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Posted in Newsclips, Samples

Frexit Update

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  • The Financial Times – Le Pen extends lead, Macron drops 5 points in latest French election poll – BFMTV
    Marine Le Pen has extended her lead in a poll of first round French voting intentions, which shows a sharp drop in support for her centrist rival Emmanuel Macron in the last week. A poll conducted by Elabe for French broadcaster BFMTV today showed at least a 1.5 point swing towards the far-right Front National leader who is vowing to hold a referendum on France’s membership of the eurozone. The eurosceptic Ms Le Pen has around 27-28 per cent of the popular vote according to the poll which varies on whether or not centrist candidate Francois Bayrou will take part in the election race in less than three months’ time. … High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. More worryingly for investors, Ms Le Pen has also made ground in the second round voting intentions, narrowing the gap on her rivals. The polls suggests she would lose out to Mr Macron by 59 per cent to 41 per cent – a 4 point gain in her favour (second graphic above).


While Le Pen is still losing to Macron by 18% in the second round, this is the first time she polled above 40%. So she continues in her uptrend for second round elections.
But given all this, as we highlighted yesterday, the French/European markets do not see this election as a threat. Yes, the French/German 10-year spread is reacting to it. But beyond that, little else is moving on these polls. As we concluded:
It appears that European equity markets, and indeed global risk markets, are expecting a very benign outcome from the French presidential election even as other markets are showing rising levels of concern. Investors may be emboldened by the rapid recovery from initial Brexit worries and the even more rapid rebound from the initial Trump election sell-off. Whether the results of the French election are more favorable to the establishment remains to be seen. In the meantime, sovereign debt markets and, to a lesser extent, Forex markets are beginning to price in significant risk premiums.

Posted in Newsclips, Samples

Is Merkel In Trouble?

  • Reuters – German Social Democrat candidate would beat Merkel in chancellor vote – poll
    Martin Schulz, the German Social Democrats’ candidate for federal elections in September, would beat Chancellor Angela Merkel if balloting was based on a direct leadership vote, a poll showed on Friday.  The poll carried out by Forschungsgruppe Wahlen for broadcaster ZDF showed 49 percent of Germans wanted former European Parliament President Schulz to be their chancellor while 38 percent would prefer Merkel to stay in office.  That marks a turnaround compared with the end of January, when the same poll showed Merkel had 44 percent support compared to Schulz’s 40 percent, ZDF said.  Earlier this month another poll also showed Schulz had overtaken Merkel.

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  • Spiegel (Germany) – Climate Change in GermanyMerkel Might Lose After All
    With just six months until Germans go to the polls, Angela Merkel’s re-election is looking less certain by the week. Martin Schulz is a dangerous adversary and his Social Democrats are full of the kind of enthusiasm that the chancellor’s party lacks.

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Posted in Charts of the Week, Samples

Posted in Newsclips, Samples


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Posted in Newsclips, Samples

More On The Forward Curve And The Fed

  • Harvard Business School – Jeremy C. Stein and Adi Sunderam: Gradualism in Monetary Policy: A Time-Consistency Problem?
    We develop a model of monetary policy with two key features: (i) the central bank has private information about its long-run target for the policy rate; and (ii) the central bank is averse to bond-market volatility. In this setting, discretionary monetary policy is gradualist, or inertial, in the sense that the central bank only adjusts the policy rate slowly in response to changes in its privately-observed target. Such gradualism reflects an attempt to not spook the bond market. However, this effort ends up being thwarted in equilibrium, as long-term rates rationally react more to a given move in short rates when the central bank moves more gradually. The same desire to mitigate bond-market volatility can lead the central bank to lower short rates sharply when publicly-observed term premiums rise. In both cases, there is a time-consistency problem, and society would be better off appointing a central banker who cares less about the bond market. We also discuss the implications of our model for forward guidance once the economy is away from the zero lower bound.


Stein and Sunderam’s conclusions are similar to comments we made earlier this month on why even one rate hike matters.

As the chart below shows, the fed fund futures forward curve (blue line) is at a new 12-month low (the purple line shows the previous 12-month low) and is well below the Fed’s expectations.  If the Fed would have hiked last week, the markets would be forced to take Yellen’s words much more seriously. As a result, the forward curve would have likely moved much closer to the Fed’s latest projections. In other words the line would have to go through the black dots. Such an adjustment, moving higher by 100 bps, would have been a big change for the bond market.

This chart shows the market and the Fed are almost in different worlds when it comes to fed funds expectations. According to Stein and Sunderam, no amount of forward guidance or promises of “one hike and pause” can reconcile this. Only an actual hike will force the fed funds market to become more closely aligned with Fed projections.


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  • The Washington Post – Robert J. Samuelson: The weakened Fed
    These are worrying days for the Federal Reserve, America’s central bank. Surrounded by critics on the left and right, it can hardly do anything without being second-guessed or denounced. Last week, the Fed decided not to raise its target “fed funds” rate, a move that was praised by some economists but was greeted by steep drops in stock prices. This captures the Fed’s precarious position: supported by some, scorned by others. Over the past decade, there has been a profound shift in its public standing. Before the 2008-09 financial crisis, the Fed enjoyed enormous prestige and freedom of action. All the Fed had to do, it seemed, was tweak short-term interest rates to keep expansions long and recessions short. What’s clear now is that we vastly exaggerated the Fed’s powers of economic management. Since 2008, the Fed has not only kept short-term interest rates near zero but has also poured nearly $4 trillion into the economy by buying U.S. Treasury securities and mortgage bonds (so-called “quantitative easing,” or QE). These policies almost certainly helped the economy, but the extent of the help is unclear and subject to legitimate disagreement. Regardless, the recovery has been frustratingly slow. The Fed’s reputation has suffered. Increasingly forgotten is its success during 2008 and 2009 in preventing another Great Depression by acting as “lender of last resort” for the financial system. Instead, Fed policies are misleadingly identified as part of the problem and in need of overhaul. The Fed is increasingly friendless. The sluggish recovery has turned it into a scapegoat. What we should have learned is that its powers, though considerable, are limited. Years of ultra-easy credit have not triggered the faster growth that most Americans desire. Even with the economy near “full employment” (August’s unemployment rate: 5.1 percent), living standards are barely budging.
Posted in Newsclips, Samples

Who Wanted To Hold Rates At Zero, Yellen Or The Majority?

  • The Wall Street Journal – Fed’s Williams Sees 2015 Interest Rate Rise as ‘Appropriate’
    John Williams, president of the Federal Reserve Bank of San Francisco, said in a speech Saturday he believes it is still appropriate to raise short-term interest rates before year-end, reiterating a timeline that remains the preference of a majority of Fed officials. In a speech in Armonk, N.Y., at a symposium on China and the financial system, Mr. Williams said there are “arguments on the side of the ledger arguing for more patience.” But he said, “Given the progress we’ve made and continue to make on our goals, I view the next appropriate step as gradually raising interest rates, most likely starting sometime later this year.” His comments are significant because they typically reflect the center of Fed officials’ thinking on interest-rate policy. They come only two days after the Fed decided not to raise rates at its September policy meeting this week.
  • The Wall Street Journal – St. Louis Fed’s Bullard Argued Against FOMC Decision at Fed Meeting
    Federal Reserve Bank of St. Louis President James Bullard said Saturday he argued against holding rates steady during the Fed’s policy meeting last week because he believes the economy has recovered enough to begin raising rates. “I would have dissented,” he said. “The case for policy normalization is quite strong since the committee’s objectives have essentially been met.” “Why do the committee’s policy settings remain so far from the normal when the objectives have essentially been met?” Mr. Bullard said. “The committee has not, in my view, provided a satisfactory answer to this question.” Mr. Bullard’s was a minority view at the meeting. Fed officials last week decided to hold off on raising rates, citing risks from economic instability overseas, particularly in China. Officials said they wanted to wait until they had more information about the economic and financial fallout of the global slowdown. Mr. Bullard described the meeting as “pressure packed,” and said the decision to hold rates steady was “a close call.”


Every quarter the Fed publishes its Summary of Economic Projections. The part that gets the most attention is the so-called dot plot. The chart below shows the year-end 2015 projections from the last four SEP updates. The green rectangle on each update highlights the number of Fed officials expecting at least two hikes this year (0.625% or higher).

  • In the December 17, 2014 update, 15 of the 17 (88%) officials were expecting at least 2 hikes in 2015
  • In the March 18, 2015 update, 14 of the 17 (82%) officials were expecting at least 2 hikes in 2015
  • In the June 17, 2015 update, 10 of the 17 (59%) officials were expecting at least 2 hikes in 2015
  • In the September 17, 2015 update, 6 of the 17 (35%) officials were expecting at least 2 hikes in 2015

FOMC members that fill out these expectations are instructed to tell us what they think the appropriate policy should be at year-end, not what they think it will be. They are also discouraged from gaming the dots by intentionally raising or lowering their projections to offset another member.

In reality, some officials are guilty of gaming the dots or offering a projection based on where he or she thinks rates will be. See the negative dot in the September 17, 2015 update. That is believed to be Minneapolis Fed President Narayana Kocherlakota, who is retiring at the end of the year, making a statement about his fear of deflation.

If we assume Kocherlakota’s projection is the exception rather than the rule, the September 17, 2015 dots show 6 of the 17 members (35%) thought the Fed should have hiked last week (we are assuming no one thinks a 50 basis point hike is realistic). Another 7 dots (41%) would have been “OK” with a hike last week. In other words, 76% of the members either wanted a hike or would not have stood in the way of a hike.

Four members projected a year-end rate of 0.125% or lower.

Of the three 0.125% dots:

  • One is believed to be Chicago Fed President Charles Evans, who earlier this year said a rate hike in 2015 would be a catastrophe.
  • Another is believed to be New York President Bill Dudley, who said late last month that a rate hike seems less compelling than it was a few weeks ago.
  • The third 0.125% dot is unknown. But if 76% of the members would have voted for a hike, only one person’s vote would be important enough to convince these voters otherwise. Enter Janet Yellen.

So did the Fed hold off on a hike because the committee was not ready to act or because Yellen was not ready to act? We think the 2015 dot plot suggests this had more to do with Yellen’s hesitance than the rest of the committee’s desire to hike.


