Commentary: Talks of Tapering Probably a False Alarm

The Fed Rumors continue to swirl that the Federal Reserve may 'taper off' its bond purchase program before the end of the year. The market response has been soggy equity markets, a rally in Treasuries, and broad dollar strength. Specifically, the Fed is concerned that communicating the exact timing and nature of its implementation of its exit strategy may cause chaos in the Treasuries and MBS markets with participants rushing to front end any policy action by shorting these securities. This may make the Fed's promise to continue its open ended commitment to purchase 85 billion in Treasury and MBS, so long as unemployment remains over 6.5 percent and inflation under 3 percent, a tricky proposition. Should the BLS report high inflation or unemployment outside the Fed's stated targets, traders may begin to short Treasuries and MBS in anticipation of the winding down of the Fed's asset purchase program. 

One fact must be considered however. Even if the Fed decides to 'taper off' its purchases, such a move not represent a tightening of policy. Rather, it would only represent a reduction of the pace at which further liquidity is injected into the financial system. Hence, actual trades by the central bank won't come into play. Instead, the market will only have to rediscount the changed pace of liquidity injection. In other words, assuming that the price of the USD, stocks, bonds, or other securities already factors in the factor that the Fed will pump in 85 billion per month of fresh liquidity, how would actors re-adjust price expectations if the Fed cut its purchases by some modest figure, say 15 billion? 

I'm not sure, but I doubt a modest reduction in new liquidity being pumped into the economy will crush risk sentiment and result in falling stock prices and a resurgent USD. True, the USD may strengthen on the news, but knowing the Fed, any winding down of the Fed's QE program will be accompanied by good economic indicators which means that the broader economy can support higher rates. (Or rather, less accomadation, since rates are unlikely to rise until the Fed raises the rate paid on excess reserves or sells securities) In other words, expectations of higher returns will make risk takers willing to pay higher rates to obtain financing. For this reason, especially with rates near their zero bound, the unwinding of the Fed's balance sheet will probably be accompanied by increased loan demand, spurred on by a growing economy, and in spite of rising rates. A resumption of robust credit growth will be highly supportive of stock prices, housing prices, domestic consumption, and growth. 

 On FX, credit growth will affect the USD in two ways. Stronger growth in the US vis-a-vis other major economies will be highly USD supportive, even if this is obtained largely via increased leverage. However, as we saw in the 2000s, credit growth can also be USD negative, especially if US or foreign firms borrow in USD but invest abroad. However, this scenario seems unlikely to repeat itself. US firms will shift their focus towards North America, especially if the United States continues to lead the global recovery among advanced economies. Furthermore, firms abroad, especially in Europe, will be able to obtain cheaper financing in Euros, especially since it remains clear that the ECB has left the door for further easing wide open. True, European capital markets don't have the depth or liquidity of the US, but this will only be a factor for very small firms. Finally, we are seeing some US firms issuing Euro denominated bonds to obtain lower rates. DirectTV floated a five hundred million dollar eurobond today. In sum, whether the special place the US has in the world economy makes the USD the financing currency of choice as the credit cycle ramps up, despite higher rates than EUR or JPY, will be the key driver of the dollar in coming years.

Weekend Update: Opportunities Abound

It's been an exciting week and the time has come to prepare for the week ahead.  This week saw USD/JPY breach the 100 handle in dramatic fashion, surging up to 101.60 by New York close Friday afternoon.  Nearly all Asian currencies are down with the Yen.  USD/THB continues its rise, closing in New York at 29.77.  USD/INR is also up, closing at 54.65.  Two other movers have been AUD and KRW, whose central banks both cut rates this week.  AUD/USD breached parity, before popping back up to 1.0024.  USD/KRW, which had fallen back as low as 1082 as tensions cooled on the Korean peninsula, surged back above 1100 to 1110.7 after the BOK delivered a surprise rate cut.  

On the other side of the world, EUR/USD was soggy, as EUR has been unable to maintain is recent rally on strong German data.  I am still neutral on this pair. I still see a chance for a slow recovery back towards 1.40, but many commentators who I greatly respect have year end targets in the 1.20 to 1.25 range. 

