Wednesday, July 27, 2022

Stop The Reverse Repo

The Fed runs an overnight reverse repo facility for institutions like banks and money market funds. It works like a one day interest bearing deposit, secured by bonds held in the Fed's portfolio. The amount on deposit has now reached the astronomical amount of $2.2 trillion, and it currently collects interest at 1.55% which will likely go to 2.30% today when the Fed raises rates again.

                                                 Fed Reverse Repo Reaches $2.2 Trillion

Reverse Repo Interest Rate Paid By The Fed

Thus, the Fed will pay a huge $50.6 billion annualized in interest to banks and money funds. Why should it?  If the Fed was a regular bank, the reverse repo would be a way to fund its existing bond portfolio, which probably earns more than 2.30% - at least for now.  But unlike regular banks and institutional investors the Fed doesn't have to worry about funding anything - it just prints the money it needs, that's the whole idea of central banking.

When amounts deposited to the Fed via reverse repo were minute (usually around $1-2 billion before the pandemic) the rate paid didn't matter.  But with $2.2 trillion now flooding the Fed the rate paid makes a very big difference, indeed.

Thus, the reverse repo is now nothing more than a direct "subsidy" to the financial sector and should be immediately stopped, or at least be modified to pay minimal interest well below market rates, say one tenth Fed funds, ie around 0.15-0.25%. Naturally, this will force financial institutions to seek other places to park their excess cash, driving short term rates lower, probably below where Fed wants them to be to fight inflation.

The problem, quite obviously, is the "excess cash" itself and this is another reason the Fed should start draining it aggressively from the system via Quantitative Tightening.

Labor And Inflation

I've been saying for quite some time that high inflation will soon cause labor demanding higher wages -  and it is already happening. Labor unions have been losing power to employers for decades, but conditions are now ripe for their resurgence.  

The close relationship between high inflation and labor actions is intuitively obvious and can be demonstrated in the two charts below.  With inflation now back to 1980s highs, will many more strikes soon follow? I believe they definitely will.

And when they do, politicians will abruptly switch allegiance from the corporate suite to the street. The Era Of Markets is clearly over.

PS In the 1970s and 1980s it was pre-Thatcher UK that led the world in strikes.  I'm not sure if we will see a repeat, since the UK is no longer an industrial nation, but after Boris the Menace the Conservative party is in disgrace and tatters.  Can Labor make a strong comeback in an economy based on financial services? If it can transform itself into New-New Labor, focusing on climate change and health services, yes it can. 

US CPI Inflation

UK Inflation

Tuesday, July 26, 2022

The Economy Is Weakening - Channel Your Inner Volcker

 The US economy is weakening very fast, much faster than most analysts are currently predicting.  

Witness yesterday's announcement by Walmart CEO: "The increasing levels of food and fuel inflation are affecting how customers spend", he said and went on to announce that earnings would drop by 13-14% this quarter, squeezed between lower demand for durable goods and non-essentials like clothing, and having to heavily discount to clear inventory.  This is Walmart's second negative announcement in just 10 weeks, which shows just how fast things are unravelling at the consumer front.

Walmart is the world's largest retailer, so what's going on there is an indicator for consumer spending trends everywhere.

There are those who are attempting to interpret this as good news for markets. Oh, since we are going into a recession the Fed will stop tightening aggressively, they posit. Well, maybe - if Powell and Lagarde prove to be totally spineless and whipsaw monetary policy back and forth. If so, inflation will become even more entrenched. Witness the German labor union for Lufthansa's ground-handling workers: they are demanding an immediate 9.5% pay hike and are going on a one day strike this Thursday. Can you blame them? With basic consumer good prices soaring well over 15%, workers need immediate real income relief.

Note to Powell and Lagarde: Channel your inner Volcker and stay the course, your duty is to the wider public not to financial markets. In fact, since you are still not doing much on the QT front, you should double down and announce truly substantive money supply shrinking measures.  Nothing else will work to kill inflation fast.