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  • MarketBeat (WSJ Blog) – Markets Flummoxed by Uncertain Federal Reserve
    It’s as if the hand that has spoon-fed the market for seven years has suddenly become shaky. U.S. stocks are dropping sharply, even after the Federal Reserve did what everybody assumed it would, which was to leave rates alone. Nobody was surprised by that. What was surprising was the indecision the bank exhibited in coming to that decision. If the economy is growing, why isn’t the Fed raising rates? If the state of affairs is so parlous, why isn’t the Fed moving in the other direction (negative rates, anybody?) Is the Fed still data dependent? Then whose data is it dependent upon? China’s? In pausing, the Fed opened a whole new can of worms. This has left the markets somewhat flummoxed…It’s a rare and curious moment for the markets. “Don’t fight the Fed” has been more than a guiding mantra, it’s has been a iron-clad law. To key off the old Chuck Prince line, the Fed has been playing the music, and the market has been dancing. Now, the Fed seems completely unsure of what tune to play, and from where it should taking its lead. The Fed has been hinting all year that the recovery was fast approaching the point where the economy could absorb higher rates. Even yesterday, the bank was talking up the economy. But its actions undercut its words. “How are market participants supposed to discount the Fed decision now?” Chris Low, the chief economist at FTN Financial, asked. “When Fischer says there is no value in waiting for another meeting for clarity because there never is more clarity, or Dudley says the Fed looks at financial markets from a long-term perspective and isn’t concerned with levels, should we ignore them?”
  • The Financial Times – Fed risks dropping the reins on US policy
    While the domestic argument for an initial policy rate change remains firm, the Fed acknowledged that global developments centred around China and emerging markets, which had led to market and economic turbulence, had swung opinion back again. But August’s tremors were not isolated or random, and force us to ask how long this stand-off can go on, given that China’s travails, for example, are not going to end any time soon. And what if it did go on?…This begs the question: how long should the Fed cite China or emerging markets as a reason for keeping rates on hold, especially if the domestic case for not doing so becomes even more compelling? Seven years of zero interest rates have already contributed to mounting financial distortions in emerging markets. If the Fed continued with financial market stability as the leitmotif of policymaking, a later but more disruptive policy adjustment and greater instability are the all too likely outcomes. The Fed should start telling markets about the difficult trade-offs it faces.
  • The Financial Times – Waiting for Yellen
    Investors would be forgiven for feeling confused. If the risk of an emerging market shock was the Fed’s main worry in the third quarter, what are the chances it will have receded by the fourth? Presumably they are slim. In which case, is a delay of a few weeks remotely adequate to the risks? Nobody said central banking was easy. But Ms Yellen’s communications have recently been at sixes and sevens. The Fed started off 2015 indicating that it would exit from zero-bound interest rates this year. Initially speculation focused on June. But another winter contraction in the economy pushed that back. Then it needed to be sure the second quarter rebound was real. Expectations were nudged back to September. It concluded the rebound was on track. Joblessness continued to fall at a rate that implied wage inflation was not far off. In between, the China crisis struck along with signs its authorities lacked “deftness” in handling it. Now the timetable has slipped again. By December the US economy may be heading into another quarterly contraction. Moreover, China’s problems, and those of other emerging markets, are likely to take years to work out. Ms Yellen has thus laid a recurring trap for herself. More hawkish officials worry that each time the Fed limbers up for an interest-rate increase, market volatility increases, credit conditions tighten and the Fed feels obliged to postpone.

Posted in Newsclips, Samples

Discussing Economic Releases


Jim Bianco was on CNBC with Rick Santelli Friday discussing a bias in the payroll survey, rent’s effect on inflation and global yields. To view the interview, click on the image above. To view any of our recent interviews, click here.
In the interview Jim talked about the following chart which shows the 12-month standard deviations of seasonally adjusted payrolls (blue) and not-seasonally adjusted payrolls (red). The seasonally adjusted standard deviation is near a 20-year low. The not-seasonally adjusted standard deviation is in the upper half of the last 20 years. In other words, the lack of variance is a function of the seasonal adjustments, not raw data results.


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We also tried to explain the payroll measurement problems explained below. We believe this is another factor in explaining the poor productivity data.

  • Real-Time Economics (WSJ Blog) – (May 25, 2015Jon Hilsenrath: Fed Confronts an Economy Plagued by Mismeasurement
    A note from Goldman Sachs economist Jan Hatzius this weekend touches on a theme that seems to be getting a lot of play of late in the world of central banking: Mismeasurement. Do we really know the world economists are trying to describe to us on a daily basis? And if we don’t, are central bankers in any position to feed this world appropriate amounts of money and interest? Goldman’s note raises questions about measurement of productivity, growth and inflation. “Structural changes in the US economy may have resulted in a statistical understatement of real (economic) growth,” Mr. Hatzius argues. The data, he says, might not be picking up changes in the economy resulting from the rapid spread of advanced software and digital content. Inflation statistics, moreover, might not grasp the leaps in quality of, say, the camera on your iPhone. My camera, for instance, can capture my dog catching a ball in slow motion, which is very cool and something I’ve never been able to do before. Mr. Hatzius argues inflation, growth and productivity statistics have been understated because the data don’t pick up the consequences of this technological change.
How do we explain the drop in productivity shown below?


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See the bottom panel above. The quarter-over-quarter productivity data just completed two consecutive declines for the first time in over 20 years! Does anyone actually believe in this era of rapid technological advances that the U.S. economy has suddenly become that inefficient? We tackled this question in March:

The payroll numbers are inconsistent with all other economic releases, earnings reports and market reactions (collapsing commodities). The payroll report says the economy is humming along nicely, but nothing else is confirming this.

Productivity, which is simply GDP growth minus aggregate labor output, highlights this deviation nicely. … The chart [above] shows the year-over-year change in productivity. This figure was negative for only the third time in 20 years during Q4 2014 (latest data).

Has the American economic suddenly become inefficient? We doubt it, so maybe some of the data is wrong. Most are inclined to explain away the poor data by pointing to factors such as weather. Maybe the weak data, which constitutes the majority of economic releases, is not wrong though. Perhaps we should be re-examining the one data point that is strong, non-farm payrolls.

We first argued that something might not be right with the payroll report last December. Below is an update.

Measuring Jobs

The BLS was created in 1915 to study jobs in four industries: boots and shoes, cotton goods, cotton finishing, and hosiery and underwear. Then, according to the BLS handbook:

During the Great Depression, there was controversy concerning the actual number of unemployed people; no reliable measures of employment or unemployment existed. This confusion stimulated efforts to develop comprehensive estimates of total wage and salary employment in nonfarm industries, and BLS survey data produced such a figure for the first time in 1936.

From 1915 to the early 1980s the BLS mailed a one-page form to roughly 60,000 establishments asking them for employment information. This data was compiled into the non-farm payroll report.

The one-page form used by the BLS was essentially unchanged from 1915 until it was revised in 2012 (no typo!). Below is how the form for manufacturing firms looked in 1947, 1968 and 1996. It is virtually the same form.


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Starting in 2012 the form was changed to four pages:


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Why was the form changed? As the BLS explained:

In 2008, the BLS started a research program to address problems with the design of the current form and produce a redesigned enrollment package. Objectives of the research were to improve efficiency of the interviewers through improved ability to explain the reporting task, to improve the respondent ’s comprehension of the task, and to decrease respondent burden.

Four goals for the redesigned package were identified. Two of the goals, items 3 and 4, were seen as significant for the project:

  1. Convince the recipient to open the package.
  2. Convince the recipient to read and attempt to understand the contents of the mail- out package.
  3. Provide a reasonably clear explanation of what the recipient is being asked to do.
  4. Persuade the recipient to comply with the request.

Research found five problems that affected the form’s ability to provide a reasonably clear explanation of the survey task:

  1. The cover letter is not well connected to the form.
  2. The reference period is not understood.
  3. Respondents do not understand that they will be called each month.
  4. Some respondents complete all months of reporting at once.
  5. The complexity of instructions for reporting multiple payrolls caused non- response.

Nowhere did they address the issue of results being skewed toward a positive response bias because of the new questions. In fact, here is what the BLS concluded about the new form:

We believe that the new form offers improvements in interviewer efficiency and data quality. These benefits include:

  1. Converting to a four page design eliminated a source of mismatched letters and forms.
  2. Improvements in Item Non-response were observed.
  3. Interviewers reported that it was easier to enroll firms with the new form.
  4. Kansas City and Niceville enrollment time results confirmed this observation. Collection times were also faster in Kansas City and Niceville.
  5. Response and Collection rates were similar between test and control samples.
  1. In other words, the BLS was looking to “push down” the burden of responding to the respondent in order to reduce the cost of collecting the payroll report.  While this is a worthy goal, our inquiries to the designer of the new form and the BLS reveal that no one tested to see if this change would result in a response bias.  We fear that it might have.  Who takes the time to read the four page report and respond (as opposed to the more expensive process of a surveyor leading you through the process?).  We believe the answer is someone that has good news (i.e., hiring employees) and wants to say it.

The Internet Changes Things


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CATI = Computer Assisted Telephone interviews
EDI = Direct Electronic File Transmission
Web = via the internet
TDE = Touch-tone data entry
Mail = Traditional Mailing of Forms
Fax = Faxed responses


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The chart below, from this 2007 study, shows the response rates for mail (yellow line) is much lower than other “modes” of collection. All the new modes of collection that have been developed and continue to be developed lead to higher response rates.


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The advent of online responses has greatly increased the respondents results in the preliminary release.


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..and reduced the revision volatility of the report.


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Does this represent a stabilization in the labor force? Or, has the new multi-mode collection and new form led to higher positive response rates, better measurements and the appearance of greater stabilization in the payroll report? While more accurate readings would definitely be a plus, are economists misreading this stability as a positive sign for the economy?

The problem is we do not have enough data to test this hypothesis. That said, we suspect a measurement issue is causing this apparent stability and not a change in the workforce.

