Has the Fed “Fallen Behind the Curve”?

In this issue:

Has the Fed “Fallen Behind the Curve”?

Have Chinese Punters Driven Up Global Inflation Expectations?

Animal Spirits versus Emergent Liquidity Strains?

Has the Fed “Fallen Behind the Curve”?

Will the US Federal Reserve raise interest rates in the coming FOMC meeting in March 14-15?

Has it been a coincidence for Fed officials to suddenly chime in to signal a March rate hike?

Last week, the big guns of the US Federal Reserve, namely presidents of St. Louis Fed James Bullard, San Francisco Fed John Williams, Richmond Fed Jeffrey Lacker, Cleveland Fed Loretta Mester, Philadelphia Fed Patrick Harker, Dallas Fed Robert Kaplan and NY Fed William Dudley, likewise Fed Governors Jerome Powell and Lael Brainhard and Fed Vice Chair Stanley Fisher has virtually expressed support for a March interest rate move.

With Fed doves L. Brainhard and W. Dudley joining the hawks, a March hike could be in the offing.

Fed fund futures as of March 3 exhibited a 79.7% chance of a March 15 rate hike.

Or has such seeming coordinated action signified a “signaling channel” intended to shape the public’s expectations?

Or has this functioned as a trial balloon to test market’s reaction?

What’s even more striking has been the speech of Fed Chair Janet Yellen who denies that the FED has been behind the curve¹

This same approach will continue to drive our policy decisions in the months and years ahead. With that in mind, our policy aims to support continued growth of the American economy in pursuit of our congressionally mandated objectives. We do that, as I have noted, with an eye always on the risks. To that end, we realize that waiting too long to scale back some of our support could potentially require us to raise rates rapidly sometime down the road, which in turn could risk disrupting financial markets and pushing the economy into recession. Having said that, I currently see no evidence that the Federal Reserve has fallen behind the curve, and I therefore continue to have confidence in our judgment that a gradual removal of accommodation is likely to be appropriate. However, as I have noted, unless unanticipated developments adversely affect the economic outlook, the process of scaling back accommodation likely will not be as slow as it was during the past couple of years.

Yet Ms. Yellen seems to be part of the “hawkish” crowd who may likely vote for a March rate increase.

It would be natural for any official to refuse acknowledgement of any errors attributed on them. Any lapses have almost always been blamed on external or exogenous forces.

Besides, falling behind the curve will be seen or judged in the context of the future than today.

Nevertheless, the rapid buildup in inflationary biases expressed in asset prices, which seems to have percolated into real economy prices, may have likely prompted for this abrupt change in sentiment of Fed officials.

US stocks have virtually been on fire or have been in a virtual meltup mode.

This can be seen via the fiery year to date returns by the Dow Jones Industrials (+6.29%), S&P 500 (+6.44%) and Nasdaq (+9.06%). Present returns may have already fully priced in whatever highly optimistic growth expectations that may emerge from Trump’s policies.

And a string of record breaking developments have occurred based on price actions, fund flows and valuations.

Price actions. The Dow Jones which hit 21,000 last week matched the record of the fastest 1,000 point advance which was last attained in 1999. Including the Russell 2000, all four major indices were at record highs last week. The S&P 500 has enjoyed the longest streak of gains without a 1% correction.

Fund flows. Mom and pop investors have been piling into the equity markets mostly via passively managed funds. Based on estimates by JP Morgan, retails plowed $ 86 billion into equity Exchange Traded Funds as of February.

Global investors funneled $62.9 billion into ETFs last February for a two month $124 billion record net inflows as reported by the ETF industry.

Goldman Sachs has warned of extreme complacency as global investors have discarded hedges and rushed “headlong into risk”.

Valuations. Conventional valuation metrics such as Shiller CAPE ratio, (Tobin’s) Q ratio and the Buffett indicator (market cap to GDP) reveals of severe overvaluations. The Shiller CAPE ratio and the Q ratio have reached 1929 highs! The trailing twelve months (TTM) PER of the small cap Russell 2000, based on Wall Street Journal’s Market Data Center as of March 3, was at a shocking 240.92! Whereas the Dow Jones Industrials, S&P 500 and Nasdaq TTMs were at 21.45, 24.9 and 25.78, respectively!

Quality matters too. High debt-low quality and low dividend paying stocks have mainly energized today’s record breaking streaks.

