried here in September. Stella gives a good overview of the mechanics now being set in place as well as some of the implications for money growth due to the use of collateral and rehypothecation in the shadow banking arena. The exit will be fraught with peril for collateral chains and for portfolio balance preferences and emerging markets. Expect volatility.
Meanwhile the credit excesses in the US continue. I have highlighted a lot of this recently. But Moody’s recently said that covenant weakness in bonds rated B1 or lower and measured on a three-month rolling basis had reached the highest level in April since they began tracking that figure in 2011.
According to Moody’s more than 19% of issues in Q1 2014 were considered “high-yield lite”, bonds with no covenants to restrict companies’ ability to add new debt or to restrict the use of funds from the bond offering. These are important safeguards in the high yield arena, especially for B1 and lower rated companies due to the precarious nature of their financial structure. The 19% figure is almost triple the figure from Q1 2011 when Moody’s began tracking this.
So what we are seeing in credit markets is a reach for yield by yield-starved investors that has eroded safeguards for those investors just as the leading economic indicators are showing a weakening economy going forward. And the Fed is tightening into this situation.
I believe the composite picture here presents an opportunity to think about getting long volatility. The Q1 corporate profitability numbers suggest that mean reversion has begun on corporate profits. This decline, coupled with a weaker macro picture and excess risk in credit markets makes the potential for volatility higher in the late summer and early fall.
The critical variable here is the Fed’s reaction function. I believe they are tightening into froth and that will pull forward credit demand. And then the question becomes how does this interact with the real economy and the Fed’s reaction function. If the use of credit can overcome the decline in the leading indicators, 2014 will prove a mid-cycle slowing and markets will resume their climb, with a full-on bubble likely. However, if real economy weakness continues, I believe the Fed will continue to signal tightening and that will make for some volatile times come August, September and October.
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