Posted in Newsclips, Samples

Energy/Crude Investors Stay Bullish, Lose Billions

  • ETF Trends (Blog) – Despite Declines, Investors Love Oil ETFs
    The United States Oil Fund is off almost 27% over the past 90 days, but that glum performance is not damping some investors’ enthusiasm for oil exchange traded funds. Even with prices of West Texas Intermediate, the crude contract tracked by USO, sliding 21% last month, investors poured $821 million into USO, nearly a third of the ETF’s $2.5 billion in assets under management, reports Rupert Hargreaves for ValueWalk. The VelocityShares 3x Long Crude ETN, which tracks three times or 300% the daily performance of WTI crude, is another struggling oil exchange traded product that investors just can’t seem to get enough. As a triple-leveraged product, UWTI has been recently drubbed, plunging 64.6% over the past 90 days, but UWTI “saw inflows rise to $653 million — once again an enormous sum in comparison to the size of the fund. UWTI has $956 million in total assets,” according to ValueWalk.
  • ValueWalk (Blog) – Oil ETFs Devour Cash As Retail Investors Try To Pick A Bottom
    July was the worst month for oil prices since the financial crisis. The price of WTI crude plunged 21% during the month, the worse single-day decline since 2008. Unfortunately, July was also the month that saw record inflows from retail investors into ETFs that track the price of oil…According to data from, traders have been throwing money at these two exchange-traded instruments since the beginning of the year, without much success (as the figures above show). Since the start of the year, USO inflows have totaled $1.6 billion while those for UWTI have totaled $1.3 billion. All the evidence points to the fact that most of the speculators plowing money into these funds don’t have a clue.


Yesterday crude oil futures took another beating, reaching lows not seen in many years. However, lower prices have not deterred investors from crude oil ETFs one bit.

The chart below shows WTI crude oil prices in the top panel (black), the cumulative money flows into all crude oil ETFs since November 28, 2014 in blue in the second panel (blue), the change in asset levels since that same date in red in the third panel, and the assets minus flows in the bottom panel in green. This last panel is meant to give a sense of unrealized gains/losses for crude oil ETF investors since November 2014.

The striking aspect of this chart is that, as the stories above point out, money has flown into these funds (blue) as crude oil prices have fallen. As prices bottomed in late March (black, top panel), money actually flowed out of these funds. In other words, traders are trying to catch a falling knife and, as the bottom panel shows, they have failed miserably. Their losses since November 28, 2014 now total $3.3 billion (green).


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The chart below shows the same set of data for energy stock ETFs. Flows (blue line, second panel) into these funds leveled off once energy stocks peaked (black, top panel). However, traders did not add or subtract to their position as prices continued downward.


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The two charts above are unique in that flows either increased or held steady during selloffs, fighting the trend of the market. This has resulted in billions of dollars of losses. Traders seem more worried about missing out on a move back to $75 than the billions they have lost betting on that move. So when will crude bottom? The contrarian would look for a real capitulation before prices could bottom. These charts suggest no such capitulation has even begun.

For perspective, the chart below shows a more normal relationship between flows and prices. It shows the same series as the charts above, but for U.S. Treasury ETFs.

The top panel shows 10-year yields on an inverse scale to mimic price movements. As one would typically expect, money flows into Treasury funds when prices go up and leaves these funds when prices go down. Again, this is not the case with crude oil/energy.


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Posted in Newsclips, Samples

Could Both Economists And The Market Be Right About A Fed Hike?

  • The Wall Street Journal – Jon Hilsenrath: Atlanta Fed’s Lockhart: Fed Is ‘Close’ to Being Ready to Raise Short-Term Rates
    Federal Reserve Bank of Atlanta President Dennis Lockhart said the economy is ready for the first increase in short-term interest rates in more than nine years and it would take a significant deterioration in the data to convince him not to move in September. “I think there is a high bar right now to not acting, speaking for myself,” Mr. Lockhart said in an exclusive interview with The Wall Street Journal. He is among the first officials to speak publicly since the Fed’s policy meeting last week, at which the central bank dropped new hints that a rate increase is coming closer into view, a point he sought to underscore. Mr. Lockhart is watched closely in financial markets because he tends to be a centrist among Fed officials who moves with the central bank’s consensus, unlike those who stake out harder positions for or against changing interest rates. His comments are among the clearest signals yet that Fed officials are seriously considering a rate increase in September.


Yesterday we highlighted the different ways to calculate the probability of a Fed hike in September. We found the probability of a September rate hike to be less than 50% using the two most popular calculation methods (Bloomberg and the CME). We also pointed out the forward rate for fed funds usually over-predicts a rate hike, meaning it often predicts rate hikes when none happen. This makes the lack of market conviction on a rate hike all the more puzzling in the face of Fed assurances that the September meeting will commence liftoff.

The story above is the latest in a litany of Fed speeches on the likelihood of a September hike. The Fed could not be more clear in their intention, yet the market does not seem to be listening.

With this is mind, we want to make the argument that maybe both the economists and the markets could be correct. Economists could be correct that the Fed will make a formal rate hike announcement on September 17 and the market could be correct that the announcement will lead to a rate rise of something less than 25 basis points.

Fed Funds – Targeting A Market That Barely Exists

In the July 29-30, 2014 FOMC minutes, the Fed said:

Almost all participants agreed that it would be appropriate to retain the federal funds rate as the key policy rate, and they supported continuing to target a range of 25 basis points for this rate at the time of liftoff and for some time thereafter.

On its face this sounds like a statement of the obvious, but it does represent a significant challenge for the Fed. As a 2014 New York Fed study noted, the fed funds market is drying up. The next set of charts shows fed funds market volume has decline about 75% since the financial crisis.


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So why is the Fed targeting the fed funds market? While never stated directly, we believe the Fed is doing it for two reasons. First is tradition – most people are accustomed to looking at the fed funds rate. Second is the belief that when the Fed’s balance sheet and interest rates return to “normal,” the funds rate will become relevant again.

That said, lack of liquidity in the funds market does pose a significant challenge. Ben Bernanke even suggested the Fed consider dropping the fed funds rate as its benchmark. From Bernanke’s April 15, 2015 blog:

Moreover, the fed funds market is small and idiosyncratic. Monetary control might be more, rather than less, effective if the Fed changed its operating instrument to the repo rate or another money market rate and managed that rate by its settings of the interest rate paid on excess reserves and the overnight reverse repo rate, analogous to the procedures used by other central banks.

Why Is The Fed Funds Market Disappearing?

Banks are required to hold reserves in an account with the Federal Reserve. The Fed has the ability to add or drain money from these accounts via open market operations. The fed funds market is where banks trade excess reserves with each other. Banks that are under-reserved borrow funds from banks that over-reserved. Every other Wednesday banks must balance their accounts.

The blue, red and green lines in the chart below show the total, required and excess reserves held in all accounts at the Federal Reserve. This chart ends on September 15, 2008 to highlight the “pre-Lehman era.”

Back then total (blue) and required (red) reserves were around $45 billion and excess reserves (green) were around $8 to $10 billion. In these days if the Fed wanted the fed funds rate to go up, they would drain a few billion from total reserves, effectively reducing excess reserves. This shortage would drive up the cost of reserves, the fed funds interest rate.


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Once the financial crisis hit, the Fed started offering emergency loans to the banks followed by various rounds of QE (i.e., bond buying with “printed money”). The chart below shows the pre – and post-Lehman era of the same chart above.

While required reserves went from $47.1 billion to $138.8 billion, total reserves shot up from $42 billion to $2.68 trillion. Excess reserves went from $14.3 billion to $2.54 trillion.

The U.S. banking system has thousands of banks with over $11 trillion in assets. Pre-Lehman, these banks traded about $10 billion in excess reserves with each other in order to balance their accounts every two weeks (bank statement period). Today every bank is collectively massively over-reserved by trillions thanks to the QEs and has no need for the fed funds market. The reason the fed funds market exists at all is because the GSEs (FHLB, Fannie and Freddie) and foreign banks that do not have reserve accounts with the Fed can access it for funding. However, as shown in the chart above, the fed funds market is a small fraction of its former self.


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How Will The Fed Target The Fed Funds Market

From the July 29-30, 2014 FOMC minutes statement:

Participants agreed that adjustments in the IOER [Interest On Excess Reserves] rate would be the primary tool used to move the federal funds rate into its target range and influence other money market rates. In addition, most thought that temporary use of a limited-scale ON RRP [overnight fixed-rate reverse repo] facility would help set a firmer floor under money market interest rates during normalization. Most participants anticipated that, at least initially, the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range.

What are these tools?

Interest On Excess Reserves Or IOER

The first tool mentioned in the passage above is Interest On Excess Reserves or IOER. This is the rate the Fed pays to the banks on excess reserves (chart above, green line). So while the Fed can pay a higher interest rate on the trillions in excess reserves, no one, including the Fed, is sure this will lead all short-term rates (fed funds rate, overnight general collateral, commercial paper, Treasury Bills, etc) higher.

The blue line in the next chart is the IOER, which has been at 0.25% since December 17, 2008 (the date of the last ease of the funds rate to its current target of 0% to 0.25%). Notice that almost all major interest rates have been trading well below this target. It appears banks are sitting on their excess reserves, collecting interest income and not passing it along in the form of higher deposit rates which would influence all these market rates higher.


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University of Chicago’s John Cochrane, who is a very influential economist in Fed circles, said this earlier this year:

What if the Fed announces the long-awaited interest rate rise, the Fed starts paying banks 50 bp on reserves and… nothing happens. Deposit rates stay at zero, treasury rates stay at zero. Congress notices “the Fed paying big banks billions of dollars to sit on money and not lend it out to needy businesses and households.” Mostly foreign big banks by the way. Nightmare scenario for the Fed.

Overnight Fixed-Rate Reverse Repo or ON RRP

The Fed recognized the problem with IOER and updated their thinking in their March 18, 2015 minutes:

In their discussion of the options and strategies surrounding the use of tools at liftoff and the potential subsequent reduction in aggregate ON RRP capacity, participants emphasized that during the early stages of policy normalization, it will be a priority to ensure appropriate control over the federal funds rate and other short-term interest rates. Against this backdrop, participants generally saw some advantages to a temporarily elevated aggregate cap or a temporary suspension of the cap to ensure that the facility would have sufficient capacity to support policy implementation at the time of liftoff, but they also indicated that they expected that it would be appropriate to reduce ON RRP capacity fairly soon after the Committee begins firming the stance of policy.

In September 2013, the Fed created the overnight fixed-rate reverse repo facility (ON RRP). Through this facility, the Fed offers repo transactions to money market funds. The Fed will currently give certain funds 5 basis points on any money deposited at the Fed. The draw for the funds is that the Federal Reserve is considered one of the safest counter-parties in the world. So if the banks take the extra IOER and do nothing with it, the Fed will go around the banks via its relatively new ON RRP facility and offer the a higher interest rate to everyone else.

The chart below shows the trading of ON RRP since its creation.