Overconfidence. Last week, a photo app developer, Snap had a sparkling debut—a 44% jump in its share prices. The company has been burning cash, has no profits and has barely significant sales and was last valued at a whopping 78x earnings!

And it’s not just stocks.

Junk bonds have become the “best performing bonds this year” as investors stampeded into them. Yields of junk bonds as exemplified by BofA Merrill Lynch US High Yield CCC or BofA Merrill Lynch US High Yield Effective Yield have plumbed to 2014 lows.

Real estate prices have almost recaptured the 2007 glory. The S&P Dow Jones reported that last December, the S&P CoreLogic Case-Shiller U.S. National Home Price NSA index posted a 5.8% yoy gains, the 10-City composite 4.9% and the 20 city composite 5.6%. The S&P/Case-Shiller 20-City Composite Home Price Index can be seen just a stone throw distance from the 2007 highs.

To add, prices of Commercial Real Estate (CRE) are at record highs. Just last February, the FED had a special mention of heightened risks in the sector: “Commercial real estate (CRE) valuations, which have been an area of growing concern over the past year, rose further, with property prices continuing to climb and capitalization rates decreasing to historically low levels”.

And again it’s more than just asset prices; it’s about inflation expectations too.

Three major inflation gauges the 10-Year Treasury Inflation-Indexed Security, Constant Maturity, the 5-Year, 5-Year Forward Inflation Expectation Rate and the 10-Year Breakeven Inflation Rate have been scaling upwards since June 2016 albeit at an accelerated rate. January’s ISM manufacturing prices (prices paid) have doubled from a year ago!

US CPI which increased to 2.5% last January has climbed for the sixth consecutive month to reach its highest level since 2012.

And it’s not just the US. Risks appetite has been whetted essentially everywhere.

Global stocks are at record highs.

In Asia, major equity bellwethers of Bangladesh, Pakistan or Vietnam continues to carve fresh zeniths. Meanwhile, stock market benchmarks of Australia, New Zealand Taiwan, and Indonesia have been testing record heights. Also, major indices of Japan, Hong Kong, Korea, Singapore and Thailand have reached 52 week peaks.

Aside from stocks, the current risk ON climate has been manifested in bonds.

Asia’s corporate debt continues to swell. The premium between emerging market sovereign debt and US corporate bonds has been in a compressing trend. And with lowered rates, such has spurred a race to sell bonds in the corporate world of emerging markets.

Moreover, sizzling global property prices have scaled upwards to near 2007 apogee. That’s based on the IMF’s global real house price index.

And again, it’s not just asset prices; but real economy prices too.

In both emerging and developed Asia, rising government CPI or CPI at elevated levels can be seen in Taiwan, South Korea, China, Sri Lanka, Myanmar, Vietnam, Indonesia and the Philippines.

On the other hand, CPI recently jumped in Japan, Singapore, New Zealand, Malaysia, Thailand and Mongolia.

From the perspective above, it’s easy to see the likely factors or influences that may have altered the perspective of the majority officials of the US Federal Reserve.

If the FED has indeed been behind the curve, timid rate hikes will only further bolster the underlying risk appetites.

And Ms. Yellen’s observation that this may “potentially require us to raise rates rapidly sometime down the road” may become self-fulling prophecy.

Have Chinese Punters Driven Up Global Inflation Expectations?

Yet mounting inflationary biases have originated mostly from the massive expansion of central bank balance sheets.

Assets of major central banks have rocketed 271% to $17.6 trillion (January 2017) from about $6.5 billion in 2008 (Yardeni.com).

The ongoing QE programs by Bank of Japan, Bank of England and ECB accrue to around $2 trillion a year.

On top of the QEs by the trio have been China’s social financing. Total Social Financing (TSF) data has spiked to a cumulative $2.7 trillion in 12 months last January, of which bank loans at US $1.8 trillion has accounted for 67% of the lending by financial institutions, but also by Chinese households and non-financial entities.

Add to the above, outside the formal sector financing has been the US $ 3.8 trillion off-balance sheet assets, which is otherwise known as the “shadow banking system”.

Since issued money has to go somewhere, the tsunami of liquidity has only bolstered shifting episodes of frenzied speculations by the average Chinese on stocks (2015) to bonds to real estate and to commodities.