USD/MXN gave up recent gains on profit taking and lower than expected industrial output for March.  Analysts had expected a drop, in light of the Easter holiday, which fell in March this year.  However, the 4.9 percent year on year drop was a big surprise to the downside which had some worried about a possible Mexico slowdown.  The rate outlook remains mixed, as Banxico struggles to manage capital flows and rising inflation.  I am looking to sell USD/MXN at 12.20. I remain cautiously optimistic.  The February's drop in IP was couple with weaker exports.  March saw robust export demand, with exports near all time highs.  Next month's data point should confirm whether or not the recent slowdown is indeed seasonal.  

Finally, USD/ZAR is probing higher, presumably on profit taking on any short USD/ZAR positions initiated on last week's post jobs euphoria.  The fundamentals remains weak, and the overall market tone is extremely gloomy.  I look to buy this pair on rallies. 

In short, opportunities abound. Asian currencies are getting cheap as the Yen continues to get hammered.  I may elook to get long THB or even INR should frantic yen selling push them even lower.  However, selling AUD and JPY as momentum trades or buying USD/ZAR on dips remain my preferred strategy for next week.  MXN is a mixed bag, right now, though I look to cautiously expand my position.  I will look to sell at 12.20, but more importantly, I will be laser focused on Mexican economic data for the foreseeable future. 

 

Commentary: Warren Student Loan Proposal is a Disaster

Senator Elizabeth Warren (D-MA) has proposed opening of the Fed's discount window to student borrowers, albeit indirectly.  The plan would mandate that the Federal Reserve lend to the Department of Education via the discount window so that it could charge students the same 0.75 percent rate that banks pay for emergency short term financing from the Federal Reserve.  To the uninitiated, this plan sounds great.  But it is nonsense, a disaster, and a disgrace that such a radical proposal would come from a sitting US Senator.    

Since my critics will no doubt accuse me of being a defender of the big banks, or a call me a fat-cat plutocrat, let's get some background out the way.  I voted for Barack Obama in 2008, and again in 2012.  Both times my support was enthusiastic.  I have generally supported Mr. Obama and his economic policies.  I am a strong supporter of a quick and easy path to citizenship for undocumented workers, and I believe in free universal healthcare.  But if my fellow democrats don't kill Ms. Warren's proposal immediately, I will be ashamed of the capital "D" after my name. 

 So what's wrong with the Students Loan Fairness Act.  In a word, everything.  But let's go through the details just so there isn't any doubt. 

The Fed lends money to banks against collateral, typically US government bonds or other highly rated securities, on a very short-term basis, usually overnight.  The purpose of such loans is not to enrich the banks or enable them to speculate.  It is a mechanism by which the banks can temporarily convert their loans into cash to meet withdrawal demands.  Without this safety valve, banks with a sudden surge in withdrawal requests would be unable to pay depositors, since it is not possible for them to "call" loans made to other customers.  

Furthermore, the Fed takes full custody of the pledged collateral, and earns all interest accrued during the term of the loan.  The bank is also still on the hook for the 0.75 percent for borrowing from the Fed.  So the bank is not only stuck paying interest on the loan, it also must forfeit the income generated by the collateral.  The result is a big net cost to the bank.  
 Banks would much prefer to borrow on the interbank market, where rates are lower and no collateral is pledged. 

Finally, the discount window is a boon, not a cost, to taxpayers.  Since 2008, the Fed has issued over 30,000 loans via the discount window, all fully repaid on time with interest.  The result has been over 300 billion in profits remitted directly to the US Treasury.  During its entire history, due to its ultra stringent lending standards, the Fed has never suffered a default.  

So where does this leave us with Ms. Warren's proposal?  

To start, because the Fed's awesome power to print money has great potential for abuse by politicians, the Fed was intentionally walled off from the rest of government.  The Fed never funds the government.  This sacrosanct rule of central banking is key to the Fed's credibility and that of the United States.  Countries which have resorted to money printing by the central bank to fund the government have suffered calamity after calamity.  Two recent examples include Zimbabwe in the 2000s and Argentina in the 1980s.  

Despite the lessons from history, Ms. Warren's proposal engages in overt money finance, or economist jargon for printing money to pay the government's bills.  She would direct the Fed to provide financing to the Department of Education to fund its Stafford student loan program.  While the goal of helping students is laudable, the means represent a dangerous crossing of the Rubicon which cannot be ignored. 

But perhaps worst of all, Ms. Warren's rhetoric in promoting her bill reminds of the cynical, rank, pandering usually employed by the Right.  Comparing central bank loans to banks, which are secured by firm collateral and usually last days, to student loans secured by nothing but the student's character and repaid over decades is the kind of despicable dumming down of issues that makes getting an education so important in the first place. 