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Starting in October 2014 the Fed capped this facility at $32 billion per counter-party and $300 billion for the entire facility. This is noted in red in the chart above. Why would the Fed cap this program?

To put it bluntly, the Fed is afraid of what we have described as “the infinite black hole.” Money market funds essentially yield zero. Additionally the “breaking of the buck” by a money market fund called The Reserve Fund two days after Lehman failed (September 17, 2008) almost brought down the financial system. This remains a seminal event for the money market fund industry, one that has led to many rule changes to prevent the same thing from happening in the future.

Fund management companies do not make money on zero yielding money market funds. And attitudes among fund investors have changed since the Reverse Fund failure in September 2008. Now money fund investors are wary of any money market fund offering a yield significantly higher than its peers. It is looked upon as a fund that is taking too much risk and should be avoided. Fund managers continue to offer money market funds to complete their product list but do not make money on them and devote as few resources as possible to them.

Given these new attitudes, if the the Fed is offering itself as a counter-party and a competitive interest rate, then why wouldn’t 100% of all money in these funds is go into ON RRP with the Fed? The Fed worried about this exact scenario, which is why they capped the program at $300 billion in total.

Lifting The ON RRP Cap

So if the program is capped at $300 billion and the Fed said it is a priority to ensure appropriate control over the federal funds rate and other short-term interest rates, can it still work? Is it possible T-bill yields and general collateral repo rates will stay near zero once the Fed offers a higher IOER and ON RRP rate?

University of Chicago economist John Cochrane addressed this point earlier this year:

You can also see from my story, that if the ON RRP facility is important for transmitting higher interest on reserves to other assets, the Fed might need to do a lot of it. A lot. We’re trying to raise the interest on Treasuries, Agencies, commercial paper, etc. etc. etc. by having money market funds attempt to sell those and hold reserves. They might buy a lot of reserves before rates are equalized.

Cochrane is correct. These tools will effectively move interest rates if they are done in big enough size. How big? Since this has never been tried before, nobody is really sure. Cochrane estimates this facility might have to offer several hundred billions of dollars in repos, maybe more than $1 trillion dollars.

The man in charge of executing this program is Simon Potter, the head of the New York Fed open-market desk. In an April 15 speech he discussed this:

In conclusion, although the Federal Reserve will be removing its policy accommodation in a much-changed money market environment, the Desk is ready to implement policy firming when the FOMC determines that economic and financial conditions warrant it. The minutes of the March FOMC meeting outline the Federal Reserve’s intended operational approach, and our testing program gives us confidence that we have the necessary tools to enable a smooth liftoff. The minutes highlight that policymakers will be particularly careful at the start because demonstrating appropriate control over the federal funds rate and other short-term rates is a priority. This may entail elevated aggregate capacity in an ON RRP facility at liftoff because we don’t know how much support we are currently getting from the zero lower bound, which creates some uncertainty about the demand for ON RRPs. However, the ON RRP will be used only to the extent necessary for monetary policy control because it has some potential financial stability and footprint costs associated with it. Moreover, the Federal Reserve has a number of backup tools should things work differently than expected, and policymakers will make changes as necessary as normalization proceeds.

In short, when the Fed signals it is going to raise rates, it is critically important they show they have control over short-term interest rates. When the Fed signals interest rates are to rise 25 basis points, all short-term interest rates need to rise 25 basis points. The Fed intends to accomplish this by offering higher ON RRP rates in large enough size to compete with other money market rates.

This is where the infinite black hole argument comes into play. If ON RRP expands too much it instantly becomes a significant part of the short-term interest rate market. Other short-term rates could go begging. This could cause financial stability issues.

But, if the Fed does not expand the ON RRP enough, short-term interest rates don’t move up with the Fed’s announcement and the Fed looks like they have lost control. So how big should this facility be? No one knows since it is less than 2 years old and such a tool has never been used.

The FOMC is worried about this. From the January 28, 2015 FOMC minutes:

A couple of participants expressed continued concerns about the potential risks to financial stability associated with a large ON RRP facility and the possible effect of such a facility on patterns of financial intermediation


This brings us back to our original question – why is the fed funds futures curve diverging so much from Fed expectations? The simple answer is the market does not believe the Fed will follow through with their time table for rate hikes.

Could the subtle answer be the markets are afraid the Fed may be too timid to raise the ON RRP cap to move short-term interest rates, including the fed funds rate? Could economists be correct that the Fed is going to announce a rate hike in September while the market could be correct that rates will only rise a fraction of that 25 basis point announcement?

If so, how will market participants interpret this?

Posted in Newsclips, Samples

What Are Credit Spreads Telling Us?

  • The Wall Street Journal – High-Yield Jitters Lead Some Advisers to Sell ETFs
    An interest-rate rise could trigger an exodus, they say, and they are trying to get out first
    Some financial advisers have been trimming their clients’ exposure to high-yield bond exchange-traded funds or cutting it altogether in recent months. They are worried that an interest-rate rise could trigger a rush for the exits that might exacerbate current liquidity issues in the market for below-investment-grade debt. After seven years of low rates, “we are in uncharted water” as to how quickly the Federal Reserve will raise rates and how quickly that will affect the value of current income holdings, says Michael Johnson, a broker with Raymond James Financial Services Inc., in Elm Grove, Wis. He says he wants to proceed carefully “and have a life vest nearby.” Low interest rates have driven investors to take on added risk in their hunt for yield. It is easy to see why they have been drawn to high-yield bond ETFs, which can yield more than 5%, compared with just 2% for an ETF investing in seven- to 10-year Treasurys. Nearly $26 billion flowed into high-yield bond ETFs from 2008 through 2014, according to Thomson Reuters Corp. ’s Lipper unit. Another $1.09 billion has flowed into the funds this year through July 22, bringing their assets to $37.8 billion, Lipper says. Those investors have flooded in as Wall Street securities firms have had to rein in their risk-taking, including their bond buying, as a result of the Dodd-Frank Act. Their reduced involvement has raised fears that buyers could dry up if a short-term interest-rate increase by the Federal Reserve prompts bond investors to flee.


The next two charts show high yield and investment grade credit spreads both hit their narrows over a year ago (June 2014) and are currently making new wides.


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The next chart shows how credit spreads compare to the stock market. It’s been over a year since spreads hit their narrows (first two panels), but stock prices continue to power higher through this summer (and may not be done).


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The next chart shows the economic bottom in 2008/2009 (shaded area = Great Recession). The first two panels show credit spreads peaked first, months before stocks.


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The next chart shows the economic top in 2007 (shaded area is the beginning of the Great Recession). Credit spreads hit their narrow months before the stock market.


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Finally, the last chart shows the markets around 2001. In 1999 credit spreads hit their narrows months before stocks and the 2001 recession (shaded area).


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Interestingly, credit spreads and stocks both bottomed at the same time in October 2002, 11 months after the recession ended. As the next table shows, this was only the second time in the last 115 years that the market “turned” after the recession ended (the other one was 1921).


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Credit spreads led both equities and the economy over the last two recessions and the last four economic turns. The fact that credit spreads bottomed over a year ago and continue to widen could be considered a warning sign for both the economy and the stock market.

Posted in Newsclips, Samples

The Biggest Issue With The Fed Right Now

  • CNBC – More of Wall St. sees a later rate hike: Survey
    These are the times that try the souls of those forecasting a September rate hike. The latest monthly CNBC Fed Survey still shows a majority on Wall Street forecasting that first rate hike in nine years to come in September, but it’s a dwindling majority rife with defections to the later months of October and December. “The market seems to be saying ‘no’ even as the Fed is saying ‘yes’ to a near-term rate hike,” Kevin Giddis of Raymond James/Morgan Keegan wrote in response to the survey. “While the Fed ultimately has the stick, they really need the market to come along so we don’t find ourselves in a highly volatile limited liquidity aftershock of the Fed’s action.” Just over half of the survey’s 35 respondents of economists, fund managers and analysts, say the rate hike will come in September, down from 63 percent in the prior survey. And the forecast for the year-end Fed funds rate continues to decline, with the average now just 0.47 percent. Last July, Wall Street looked for a year-end funds rate just above 1 percent, showing how much tightening has been baked out of the market this year. To be sure, 82 percent say the Fed will hike this year, but that’s down from 92 percent in the prior survey.


The week before every FOMC meeting, CNBC surveys about 50 economists and money managers about the Fed. The full survey is above.

We found the question below very interesting.


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59% of respondents do not believe the Fed will consider market expectations when hiking. As regular readers know, we believe market expectations are hugely important to the Fed’s thinking. As the graphic below shows, the CME’s Fed Monitor puts the probability of a September hike at 20.83% (yellow highlight).


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Why do market expectations matter? We detailed this last month:

New York Federal Reserve President Bill Dudley said this [last month]:

Moreover, the appropriate stance of monetary policy will be influenced by how financial market conditions respond to the Federal Reserve’s actions. All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly.  In contrast, if financial conditions were not to tighten at all or only very little, then—assuming the economic outlook hadn’t changed significantly—we would likely have to move more quickly.  In the end, we will adjust the policy stance to support the financial market conditions that we deem are most consistent with our employment and inflation objectives.

We translate this to mean the Fed will be watching equity prices closely. Falling equity prices could prompt the Fed to get more accommodative while stable-to-rising equity prices give the Fed an all-clear signal to continue raising rates. Note that he did not say anything about the economy.

This kind of comment is not new for Dudley. Last December he said:

“With respect to “how fast” the normalization process will proceed, that depends on two factors—how the economy evolves, and how financial market conditions respond to movements in the federal funds rate target. Financial market conditions mainly include, but are not necessarily limited to, the level of short- and long-term interest rates, credit spreads and availability, equity prices and the foreign exchange value of the dollar. When the FOMC adjusts its short-term federal funds rate target, this does not directly influence the economy since little economic activity is linked to the federal funds rate. Instead, monetary policy affects the economy as the current change in short-term interest rates and expectations about future monetary policy changes influence financial market conditions more broadly.

The question is how much “instability” in financial markets will/can the Fed tolerate? And why are they talking about equity prices and not interest rates? Consider what Bernanke said last [month] in his blog:

Stock prices have risen rapidly over the past six years or so, but they were also severely depressed during and just after the financial crisis. Arguably, the Fed’s actions have not led to permanent increases in stock prices, but instead have returned them to trend.