Aggregate trading volume of commodity futures roared to a record 177.4 trillion yuan ($25.5 trillion) or up 30% yoy in 2016, according to Bloomberg.

This entails that perhaps much of the price inflation seen in the commodity spectrum have been from the Chinese speculators. And this could have been interpreted as “reflation” by most of the world.

To emphasize, the above central banks infused humongous amounts of liquidity to the tune of nearly $ 5 trillion last year! And they are likely to continue with such infusions in 2017. And this excludes other emerging market central banks that have mimicked their developed market peers.

Yet if my suspicion holds true that the perceived “reflation” had largely been a transmission mechanism from the Chinese punters indirectly financed by the PBoC, just what would happen to the “reflation” trade once there could be a pullback in liquidity?

WTIC and Brent prices appear to be manifesting a topping formation. Gasoline and gold prices cratered last week, perhaps in response to the Fed’s hawkishness.

For instance, given that energy and transportation have largely influenced the recent spike in US CPI, then what happens if oil and gasoline prices fumble anew?

Would the FED reverse course and reintroduce QE?

Animal Spirits versus Emergent Liquidity Strains?

Curiously, despite the huge ballooning of credit creation, which can be seen in the sizeable expansion of assets of China’s central bank, the People’s Bank of China (PBoC), its foreign exchange holdings continues to fall (see above).

And this appears to have been reflected in the decline of the offshore (CNH) and of the onshore (CNY) yuan. The falling yuan has popularly been attributed to capital flight or “capital outflows”

And despite the repeated injections by the PBoC, Shibor rates across the curve remains elevated and unstable since the 2H of 2016. Perhaps part of these may have been from the 54% surge in bankruptcy cases in 2016. But the liquidity pressures can be seen, not just in Shibor, but in CNH Hibor (Hong Kong) rates too.

All these looks like signs of US dollar liquidity shortage amidst a flood of liquidity in the yuan. This demonstrates that domestic liquidity has a much different dynamic than the US dollar liquidity. Maybe the PBoC has been substituting US dollar illiquidity with yuan liquidity in the hope to contain tensions from the mismatch.

Yet once domestic liquidity recedes in China, out of political design from authorities or by sheer weight of market forces, it is likely to reverse present signs of “reflation”. Even more, this could amplify the US dollar illiquidity strains.

And US dollar illiquidity may not be confined to China but likewise to the $9.7 trillion US dollar borrowers outside the US whereby emerging markets account for a third. Slower economic growth would likely induce greater demand for the US dollar.

And should the Fed persist to increase interest rates, China’s US dollar liquidity dilemma may be amplified.

And even worst, should a trade war be opened, present liquidity flows will most likely experience dislocations, hence, liquidity conditions can be expected to deteriorate

It’s not just in China. Even amidst the ongoing euphoria in the US markets, signs of liquidity strains have been present.

LIBOR rates have been rising across the curve since 2015: overnight, 1-month, 3-month, 6 month, 12 month. Goldman Sachs estimated that $28 trillion of loans have been tied to Libor. While LIBOR rates are way off the highs 2007, the fact they are rising could be a sign of emergent hidden stress.

The same rising dynamic applies to the liquidity indicator the TED spread.

Much of these had been blamed on the 2a7 reform, but today they seem as mostly imputed to prospective interest rate actions by the FED.

And yet, despite higher inflation expectations, yield spreads have been flattening. An example would be the 10-2 year spread.

Perhaps such has affected the rate of growth (% from a year ago) of commercial industrial loans, which at 6.7% in January, has tumbled to 2013 lows.

In addition, hard data seem to have departed from the ebullience exhibited by survey based “soft” data and the financial markets.

For instance, US 4Q GDP slowed to 1.9%. In addition, Atlanta Fed’s GDPNOW marked down 1Q 2017 to 1.8%.

In Europe, the ECB’s payment and settlement system TARGET2 has now been running a record.

In January, Germany posted its highest ever inflow. On the obverse side have been record outflows from Italy and Spain. Spain appears to be fast catching up with Italy.

It is not clear whether this is about populist politics or about Europe’s fragile banking system. It can even be both. France, Germany and Netherlands are slated to hold national elections this year.

At the end of the day, current market activities have been reflecting on mostly “animal spirits” or the herding effect that has been lubricated by domestic liquidity and rationalized on hope.

Yet ultimately, liquidity conditions will likely determine its sustainability.