Ms. Warren has made her career going after the excesses of Wall Street and helping to regulate the financial system.  She helped stand up the CFPB and assisted with overseeing the TARP bailout.  I therefore find it hard to believe that Senator Warren does not understand the basics of discount window loans or how it differs from loans made to consumers or students.  The fact that she would take advantage of the public's ignorance of an obscure but crucial function of government to score political points is shameful.  And ironic, since the objective of this whole exercise is supposedly to promote higher education.  Perhaps Ms. Warren should remember who exactly she is trying to help.          

News: USD/JPY Zooms Past 100, focus on 105

Sentiment on USD/JPY has turned firmly bullish as the pair surges over 100 for the first time in four years.  Techs and strategists alike are gearing up for a further leg upward in coming days and weeks.  News wires have talk of USD/JPY testing 102 as early as tomorrow.  Clearly from a technical perspective, 100 represented a major barrier, as evidenced by several failures to break above the 99.9 level in past few weeks.  Despite the take breach of this major level of technical resistance, don't look for a wave of short covering.  Per CTFC futures data, speculators were already long at about a five to one ratio.  Corporates continued to hedge their bets, piling up big Yen long positions.  Its unclear whether this is Japanese names "protecting" dollar denominated receivables, but this divergence in trader activity highlights the differing objectives of the participants on the FX market.  Corporates aren't concerned about the money they lose hedging on the futures market, so long as earnings from operations are "protected."  Furthermore, many companies always hedge, regardless of the fundamentals.  Therefore, corporates will stay long JPY for the foreseeable future, out of an unwillingness to take FX, or an inability to the work necessary to take said risk.  The as long as the specs continue to happily sell puts to the corporates, its up, up, and away for USD/JPY.     

News: MXN Up Big on Fitch Upgrade

The Mexican Peso sharply appreciated this afternoon after Fitch raised the nation's sovereign credit rating one notch to BBB from BBB-.  The rating house cited progress on the internal security front, macro-economic and political stability, and the Pena Nieto's ambitious reform agenda which has already passed sweeping education reform and now is looking to tackle the telecom and oil monopolies.  The Peso surged nearly 1000 pips on the news, strengthening to a near two year high to 11.97 per USD.  This also marks the first time USD/MXN has been under 12 since 2011.  The techs are now salivating for chance to retest  the 2011 low of 11.48.  CTFC long/short data shows that speculators have already built up a huge net long position for MXN, while corporations have largely maintained their equally large short MXN position, presumably to hedge MXN denominated receivables.  MXN is technically a mixed bag, but the fundamentals remain excellent.  Therefore, USD/MXN is a sell on rallies.  I maintain my 2-3 year target of 10, and expect this pair trade in the 11.10-11.25 range by year end.  

Meanwhile, Governor Carstens of the Banco de Mexico may be regretting his calls for the rating houses to upgrade Mexico.  Last Spring, when the Peso was tumbling with all EM currencies as the Grexit seemed inevitable, Carstens had hoped that an upgrade in light of Mexico's sound finances may help shore up MXN amidst terrified markets selling off nearly everything but USD and JPY.  Today, the Bank is warning of 'hot money' inflows which may drive up the exchange rate short term but could cause a sudden crash should they stop or reverse.  The recent upgrade should only further stoke foreign demand for MXN denominated securities, which is already at an all time high, thus exacerbating the 'hot money' problem.  On monetary policy, the Bank faces a tough choice.  Inflows from abroad typically drive inflation up because firms find cheaper financing as foreign investors pour money into local bond markets.  However, any rate hikes make it only that much more attractive for investors to park money in Mexico. 

Mexico is projecting an aura of vigilance.  It is loathe to suffer the same fate as Brazil and Costa Rica, whose local money markets were flooded with foreign deposits as world investors chased yield.  The result was high inflation that the central bank felt powerless to contain, lest it encourage even more short-term inflows.  A key theme for MXN going forward will be how the central bank signals its policy as to what it may do if it determines that inflows have reached "critical mass."   As long as Mexico continues its strong growth and maintains healthy public finances, the inflows remain largely in line with the fundamentals, for now.             