So, according to Bernanke, monetary policy has boosted stock prices and the Fed should proudly take credit for it. Further Bernanke said the Fed has boosted stock prices to a “good level” but has not overdone it to a “bad level” (we discussed this last week).

So will the Fed be willing to let equity prices fall after it worked so hard to boost them? In April Bernanke responded to a harsh criticism of monetary policy by concluding with:

We shouldn’t be giving up on monetary policy, which for the past few years has been pretty much the only game in town as far as economic policy goes. Instead, we should be looking for a better balance between monetary and other growth-promoting policies, including fiscal policy.

He also offered the following in a Jackson Hole speech in 2012:

Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.

As well as this in a November 2010 Washington Post editorial:

Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

The Fed thinks QE saved the world by creating millions of jobs and adding percentage points to GDP. It ramped stock prices higher, creating a wealth effect.

While we disagree with this diagnosis, it is important to understand the Fed thinks this way. This being the case, we can’t imagine they would upset the single metric that saved the economy.  Restated, they will not do anything that will hurt stocks.

If this is the case, how does the Fed ever tighten? As we have said in the past, the markets must first price it in. That means the effects of higher rates are already baked into the market and the act does not become an event for markets but rather a formality. Given Dudley’s obsession with financial stability and Bernanke’s belief that QE has pushed stock prices to a “good level” that has created millions of jobs, the Fed is not going to fight the market and risk it all.

  • – (October 2, 2012) Bernanke Seeks Gains for Stocks in Push for Jobs: Economy
    Chairman Ben S. Bernanke is increasingly aiming for gains in stock prices as the Federal Reserve reaches for new tools to spur the three – year r ecovery and reduce unemployment stuck above 8 percent. Bernanke, setting the stage for a third round of quantitative easing in an Aug. 31 speech in Jackson Hole, Wyoming, said the strategy works in part by boosting the prices of assets such as equitie s. In a speech yesterday in Indianapolis he said higher stock and home prices would provide further impetus to spending by businesses and households. “ It’s pretty clear that the stock market is the most important transmission mechanism of monetary poli cy right now ,” said Peter Hooper, chief economist at Deutsche Bank AG in New York. “That’s where you’re getting most of the action in terms of lift to the economy. It’s the stock market that’s going to have to be carrying the load.”

CNBC Fed Survey – July 28, 2015 by CNBC

Posted in Newsclips, Samples

Reasons To Like Gold

  • Barrons – Gold Is Falling So Hard It Looks Like Capitulation
    Gold is a falling knife. I am not advising investors try to catch it. The trend is down, and as of today a fairly sizeable technical pattern is broken to the downside. But there is something intriguing now about the yellow metal, and it has everything to do with fear. Investors seem to be willing to dump their gold holdings en masse even at already depressed levels, following the perceived lead of China, which reported last week that it wasn’t holding as much gold as originally thought. It is ironic that gold, recently trading at a 5-year-low just above $1,100, is supposed to be the hedge investors use when they are fearful about other things, such as the economy. But right now, the fear is for gold. Never mind that central banks around the globe have been selling gold for years…I will watch for a sharp rebound here and possibly even a follow-through day signal that is often found in the stock market. In a nutshell, the signal looks for a surge in price and volume about a week into the rebound attempt. It seeks to avoid falling for oversold bottom fishing moves and jump back into a market when there is proof that demand has come back. Another sign would be found in the Commodity Futures Trading Commission’s commitments of traders report, to be released next week. It will be interesting to see if speculators continue to press their bearish views while commercial hedgers pivot more to the bullish side. But for that, we will have to wait. The bottom line is that, with fear in the air and blood in the streets, gold and related markets may be in the final stages of their bear markets. Once the turn is made, whether it is this month or later this year, there should be ample technical evidence in place to tell us. But for now, a bottom it is still an unproven theory.


The story above uses several technical indicators to make the case gold could be nearing a bottom. While the past few years have not been kind to the shiny yellow metal, we actually believe it has many factors working in its favor at the moment.
First, consider prices on a much longer timeframe. From the time this rally started in August 1999 until its peak in 2011 the price of gold was up over 658%. For those technically inclined, the most recent plunge in gold brought prices right to its 50% Fibonacci retracement of the past several years. This is often a line in the sand from which prices can rebound.


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Second, much of the speculative money has already left the gold market. As the chart below shows, gold ETF held almost 85 million ounces of bullion at their peak. Now they hold roughly 50 million ounces. Once holdings bottom out, all the short-term, weak-handed speculators have been shaken out of gold ETFs. This would signal a bottom in prices. It’s too early to confidently predict a bottom in holdings, but this week’s price action has undoubtedly shaken out many of the weak-handed speculators.


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To further the case that speculative money does not think too highly of gold right now, consider the chart below. As we pointed out Monday, money managers are actually net short gold futures for the first time since the Commitments of Traders disaggregated data series began in 2006.


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Finally, consider gold’s returns during both QE periods and a non-QE periods. As the chart below shows, gold has fared much better during non-QE periods than it has during QE-periods.


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The charts above are largely measures of market sentiment. While this type of data is not necessarily meant to be used as a market-timing tool, a bottom in gold may not be far in the offing.

Posted in Newsclips, Samples

Why Does The Fed Want To Raise Rates?

  • – Yellen Maintains Outlook for First Interest-Rate Rise in 2015
    Federal Reserve Chair Janet Yellen said she still expects to raise interest rates this year and repeated that the subsequent pace of increases will be gradual. “I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy,” Yellen said in her first public remarks since the June meeting of the Federal Open Market Committee. “But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step,” she said in the text of a speech Friday in Cleveland. Yellen, 68, is moving the Fed cautiously toward its first interest-rate increase in almost a decade as she weighs conflicting pressures at home and from abroad. While improving economic data in the U.S. may push the Fed to consider tightening as soon as September, risks from Greece and China could prompt a delay. In her only mention of Greece in her prepared remarks, Yellen said the situation in that country “remains unresolved.” Fed policy makers in June forecast two quarter-point rate increases this year. The pace of tightening next year will be more gradual than they expected in March, the latest forecasts show. Since the June meeting, the labor market has shown further gains, along with housing and manufacturing, adding to evidence the economy is overcoming a first-quarter slump…The Fed chair devoted a large section of her speech to explaining how labor markets still haven’t met her criteria for full employment. The unemployment rate stood at 5.3 percent in June. “A significant number of individuals still are not seeking work because they perceive a lack of good job opportunities,” she said. “While the labor market has i mproved, it still has not fully recovered.” Yellen said the share of workers in part-time jobs who would prefer full-time work “remains higher that it would be in a full-employment economy.” She said there have been “some tentative hints” of a pick-up in wages that “may indicate that the objective of full employment is coming closer into view.


As the story above points out, Yellen reiterated her call for a rate hike this year. She noted that economic fundamentals appear to be sound. As has been the case all year, the market seems skeptical of a rate hike this year as it assigns an 18% probability of hike in September (WIRP <go> on Bloomberg) and it projects the year-end funds rate at 31 basis points, versus 63 basis points according to the Fed’s latest (June 18) dot chart.


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As we have been arguing all year, something is amiss. The market prices in a different reality from the Fed. Could these groups have different views of the economy?

What Is A Bad Economy?

At its September 13, 2012 FOMC meeting the Fed said:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

In other words, the economy was so bad in September 2012 that the Fed initiated an open-ended commitment of $85 billion of bond buying a month to boost growth.

So how bad was the economy in 2012? The next two charts show some broad measures of the economy since 2011. Both charts show nominal and real GDP in the top panel as a reference. The black vertical line on the left marks September 2012. The gray vertical line on the right marks December 2013, when the Fed said things were so much better that they announced the start of the taper.


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What did the Federal Reserve see in the economic landscape that improved over this span of time? GDP growth rates are lower now. Inflation is lower. Personal expenditures were roughly the same. Payroll growth is roughly the same. In other words, the economy was roughly the same then as it is now.

The one big exception is the unemployment rate. As the bottom panel in the middle chart above shows, the unemployment rate is down a lot (blue line), but half of its fall is due to the drop in the participation rate. The red line adjusts the unemployment rate for a static participation rate.

If one wants to make the case that the fall in the unemployment rate is the reason the Fed is removing the punch bowl, we can understand the argument. However, Yellen addressed this in her speech on Friday:

As I noted, the national unemployment rate has declined markedly during the economic recovery. But it is my judgment that the lower level of the unemployment rate today probably does not fully capture the extent of slack remaining in the labor market–in other words, how far away we are from a full-employment economy.

Yellen seems to be discounting the fall in the unemployment rate. If so, we are left wondering why the Fed is so intent on raising rates.

Financial Stability

We do not believe the economy has changed enough since 2012 to warrant a completely different outlook from the Fed. If they supported open-ended QE in 2012, the economy should dictate the same policy now. We believe the Fed wants to raise rates for other reasons – ones they cannot say out loud.

Those other reasons are what the Fed terms “financial stability.” They understand QE distorts markets, so they want to normalize before things get out of hand.

The Fed cannot vocalize this without admitting their policy artificially propped the markets over the last several years, so they instead focus on data dependency. The problem, however, is they want us to believe that the economic stats shown above are now materially better than they were in 2012.

As the fed funds chart above shows, the markets don’t buy the Fed’s line of reasoning. They do not see the material economic changes since 2012.  Additionally, markets like easy policy. So the markets are not pricing in hikes at the pace the Fed is suggesting.

Because of this divide, Fed officials like Yellen will continue to point to a 2015 rate hike in their speeches in the hopes the markets finally follow suit. If the markets refuse to budge, will the Fed fight the markets and hike anyway? The Fed’s actions in the post-crisis era suggest they will not fight the markets:

  1. As QE1 came to a close, they claimed there would be no more QE
  2. As QE2 came to a close, they claimed there would be no more QE
  3. They claimed Operation Twist would end on September 30, 2012 only to see it extended
  4. Calendar guidance was offered and abandoned
  5. Forward guidance was offered and largely abandoned
  6. Economic thresholds were offered as guideposts:
    1. First the Fed said it would raise rates once the unemployment rate dipped under 7%
    2. Then it was 6.5%
    3. Then it was “well below” 6.5%
  7. Then it was “considerable period” that Yellen mistakenly defined as “about six months”
  8. Then it was “patient” which Yellen defined as “about two meetings”
  9. Then it was “meeting-to-meeting”
  10. Currently it is “data dependent”

When it comes to Fed policy, we believe the market marches to its own (dovish) beat and tells the Fed what it wants. The Fed tries to influence the market via speeches, the FOMC statements, the SEP and minutes. But as the list above shows, the market typically gets its way. In the end we believe the Fed is so worried about financial stability that they will cave to market opinion. This is why taking the Fed at face value is a dicey proposition at best. Following market pricing is more accurate.