1 Chairman Janet Yellen “From Adding Accommodation to Scaling It Back” At The Executives' Club of Chicago, Chicago, Illinois March 3, 2017

Another Bullseye!!! Record BLOWOUT in 2016 Fiscal Deficit Mainly Financed by the BSP!

The Bureau of Treasury finally came through with the much-belated publishing of government’s budget balance in 2016.

And the result was a WOW! A record BLOWOUT in deficit!

Remember this?

The Duterte regime has very ambitious spending programs covering all aspects of government (bureaucracy, welfare, warfare and public works). This will compound on the financing needs by the government, which will be funded partly through the raising of taxes, and mostly through credit expansion and the monetization of spending by the BSP.

Such actions essentially underwrite the coming dramatic fall of the peso (regardless of what the FED does—or even if the FED embarks on another QE). 

See As USD Peso Touched 50, a November 2008 Low and My Yearend Target, Pandemonium and Confusion Engulfed the Mainstream! November 27 2016

Or how about a rewind…my pre-elections forecast?

Given that government will assume a bigger role, then this means that the rate of growth of government spending should rise faster than the economy. Therefore, fiscal deficits will only balloon.

Even more, the cost of financing a bigger government should translate to lower economic performance…

And finally, since deficits will bulge, the government will have to raise taxes and or fund itself with more debt. Again, higher taxes in itself will not automatically weaken the peso. For as long as it can be paid for by taxes, more debt will also not contribute to the attenuation of the peso. The debilitation of the peso will occur when government increases money supply to directly monetize its spending, or, beyond the ability for taxes, employ bank credit expansion to fill the spending gap by purchasing government debt

See Phisix 7,150: Prospects of a Strong Man Rule Sends Peso Tumbling, Why A Shift to the Political Left Will Mean A Weaker Peso May 1, 2016

Figure 1: Record Deficit, Revenue and Expenditure Growth

And the deficit explosion came with the worst mix: the shrinkage in revenues PLUS a blast off in expenditures!

Because government revenues grew by only 1.1% last December, 2016 revenue growth clocked in at 4.12%. This accounted for the lowest growth rate since 2010!!! (see lower window figure 1)

And notice that government revenue growth rate peaked in 2012, decelerated through 2015 before last year’s meltdown.

On the other hand, because government expenditures ripped by a stunning 18.8% in the last month of 2016, the year’s growth outlays accrued to an incredible 14.3%; this was the highest growth clip since 2007!!! 2016’s growth rate 14.3% edged out 2012’s 14.13%.

Record fiscal deficit wasn’t just a single month rendition though.

In the second semester, aside from December, government spending boomed by a staggering rate of 29.5% and 33.2% in September and November, respectively!!!

In perspective, 65% share of 2016’s Php 353.4 billion record deficits was acquired by the Duterte regime while the residual 35% was incurred by the previous Aquino administration!

The Php 353.4 billion record deficits accounted for 2.45% of the government’s 2016 GDP (NGDP 8.6%, RGDP 6.8%). Yet the latter number, I believe had been inflated.

And December 2016’s deficit of Php 118.229 billion was the largest monthly funding shortage since 2008, or the earliest date available in the current Bureau of Treasury’s monthly data

The record bulge in funding requirements only validates my expectations that there would be NO tax cuts (or tax reform). Instead, the Philippine government will most likely impose a series of tax hikes and expand financial repression measures (including the inflation tax).

And if collections remain insufficient to finance aggressive spending, then expect the war on mining to reverse.

Figure 2: Revenue Composition, Debt Performance

The plunge in 2016’s top line was mostly due to the collapse in non-tax revenues (-26.55%). Non-tax revenues accounted for 10% of overall collections.

Collections from the Bureau of Internal Revenue (BIR) posted a 9.34% growth rate in 2016. Although this was an improvement from 2015’s 7.38%, such number came significantly below the 2010-2014 levels. The BIR’s tax collection rate, which accounted for 71.3% share of 2016’s revenues, has been in a downtrend since 2012.

Collections from Bureau of Customs (BoC) jumped 7.84% compared to 2015’s -.472%. BoC collections have been quite volatile. Yet the share of collections from BoC accounted for 18.1% of 2016 intake.

Nevertheless, the collection rates of BIR and the BoC has been insufficient to cover the void generated by non-tax revenues.