Trade Idea: Buy USD/ZAR

Okay, so for those of you here to make money and not analyze my philosophical musings, here's my idea to play the strong NFP data.  Buy USD/ZAR.  ZAR rallied on the news to make new multi-week highs against the dollar.  This appears to be the return of risk on, risk off sentiment that drove the Rand last summer.  When markets realized that South African fundamentals had deteriorated, ZAR sold off, plummetting on October 5th, despite the strong NFP data that day.  The Rand's recent rally seems to be driven entirely by post jobs euphoria.  As such, trader conviction should be light, and selling the news on the Rand looks like nice short-term play.  I jumped in around 8.93, and will target 9, though longterm I see USD/ZAR at 10.    

Preview: Post War Trends in US Employment

Rather than dissect the market gyrations from the latest jobs report, I thought it might be more insightful to share an except from a larger project I am working on about the US economy and capitalism.  The following is a chapter on post-war employment and labor trends. 

Preface

Work and daily occupation is a cornerstone of society, as well as a key component of our political economy. In order to share in the social surplus, one must earn his piece by working. Work and labor is undoubtedly an economic input. Labor is a required ingredient to many productive processes which create the commodities and services modern consumers demand. Somewhat strangely however, workers are rarely paid based on productivity or output, and labor unions have often resisted piece-work schemes or performance based pay. Firms are often reluctant to lay-off surplus workers when times are good and profits are relatively stable.

Therefore, modern work is as much a political and social construct as an economic phenomenon. This reality helps to explain why firms don't lay off in mass, even when doing so might maximize profits. It also explains things such as vacation pay and severance packages, and employer-based healthcare. Furthermore, it might also explain while socially pleasant but incompetent workers often not only retain their jobs, but receive promotions.

A Permanent Shortage of Aggregate Demand

Centuries of capital investments and savings have given us an economy which can produce many times what it can consume. This supply and demand mismatch would normally lead to divestment and contraction, and in particular industries this has certainly been the case. The overbuilding of houses caused a bust in the construction industry in recent years, and forecasters have seen recent upticks in construction employment as a sign that the economy is healing. However, in the broader economy, the reality is that the difference between supply and demand is absorbed by debt and waste.

This is somewhat true on the household level, as families racked up credit card and housing debt during the the last business cycle, only to aggressively pay down this debt after the collapse. However, consumers, by their very nature are fickle, and households have trouble maintaining spending during lean times. Therefore, the most important borrower and spender has been the US government.

Agricultural subsidies, much bemoaned by many on the left and right, continue to provide nearly 20 percent of income for farms. Decades of farm subsidies have created incentives for tremendous increases in efficiencies in farming. The result is that the US is one of the worlds largest per capita food exporters with a relatively small number of workers in the farm sector. The European Union, which also heavily subsidizes agricultural also posts similarly impressive figures.

While on the surface it appears that the government is simply paying farmers to produce crop surpluses, these subsidies (financed via government debt) are really investments which have produced and sustained a large and highly efficient food system capable of feeding the world with relatively few workers. In a world where hunger is still a problem, this system is an invaluable asset both in terms of easing human suffering and raising general living standards.

Similar stories have played out not just in farming, but also high-tech industries like aviation. For fiscal year 2014, the government will spend nearly 40 billion dollars on new aircraft. Even though this figure represents a 12 percent year on year reduction since 2013, it still accounts for nearly 25 percent of all new aircraft orders for 2014. Although policy makers at the Defense Department say that many of these procurements are unnecessary, Congress has forced Defense to go through with these slated orders anyway. The political explanation is that many Congressman have corporate and natural person constituents highly dependent on government contracts and orders. However, economically, these orders, again financed largely through debt, have built up a huge high tech industry which has revolutionized life for the average American. Let us not forget that the internet comes to us courtesy of investments made by the US military.

Recessions Drive Restructurings via “Shock Therapy.”

These high levels of capital investments are also in line with massive exodus of labor from capital intensive industries into the service sector. The following figures show the amazing reality that while manufacturing jobs have been lost in the US, manufacturing output has soared. As evidence in Figure 1, it's almost as if the more people manufacturers lay off (and replace them with machines) the higher output rises.

Figure 1: Indices of manufacturing output(red), employment(blue), and investment in machines and software(green). Employment has tends to stay steady but roughly fall during recessions, never to recover. Output rises sharply during boom times, falls during recessions, only to robustly recover. Fixed investment rises steadily, regardless of the business cycle.