Posted in Newsclips, Samples

Will This Become The Fed’s New Preferred Measure Of Wage Growth?

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  • – This New Indicator Shows the U.S. Job Market Finally Heating Up
    Just how quickly is everyone’s paycheck growing? It’s one of the most important questions in the American job market right now, with only inconclusive answers derived from conflicting data so far. This week, a regional Federal Reserve bank added a new indicator to the mix in hopes of offering policy makers a closer look at what’s really happening in the U.S. job market. The new index—which shows a median wage increase of 3.3 percent in the 12 months through May, a substantially faster pace than even just a year ago—gives ammunition to central bank hawks who would like to raise interest rates in September. There are currently two principal measures of wages: the Labor Department’s average hourly earnings measure, which will be reported on Thursday, and the Employment Cost Index, a broader measure that includes benefits. They give somewhat conflicting pictures on the state of wages, with hourly earnings up 2.3 percent though May and quarterly ECI up a more robust 2.8 percent through the first quarter, excluding government workers. The Atlanta Fed’s newly introduced measure is based on Census Bureau questions to thousands of households, compared to other measures that survey businesses. “We are seeing signs of wage pressure,” says John Robertson, a senior policy adviser at the regional bank. While some economists consider the Employment Cost Index the single best measure of earnings, an advantage of the Atlanta Fed’s tracker is it will come out monthly and provide a much faster take on the job market.


Here we go again. The highlighted passage above is spot on.

18 months ago the Fed did not want to raise rates and the diving unemployment rate was “getting in the way.” No worries, the Fed invented the Labor Markets Condition Index (LMCI) to show the labor market as weak. Now that many at the Fed want to raise rates, they invent a metric that shows wage pressure.

The Fed has a history of dragging out new indicators that support their preconceived views of the economy. They have hundreds of PhDs and statisticians on their payroll constantly constructing new indices like the one mentioned in the story above. It then becomes very easy for Fed officials to start with a conclusion on the economy or desired monetary policy and find one of these relatively obscure measures that supports their view.

We are not suggesting this indicator is less than an honest effort. It uses public data and is very clear on how it is calculated. But like all invented Fed indicators, it has a point of view.

Case in point, why doesn’t the Philadelphia Fed’s Aruoba Diebold Scotti Business Conditions Index, mentioned in the story below, get more attention? It is a high frequency measure with a good track record.

  • The Philadelphia Federal Reserve – Aruoba Diebold Scotti Business Conditions Index
    The Aruoba-Diebold-Scotti business conditions index is designed to track real business conditions at high frequency. Its underlying (seasonally adjusted) economic indicators (weekly initial jobless claims; monthly payroll employment, industrial production, personal income less transfer payments, manufacturing and trade sales; and quarterly real GDP) blend high- and low-frequency information and stock and flow data. … The average value of the ADS index is zero. Progressively bigger positive values indicate progressively better-than-average conditions, whereas progressively more negative values indicate progressively worse-than-average conditions. The ADS index may be used to compare business conditions at different times. A value of -3.0, for example, would indicate business conditions significantly worse than at any time in either the 1990-91 or the 2001 recession, during which the ADS index never dropped below -2.0.


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As we said last month:

We believe that economic analysis often tells you little about the economy and a lot about the bias of those torturing the data (we, of course, are immune to such biases at Bianco Research!).

The Fed wants to raise rates, so any indicator that supports such a view immediately moves to the top of the list. The indicator mentioned above, with a demonstrated 6-year track record of success, shows the economy is still underperforming. Since it does not support the narrative the Fed wants right now, it gets ignored.

Finally, as is often the case, as the Atalanta Fed says wage growth is going up, the St. Louis Fed finds something different.


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  • Federal Reserve Bank Of St. Louis – Lagging Long-Term Wage Growth
    The long-run trend of average wages has consistently failed to keep pace with overall economic growth.
    The U.S. economy has experienced a slow job recovery since the 2007-09 financial crisis. As the unemployment rate finally fell below 6 percent in the last quarter of 2014, concerns about the state of the economy gradually shifted to wage growth. Instead of focusing on wage growth during the years since the financial crisis, in this essay we examine long-term wage growth since 1972. Specifically, we see if wages have kept pace with overall growth in the economy by comparing hourly wage growth with per capita gross domestic product (GDP) growth. We compare GDP data from the National Income and Product Accounts (NIPA) and two hourly wage data series. The first data series is from the Bureau of Labor Statistics establishment survey, which reports the average hourly wage for all nonsupervisory workers.1 To check for robustness, we also compute a second hourly wage series by dividing the total wages and salaries reported in NIPA by the total hours worked from the establishment survey data. Finally, we deflate all nominal price data, including nominal GDP data, to real GDP data using the personal consumption expenditures (PCE) price index.
Posted in Newsclips, Samples

Bond Liquidity

  • Bloomberg Business – Tracy Alloway: A Perfect Storm Brews for Bond Funds
    Soon it could be tough to save for a rainy day
    Post-financial-crisis regulation has sharply reduced investors’ freedom to buy and sell securities without affecting prices, according to many (many) market participants. Overheating in the bond market has exacerbated the problem, according to many others. That’s caused some to worry about the ability of fixed-income funds to withstand a big sell-off in bonds. Many fund managers have been increasing their credit lines to protect themselves against the possibility of a wave of redemptions by nervous investors. Bloomberg reported last week that Aberdeen Asset Management has arranged $500 million in credit lines to cushion the blow of a potential bond sell-off. BlackRock, Vanguard, Goldman Sachs Asset Management, Guggenheim Partners, and Eaton Vance are also said to have made extra borrowing arrangements with banks in recent months. Those arrangements may prove prudent, according to Barclays analysts led by Brad Rogoff. In research published on Friday, the Barclays analysts look specifically at funds that comprise or track leveraged loans, or loans made to companies with weaker balance sheets. Liquidity is a particularly acute problem for such funds, since leveraged loans are traded in a unique and kind of old-fashioned way. But their problems could be extrapolated to a broader array of investment vehicles.


Wall Street continues to argue liquidity problems are a function of regulation on dealers. While regulatory changes are not helping, we believe the structure of the bond market has changed.

The chart below shows bond market price volatility. The gray vertical line highlights Friday’s level (June 26) was pretty high. Only the periods of March 2009 (the height of the crisis) and November 11 (the 90 days following the U.S. downgrade) saw higher volatility.


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The next chart takes the same price volatility index (blue) and overlays it with the popular MOVE index (red). The MOVE index measures yield volatility.

Note that the price volatility measure (blue) and the yield volatility measures (red) closely followed each other from 2000 to 2010. Since 2010 price volatility and yield volatility have diverged with price volatility remaining consistently higher.


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Why are price volatility measures consistently higher? Durations are longer thanks to positive convexity. The next three charts show measures of Treasury modified duration (how much prices move given an instantaneous 1% move in yields). Note how much longer durations are now relative to the pre-crisis period. When central banks engage in QE and force rates down, they push durations very long and make price movements larger for the same yield movement.


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The next two charts show duration measures in Europe. With ECB QE pushing yields to record lows, European durations have also extended to record levels.


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Posted in Newsclips, Samples

Worrying About A “Triple Taper Tantrum”


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  • The Financial Times – Reasons to fear a ‘triple taper tantrum’
    Central banks have no contingency plan for a revival of growth
    The “taper tantrum” during summer 2013 was a chastening exercise in exit communication. Since then, not only the Federal Reserve but also other central banks with enlarged balance sheets have been careful not to provide any reason for markets to overreact. The removal of monetary accommodation, as it becomes appropriate for each economy, is likely to be extremely gradual. Together, a gradual exit and careful communication should rule out the risk of another taper tantrum that could disrupt financial markets — at least that is what central banks and most investors expect. Why then are we worried not just about a taper tantrum but a “triple taper tantrum”? Because central banks do not have a contingency plan for success. Even partial success — stabilisation of growth rather than an outright revival — could be enough to derail their best-laid plans for a smooth exit from excessive monetary accommodation. Specifically, a combination of data in the US that are good enough to warrant policy rate rises and a stabilisation of growth in the euro area and Japan will probably be enough to raise the risk of a triple taper tantrum. Let’s run through this argument in three stages. First, what are the chances of growth in the G3 economies matching the profile that could spark a triple taper tantrum? US data have been weak, but may be taking a turn for the better. Rather than spending the oil windfall, consumers saved most of it. Recent surveys suggest they had little confidence oil prices would remain low, and held back consumption as a result. If oil prices do not rebound much further, conviction that the windfall is permanent would probably lead to improved consumption.
  • The Wall Street Journal – Grand Central: The Untaper Tantrum
    One of the more puzzling aspects of a puzzling week in Europe’s financial markets is that investors have acted as if the European Central Bank had signaled it might taper its bond-purchase program, when it fact it did the opposite. To recap: last week, the ECB left policy unchanged. During his regular news conference, ECB President Mario Draghi said investors should get used to volatility. Already on the climb going into the news conference, yields on German government bonds surged, while stocks fell. Nobody is entirely sure why this happened, although my colleague Richard Barley has drawn some interesting conclusions from the episode, which we might dub the “untaper tantrum” to distinguish it from the jump in U.S. Treasury yields of 2013 that followed Fed hints it would start winding down its bond purchases. What was overlooked was a firming up of the ECB’s commitment to do whatever it takes to hit its inflation target. Mr. Draghi said the central bank had not been at all surprised by the return to inflation in May, even though some policy makers had forecast a lengthier brush with deflation. Then he signaled that policy makers had been a little underwhelmed by recent signals on growth–there were signs of “some loss of momentum.” And Mr. Draghi then said it may be necessary to increase the scale of the bond-buying program, known to many as quantitative easing, or QE.
  • – Why bonds are the most important asset class
    If you want to make the most money, you should invest in stocks. But if you want to keep the money you made in stocks, you should invest in bonds. It’s ironic, but true: The most important asset class, bonds, is the one that has the lowest expected rate of return. At their core, bonds are quite simple. Yet decade after decade, investors tie themselves in rational and emotional knots trying to deal with bonds. These days, most people are concerned that interest rates will soon rise. (This has been the case for much of the past 20 years, by the way.) Most investors know that higher interest rates will mean lower bond prices. So how can it make sense to buy bonds now? Actually, it makes very little sense right now to buy or own bonds in the hope that you’ll be able to sell them later at a higher price. And that’s exactly the problem that gets investors into trouble. They think that if you can’t sell an investment at a profit, that investment is a bum deal. However, the truth is this: Making a profit isn’t why you should own bonds. For an analogy, think about an automobile. The reason to own a car is to go places. As everybody knows, that requires an engine. The moneymaking engine in most portfolios is made up of equities. But would you drive a car that had no brakes? I doubt it. Bonds are like the brakes in a car. The analogy is imperfect, but the point is valid. Like the brakes in a car, bonds let you control the risk of owning equities.