Fiscal deficits mean greater government spending relative to collections covering a given period. Because collections have been insufficient to cover spending, thus the government will have to source its funding through other means. They do this either through debt (future taxes) or through central bank monetization (inflation tax).

Total debt rose by Php 135.7 billion or 2.28% with most of the gains emanating from external debt which went up by 4.15%. The latter may signify the currency effect of the present debt stock. Based on BSP’s data, the average USD peso rose by 4.4% to Php 47.4925 in 2016 from 45.5028 a year back or in 2015.

The 2016 debt figure translates to the financing of 38.4% of deficit requirements. But since this most likely includes the effect of changes in exchange rates to the external debt stock, this means debt has contributed to much less than the indicated numbers.

Clearly, by avoiding the debt channel, the government intended to embellish their debt profile to project the image of a “strong macro”

But there is no such thing as a free lunch. The government’s spending spree has to be financed.

Figure 3: Net Claim on Central Government, Banking Loans, Liquidity and CPI

With debt out, this leaves the stealth inflation tax.

In 2016, net claim on central government as reported by the Bangko Sentral ng Pilipinas or the Philippine central bank, rocketed by a staggering 239% to Php 344.45 billion from 2015’s Php 144 billion. (upper pane figure 2)

The Php 344.45 billion suggests that the BSP financed 97% of 2016’s acquired deficits!

And December’s phenomenal record Php 118.23 billion funding shortage was also 92.4% covered by the BSP’s net claim on central government which chalked in at Php 109.23 (month on month nominal)!!!

As a side note, because the net claim on central government went down by Php 28.18 billion, perhaps the government registered a surplus in January 2017.

BSP’s actions were not just aimed to finance deficit, it most likely targeted monetization as means to “stimulate” the economy. Two birds with a single stone.

Again, since the BSP went into a bond buying spree (Quantitative Easing Philippine version), growth rates of the banking system’s loans, domestic liquidity (M3) and CPI suddenly and simultaneously perked up! (lower pane figure 2)

As I previously noted, the non-political sensitive government inflation measures as General Retail Price Index (survey based on price paid by consumers at retail outlets) which for January 2017 continued to climb past 2014 high (!), General Wholesale Price index (December 2016), Construction Materials Wholesale Price Index (January 2017) and Construction Materials Retail Price Index (January 2017). All four price indices have soared to three or four years highs!!!

Hence, a substantial degree of nominal growth attained through (gross) sales, taxes paid and corporate profits were mainly due to the huge doleout by the BSP to select firms (who were the biggest bank borrowers), and most importantly, to the government.

Yet the difference in the impact of BSP chief’s “trickle down” or negative real rates policies with developed economies has come down to aggregate balance sheets of the private sector.

Credit easing policies employed by central banks in the developed economies has signified attempts to administer previous overleveraging through lower rates—implemented through unconventional means—Negative interest rates (NIRP) and Large Scale Asset Purchases (QE). 

On the other hand, credit easing policies employed by the BSP has revved up a credit cycle in relatively less leveraged balance sheets. Because such stimulus has been in place since 2009, the effect of additional stimulus has been immediate: increased credit uptake, spikes in domestic liquidity, upside pressures in nominal prices and the weakening of the currency, the peso.

But again, upside pressures in the real economy prices, as well as, the corrosion of the peso will either force the BSP to reverse its credit easing methods or the markets will.

In a working paper, Mr. Claudio Borio, head of the monetary and economic department in the Bank for International Settlements, together with Ms. Anna Zabai recently warned

Unconventional monetary policy measures, in our view, are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large. Short-term gain may well give way to longer-term pain. As the central bank’s policy room formanoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come. The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong. Ultimately, central banks’ credibility and legitimacy could come into question.

And with further plans to expand the government’s activities, such as the proposed recruitment of 14,000 new soldier to augment the Armed Forces, which means not only a boost in manpower spending, but as well as, required logistics to back them, deficits will continue to balloon. And the process of “crowding out” of private sector activities will only escalate.

Hence, last week’s technical rounded bottom breakout by the USD peso which targets 59.50 has been solidly backed by present policies. The BSP has been purposely weakening the peso in order to finance the government! [See My Major Homerun: Philippine Peso Dives to RECORD 10 Year Low! Don’t Tell the Public That The BSP Has Pursued a Weak Peso Policy! February 26, 2017]

As one would note, a historic process is in the making!