Another interesting feature is that firms only tend to lay off during recessions, or as a last resort in order to survive. From 1992 to 2000, manufacturers added few jobs while output soared. Then the 2001 recession resulted in huge layoffs and a drop in output. However, output quickly recovered while layoffs continued through the 2000s. Technology advances rapidly, however, such a marked change in business model over a single year can hardly be accounted for by technological progress. The fact that men could be replaced by machines was probably largely true several years earlier in the 1998, during the internet boom. It is also worth noting that investments in equipment (green line) did not break their upward trends during the past few recessions. Finally, some sudden technological innovation would entail a spike in capital spending as manufacturers rushed to bring the newest most efficient machines online. Instead we see a steady rise in capital spending, which occurs regardless of cuts in labor costs.

Conclusions we can draw from this data are that manufacturers tend to lay off only as a last resort, not to maximize profits. Recessions act as 'shocks' which force firms to lay off in mass, after which manufacturers quickly realize that most of the labor let go during the layoffs can be replaced by machines and retained employees. Indeed, investment in equipment has risen steadily even through recessions. Unit labor costs, or the labor costs per unit of output, also tend to fall during recessions, reflecting that retained employees tend to raise their productivity after layoffs.

In sum, the unwillingness of firms to gradually adjust to changing fundamentals adds instability to the economy and probably prolongs downturns. Rather than waiting to be forced to layoff workers in mass, firms should replace workers with fixed capital as it becomes more profitable. This would avoid the mass flood of workers onto the labor market during downturns as firms layoff workers as a last resort. It would also allow the broader economy more flexibility in absorbing excess workers, a theme we will explore in the next section.

Ironically, at least in the manufacturing sector, data suggests that hiring and firing decisions during boom years are not based on profit maximization. Other factors, such as loyalty, social cohesion, and satisfaction with being an employer may cause firms to retain many otherwise unnecessary employees.

The Service Sector Absorbs Excess Labor, For Now

Thanks to the dynamism of the US economy, labor formerly employed in the manufacturing sector has largely been absorbed by the service sector. In recent years, this has been reflected by the strong growth in food service and healthcare jobs. Furthermore, as shown in figure 2, the losses of jobs in manufacturing have been a continuation of the post-war trend, beginning around 1950.  

Figure 2: The relative composition of the total workforce by sector. Services(red), manufacturing(blue), government(green)

So largely, losses in the manufacturing sector have be off-set by gains in the service sector. Modest gains in the public sector, on the order of about 5 percent as a relative share of the total workforce, have also eased the transition. Furthermore, there is little evidence that machines will replace workers in the broader, service oriented economy. Thus, the service sector has acted as a safety valve to redirect displaced manufacturing labor. Indeed, unlike manufacturing, in the broader economy, investment in human labor (wage growth) continues to outstrip investment in fixed capital. (office computers and software, buildings, ect.) Figure 3 illustrates.

Figure 3: Labor and capital investments in the broader economy. Wages (red) continue to outpace growth in capital investments (blue). Unlike in manufacturing, capital investment moves with the business cycle. This suggests that service industries are not as easily able to save labor costs through up front capital purchases.

It therefore is evident that the broader economy is much more dependent on hiring to increase output. So long as this remains the case, labor can continue to shift from manufacturing into to service, albeit with great disruption to many households.

Modern employment trends started nearly 60 years ago. The same post-war mechanisms of recession induced layoffs in manufacturing, and job growth recovery coming in the service sector, are at work today. Fixed capital investment in manufacturing has remained robust and surprising strong even in business contractions. This is consistent with the steady replacement of man with machine in the manufacturing sector. The service sector remains the key absorber of excess labor unemployed in manufacturing. Furthermore, service sector wage growth continues to outpace capital investments in service oriented industries. This suggests that machines will not replace humans any time soon in the service sector. Advancement in technology may someday cause the service sector to go through the same revolution that manufacturing has undergone in the past 60 years. This would clog the key safety valve which has historically soaked up excess labor. The result of such a “service sector revolution” would be foreshadowed by large capital investments in service industries, followed by layoffs during recessions. These workers would not be rehired, but replaced by further capital investments. Some futurists envision much service work being done by intelligent machines. This would result in permanently high structural unemployment, because at this moment, unlike the times of industrial mechanization, no obvious absorber of excess workers exists. The economic and sociological implications of this hypothetical are profound. But that is a subject for another book.