In our conference call two weeks ago titled Bond Volatility … Get Used To It (transcript, webcast/audio) we discussed how lengthening durations and extreme positioning are setting up the bond market for big bouts of volatility.

This volatility began earlier this year when January was one of the 30-year Treasury’s best total return months in history (detailed here).


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The chart below shows the worst one-year total return declines in history. The thick brown line shows the decline since January 30 (top axis). The thick blue line shows the worst total return decline ever (2008/2009). Also on the chart are the 2013 taper tantrum (black), the carry trade unwind of 1994 (red), Volcker’s Saturday Night Massacre in 1979 (green) and Greenspan’s “considerable period” decline of 2003 (pink). The current selloff is right in line with these historic total return declines. We cannot wait to see what the second half of the year brings!

Does this volatility mean the end of the bull market? Not necessarily. It did not in 1994, 2003, 2008 and 2013. In all these cases the market eventually recovered all those losses. As the chart below shows, some of them did so in less than a year.

How wild has this year been? Dan Fuss of Loomis Sayles started in the bond business almost 50 years ago. It is probable that Loomis also hired some newly minted college graduate in the summer of 2014. When both of them talk about the biggest rallies and declines they have seen in their career, they could very well both pick January 2015 (rally) and the current decline.  When asked about the wildest day they have ever seen, again both could pick the bond yield flash crash of October 15, 2014.


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Posted in Newsclips, Samples

What Happened To The Spending Boom From Gas Savings?


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Yesterday we noted that April’s retail sales numbers disappointed. This follows a string of disappointing results which, as the chart above shows, has led to the slowest year-over-year growth since the recovery began.

Below is a story detailing what money is being spent on and what it is not being spent on.


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Americans have gotten a windfall from cheaper gasoline prices. But so far, they appear to be saving some of that money rather than spending it.


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It hasn’t been all doom and gloom. Some discretionary spending has been particularly strong. Restaurant and bar sales jumped 0.7% last month, suggesting Americans are willing to shell out money on nonessentials. That may be coming at the expense of grocery store sales, though.


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And in another sign that many households are merely shifting expenses–and habits–rather than boosting spending, nonstore retailers (largely online sales but also those via infomercials, catalogs, door-to-door sales and vending machines) saw a healthy gain last month while department stores continued their long decline.


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So how much money are Americans spending? The charts below show the broadest measure available, the consumption component of GDP.  Retail sales is a subset of this measure.

The first chart below shows real GDP in orange, the consumption component of GDP in blue and consumption as a percentage of real GDP in green. In Q1 2015 consumption made up 68.53% of GDP, the second highest percentage ever (only Q1 2011 was higher).

As a side note, this chart illustrates why the Fed favors borrowers who want lower rates over savers who want higher rates. Nearly 70% of the economy is driven by consumption, so spenders must be accommodated when the economy needs a push.


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The bars in the next chart show actual year-over-year consumption growth while the blue line shows a 5-year annualized growth rate.

First quarter year-over-year growth was rather disappointing at 1.90%, which was below the 5-year annualized growth rate of 2.25% (which now excludes the Great Recession). From Q4 1983 to Q4 2008 the 5-year annualized growth rate was always above 2.25%.


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Despite slow growth throughout the past few years, economists are optimistic that consumption will dramatically pick up over the next two quarters. The next chart shows Bloomberg’s median consumption estimate from roughly 25 economists. The blue line shows Q2’s estimate while the red line shows Q3’s. Wall Street expects consumption to spike from the current reading of 1.90% in Q1 to 3.4% in Q2. Q3 forecasts are at 3.0%. Note these forecasts have trended higher since late last year. This optimism has largely been based on the idea lower gasoline prices will drive consumption growth higher.

Also note that these estimates have not been updated in the wake of yesterday’s disappointing retail sales. We suspect these forecasts will fall in the weeks ahead.


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The Biggest Economic Story Of The Year

We believe the biggest economic story of the year thus far has been sluggish growth in retail sales and overall consumption despite plummeting gas prices. Economists were positively giddy about the prospects for the economy at the start of the year based on the collapse in oil prices. The lack of follow-through in spending, and the larger economy, can also be seen in the block above showing the big slide in the Citi and Bloomberg Surprise indices.

Five months into the year economic data is still sub-par. Retail sales growth is almost negative and consumption was lackluster in Q1. The list of excuses are dwindling. The Spring thaw started in early March but the March and April data has not shown a big bounce back. The West Coast port slowdown, which did not affect the economy to nearly the degree many believed, ended on February 23 and is no longer a consideration in growth prospects.

So why didn’t falling gas prices boost the economy?

It Was Not A Random Event

When oil prices collapsed, economists made a fundamental mistake. They never bothered to ask why the price of crude oil fell 60%. Instead they focused on the savings to the consumer from this windfall.

We have highlighted the following chart several times to show that the fall in crude oil coincided with a fall in world economic forecasts. As the outlook for the world economy fell, it was surmised that the demand for crude oil would fall and the price declined.


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To further support the idea of lower demand for crude oil, consider the Department of Transportation’s data on the total vehicle miles driven in the United States. This data steadily rose from 1919 (page 54) to 2008. Through the Great Depression, World War 2 and the great inflation of the 1970s vehicle miles driven only stalled briefly during the worst of those periods.

The gray line in the chart below shows the monthly miles driven while the blue line shows its rolling 12-month average since 1987. The monthly average shows a tremendous amount of seasonality, but the blue line clearly shows total miles driven peaked in 2008. This is the first time since the invention of the Model T in the 1920s that this country has gone 7+ years without making a new high in total miles driven.

Why did this measure peak? Considering the daily commute to work makes up the largest part of miles driven, the spike in unemployment during the Great Recession was too large a hurdle to overcome. After that, we believe the U.S. finally hit a saturation point with cars. Everyone that wants/needs one has one. If this is the case, miles driven and car sales will now largely follow population growth.


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The effect of the peak in miles driven can be seen in the chart below. The blue line shows U.S. gasoline demand as calculated by the Department of Energy. The red line shows total U.S. crude oil production.

Although gasoline demand has peaked, the fracking boom has led to a dramatic increase in crude oil production.


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About 50% to 60% of crude oil production is turned into gasoline. So the boom in crude oil production is creating a lot of new domestic sources of gasoline supply. But the peak in miles driven, along with new efficiencies in cars, means the demand for gasoline has stagnated.

The chart above shows supply and demand on a longer time-frame. What about the last year or two?

The next chart shows total U.S. crude oil inventories. Inventories are what is left over after production and demand. As the chart shows, inventories were fairly stable until late last year. Then they spiked in an unprecedented fashion to their highest level ever.

Why did this happen? First see the production chart above. Although production ramped up many years ago, inventories held relatively stable until the beginning of 2015. This, along with the charts above supporting the idea of decreased demand, points to a change in demand as the culprit behind increased inventories.


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Economists seem to view the drop in crude oil prices as a random event, so they treated the fall in gasoline prices as a pure “tax cut”. The thought was lower gas prices would essentially put extra money in everyone’s pockets. Based on this, economists increased their forecasts for retail sales and/or consumption. These savings never resulted in spending or higher overall economic growth, so the surprise indices slumped to their lowest levels of the post-crisis recovery.

To further compound this issue, economists largely overlooked the fact that world economic growth was falling, gasoline demand was stagnating and U.S. crude oil inventories were spiking.

Crude oil fell because economic results turned south and demand slumped. This slump meant consumers were going to spend less on everything, including gasoline. As a result, consumers seem more content paying down debt or saving money rather than spending money.

When crude oil prices respond to changes in demand, they are an economic indicator. For years prices held around $100/barrel. The collapse to $60 should be taken as a sign that the economy is not nearly as robust as it once was.

Posted in Newsclips, Samples

Crude Prices Are Not Rising On A Massive Short Cover

  • Reuters – Oil rallies as hedge funds are caught short: Kemp
    Oil’s sharp rally since the middle of March has been driven by a race among bearish hedge funds to cover loss-making short positions rather than any great bullishness about the outlook. On the eve of the rally, hedge funds and other money managers had amassed record short positions in WTI-linked futures and options amounting to 209 million barrels of oil. But in the seven weeks between March 17 and May 5, hedge funds cut their shorts by almost 116 million barrels to 93 million, a decline of more than 55 percent. Over the same period, hedge funds added only 7 million barrels of net new longs, a 2 percent increase from 381 million to 388 million, according to the U.S. Commodity Futures Trading Commission (CFTC). Hedge fund short covering coincides almost precisely with the rise in front-month WTI prices, from a recent low of $42 per barrel on March 18 to a high of more than $62.50 on May 6, an increase of nearly 50 percent.


To be blunt, we view this story as completely wrong. It seems to start with the premise that crude oil prices are rising on a short cover and tortures the data to confirm that conclusion.

As we noted last week:

During the height of the financial crisis in October 2008 the financial media was tying itself in knots because stocks were vacillating between a correction (10% decline) and a bull market (20% advance) about every four days. In other words, they could not adjust to the heightened volatility and acted as if every day brought a new bull market or major correction.

The same is now happening with crude. 20% to 30% moves have become common. But as we read the tone of the story above, each one of these moves should be looked at as a breathless opportunity.  Crude has moved more than 4% on 24 different days already this year. How would you view the stock market if the DJIA moved at least 500 points 24 different times this year?  That is the volatility we have seen in crude.

See the chart [below]. Crude oil has only retraced 25% of its July-to-March decline. Technical analysts will tell you any market can retrace 38.2% while still maintaining its trend. As noted on the chart above, WTI can trade to $68 and its downtrend is still in tact. Even if it trades above $68, the trend is only in question. Only if it goes to $75 to $80 can the trend be described as up.

Crude prices have simply retraced 25% of their July-to-March decline. According to technical analysis, the downtrend is still intact.


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Many are simply getting caught up in the fact that crude oil has rallied nearly 50% in the past couple months while forgetting how far prices fell to begin with. Such quick moves are often associated with short squeezes. As the story above states:

hedge funds and other money managers had amassed record short positions in WTI-linked futures and options amounting to 209 million barrels of oil. But in the seven weeks between March 17 and May 5, hedge funds cut their shorts by almost 116 million barrels to 93 million, a decline of more than 55 percent. Over the same period, hedge funds added only 7 million barrels of net new longs, a 2 percent increase from 381 million to 388 million, according to the U.S. Commodity Futures Trading Commission (CFTC).

Frankly, in this case the CFTC data mentioned above should not be analyzed on a long-only or short-only basis. It should be viewed on a net basis.

The red line in the second panel below shows the combined net long position in both Brent and WTI futures and options among money managers. This group is the largest speculative category and they are now at a new record net long position.

This chart shows the opposite of a short squeeze. It shows a speculative frenzy to get long.


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The chart below shows the speculative frenzy is also occurring in crude oil ETFs. It details the difference in growth between flows in blue and asset levels in red since November 28, 2014. The green line in the bottom panel shows the difference between assets and flows over this period. In other words, this line shows the profit/loss incurred by crude oil ETFs over this period.

Since November 28, long crude oil ETF buyers plowed about $5.7 billion into 24 different crude funds. However, assets have increased by $5.2 billion. So these investors, by buying through the collapse and a 40% rally off the low, are still roughly $500 million underwater. Restated, these are very weak hands that are still sitting on losses.


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So why are we making a big deal about this?

So much of investing/trading is based on folklore. After reading many times that crude is up 40% or 50% in two months, you would be forgiven for concluding that there must be a massive short squeeze going on. This is simply not the case with crude oil right now.

Posted in Newsclips, Samples

Capital Gains Drive The Federal Deficit

  • The Christian Science Monitor – Whatever happened to the big, bad federal deficit?
    Spending is up in Congress and only one likely GOP presidential candidate has mentioned the ‘d’ word. What happened to the red ink menace?
    Whatever happened to the big, bad federal deficit? You know, the red ink menace that was supposed to devour America’s fiscal future? We ask because the way Congress is acting the deficit must have gone into hiding. Look at how eager lawmakers were to whoop through the “doc fix,” the big bill averting (permanently) planned reductions in Medicare reimbursements for physicians. It passed the Senate today by a 92-to-8 vote, having squeaked through the House last month, 392-to-37. Yes, the move is popular, obviously. It resolves an issue that’s been a problem for years. Yet the doc fix is expensive, and only about one-third of its cost is offset by budget cuts. It’ll add some $141 billion to the deficit over the next 10 years.


The chart below shows the federal deficit on a rolling 12-month basis. As of March 31, 2015 the U.S. government reported a deficit of $509.52 billion.


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So what drives the deficit? We have argued it is capital gains. The next chart shows total capital gains income that comes from IRS data and is compiled by Emmanuel Saez of Berkeley.

What jumps out about this chart is the amount of capital gains created in 2013 was down from 2012 and well off the 2000 (tech stock bubble) and 2007 (housing bubble) peaks.


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Even if these capital gains are adjusted for population (per-capita) and inflation (2010 constant dollars), the total is still well off its 1986, 2000 and 2007 peaks.


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In other words, the economy is not producing capital gains at the rate it was prior to the all-time highs in the stock markets (1986, 2000, 2007). This is probably because housing, a primary source of capital gains, is still well off its 2006 peak.


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The next chart shows the relationship between capital gains and the deficit both before and after the 1986 Tax Act. Since 1986, capital gains have had a strong relationship with the deficit.  Before 1986 this relationship was much more sporadic.

How does Washington close the massive budget deficit? Create capital gains!


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While there are too many moving parts to accurately forecast capital gains, as they involve home prices, stock prices and confidence in the economic environment to transact, we believe they do drive the deficit.

Should the market tumble again, expect the deficit to widen. If the markets rally, including housing, expect the deficit to close. Politicians in Washington hate this conclusion since it essentially makes them hostage to a rising market.

Posted in Newsclips, Samples

The Fed’s Other Big Decision


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  • Bloomberg Business – Forget Interest Rates, the Fed Has Another Big Decision to Make in the Next Year
    In case exiting years of zero interest rates won’t be hard enough, Federal Reserve officials have another challenge approaching quickly: when to begin unwinding trillions of dollars of bond purchases that constitute the world’s largest fixed-income portfolio. Less than a year from now, the Fed must decide whether to reinvest $216 billion of proceeds from Treasury debt maturing in 2016, or shrink its balance sheet by allowing it to expire. By not reinvesting, the Fed would increase the supply of securities available to investors and put upward pressure on yields. Shrinking the $4.2 trillion portfolio will add to the monetary tightening from increases in the benchmark interest rate officials envision for this year. That would mark a reversal of the easing the Fed achieved when it bought bonds to speed a recovery from the worst recession since the 1930s. The timing will be tricky. Fed Chair Janet Yellen, concerned the economy remains fragile, has said the pace of rate increases is likely to be gradual and cautious. A decision to start unwinding the Fed’s bond portfolio could give her more reason to proceed slowly or even stop raising rates for a time, said Drew Matus, deputy U.S. chief economist at UBS Securities LLC in New York. “From an economist’s perspective, you kind of want one thing happening at a time,” said Matus, a former analyst on the New York Fed’s open-market desk. “Our baseline view is that they keep the pace of rate hikes slow as they are moving toward and into the initial roll-off period, but it’s also possible that becomes a great time for them to pause for six months.”


As the markets debate the timing of the first rate hike, it is important to keep in mind rates are actually still well below zero because of the various injections via QE over the past several years. As the story above points out, the Fed still has to make some major decisions on how or when they will shrink their balance sheet.

Based on comments made by FOMC officials since QE’s inception, it is possible to estimate just how far below zero rates actually are. First, a quick look at the Taylor Rule shows us where the neutral funds rate is currently.

The San Francisco Federal Reserve Version Of The Taylor Rule

One popular version of the Taylor Rule was published in June 2011 by the San Francisco Federal Reserve:

The Taylor rule is a policy guideline that generates recommendations for a monetary authority’s interest rate response to the paths of inflation and economic activity (Taylor 1993). According to one version of this rule, policy interest rates should respond to deviations of inflation from its target and unemployment from its natural rate (Rudebusch 2010). A simple version of this rule is:

Target rate = 1 + (1.5 x Inflation) – (1 x Unemployment Gap)

The target rate recommended by the rule is a function of the inflation rate and the unemployment gap. That gap is defined as the difference between the measured unemployment rate and the natural rate, that is, the unemployment rate that would cause inflation neither to decelerate nor accelerate. The literature shows that this simple rule or close variations approximate fairly well the policy performance of several major central banks in recent years (see Taylor 1993 and Peersman and Smets 1999).

The Federal Reserve’s preferred measure of inflation is the headline year-over-year (YoY) change in PCE. Using this measure, their preferred target is 2.0% (as of January 2012).

Although the natural unemployment rate is currently a highly debated topic, the OECD states it is currently 5.45%. Dennis Lockhart recently estimated it was around 5% or possibly lower.

Here is the raw data used in the Taylor Rule:

Latest YoY PCE is 0.33%
Latest YoY core PCE is 1.37%
February’s unemployment rate (to match the February PCE data) was 5.50%

From which we get the following inputs:

PCE Inflation = 1.5 X 0.3% = 0.45%
Core PCE Inflation = 1.5 X 1.37% = 2.055%
Unemployment gap = 5.50% – 5.45% = 0.05%

We can apply these inputs to the San Francisco Federal Reserve’s Taylor Rule equation and get the following results for February 2015 (latest data):

Using YoY PCE:
Target = 1% + 0.45% (PCE inflation) – 0.05% (unemployment gap) = +1.40%

Using YoY Core PCE:
Target = 1% + 2.055% (Core PCE inflation) – 0.05% (unemployment gap) =

Below are charts of the Taylor Rule’s implied funds rate (red line,top panel), the actual funds rate (blue line, top panel) and the difference between the two (green line, bottom panel). The top chart uses headline PCE and the bottom chart uses core PCE.


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Although many different iterations of the Taylor Rule exist, the results above are consistent with most other Taylor Rule estimates in targeting a positive funds rate. Despite this, the FOMC has thus far been reluctant to hike rates.

How Much Does “Additional Accommodation” Lower The Funds Rate?

Regarding how much unconventional policy (i.e., QE) matters, Bernanke offered the following testimony in February 2011:

MR. BERNANKE: We tried to make an assessment of — we asked the hypothetical question: If we could lower the federal funds rate, how much would we lower it? And a powerful monetary policy action in normal times would be about a 75-basis-point cut in the federal funds rate. We estimate that the impact on the whole structure of interest rates from 600 billion (dollars) is roughly equivalent to a 75-basis- point cut. So on that criterion, it seemed that that was about enough to be a significant boost, but not one that was excessive.

In October 2010 Bill Dudley answered a very similar line of questioning in much the same way. He stated that $500 billion of purchases would provide as much stimulus as a 50 to 75 basis point cut in the funds rate.

Bernanke and Dudley were talking about excess reserves held by banks at the Federal Reserve when they quoted these figures. As the following charts show, excess reserves now stand near $2.6 trillion.


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Using the logic above, each $6.66 billion to $10 billion of excess reserves lowers the “accommodative fed funds rate” by one basis point. With excess reserves at roughly $2.4 trillion as of the end of February, the actual funds rate has been lowered by 240 bps to 360 bps to the accommodative fed funds rate shown in the charts below.

So, with an actual funds rate at roughly 0.25% for the foreseeable future, additional excess reserves put the “accommodative fed funds rate” between -2.15% and -3.35%, which has a mid-point of -2.75% (the mid-point of the accommodative funds rate is plotted below).


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Because rate hikes appear to be the next step towards normalizing policy, the markets have correctly focused on timing the first move. However, the effect of the Fed’s bloated balance sheet should not be overlooked. Based on the math shown above using a variety of inputs, the federal funds rate is too low, especially when excess reserves (QE) are factored in.