Friday, July 22, 2022

Less Popular Indicators

The vast majority of economists and traders follow a few very popular indicators: GDP, payrolls, weekly unemployment benefit applications, inflation, home sales and starts...  

Then there are other, less popular indicators.  Here is a smattering...

  • Philly Fed Business Conditions.  Lowest in 30 years. Why?

  • GDPNow estimate from Atlanta Fed 2Q22  (-1.6%) far below consensus (+2%). Why? 
  • SPAC IPOs have evaporated in 2022. There are certainly serious regulatory issues, but down 94% from 2022 points to more trouble  than that. What could it be?

  • NFIB Small business owners' outlook for business conditions at the lowest level in history.  Why?

  • US Services PMI is at the lowest level in nearly 10 years (pandemic excepted).  Repeat: services.

Thursday, July 21, 2022

Hannibal Ante Portas

On 216 BC Hannibal was just a few dozen miles from Rome, having repeatedly defeated its legions in battle. The city was about to be sacked - terror was palpable in the population: the barbarians were at the gates (ante portas). It didn't happen, and some years later it was Carthage itself that was razed to the ground. 

Fast forward: Italy's glories are today renowned all over the world. Venice, Florence, Armani, Ferrari... a slew of luxury brands and pricy tourist destinations have supported an economy that would otherwise be more like Greece than France. Based mostly on those lifestyle sectors, Italy has grown to serious size: its economy is the ninth largest in the world. But under the glitter, Italy has serious problems, making it the Sick Man of Europe.

  • Government Debt to GDP at 155%.
  • Aged population, third oldest median age in the world.
  • Perennial government paralysis, 69 governments since 1945 (soon to be 70), one every 1.1 years. 
Just like in Greece, the adoption of the euro 20 years ago brought down borrowing costs, masking and even exacerbating the underlying problems.  But unlike Greece which accounts for a minuscule 1% of eurozone GDP, Italy comes in at 13%, behind only Germany and France.  Should Italy fall apart the eurozone would fail, and probably so would the EU itself.

How likely is an Italian collapse?  Let's start with this: it's not unthinkable. The ECB is definitely scared enough to propose some sort of mechanism to immunize its debt from market attacks.  I think the ECB has no idea how to accomplish such a task, which is precisely why it has so far abstained from providing any specifics on this mechanism.  The bond market is biding its time, with Italian 10 year bond spreads to German Bunds around 200 bp (2%) up from 90 bp last year. They briefly touched 250 bp last month, causing the ECB's "mechanism" announcement .

With eurozone inflation at 8.60% and Italian 10 years at 3.70% I cannot really imagine how the ECB can immunize Italian debt against a combination of credit and inflation related attacks (Greece is in even worse shape, by the way).  After all, the ECB has to raise rates significantly starting today, if it is to retain even a modicum of inflation fighting credibility.  

My feeling is that Rome will be sacked this time around....

PS Ex ECB head Mario Draghi just resigned as Italy's Prime Minister.  He lasted 17 months.

Recession Risk Metric

Here's an interesting recession predictor: every time the spread between 30-year fixed mortgage rates and the 30 year Treasury rises to around 250 bp (2.50%) a recession follows shortly thereafter (grey shaded periods on the chart below).

Given that 90% of all home mortgages are 30-year fixed, it makes sense... it's a sign of mortgage lenders pricing-in increased default risk, which naturally rises during a recession.

30 Year Fixed Mortgage Minus 30 Year Treasury (%)

Mortgage delinquency rates are still very low near 2%, but data are from 1Q22 and in any case delinquencies are a lagging indicator.

Mortgage Delinquency Rates

Wednesday, July 20, 2022

London Broil, And Other Spikes

The UK experienced its highest temperature on record yesterday, as thermometers reached 40 C near London.  A friend sent me pictures from Hyde Park where lush green lawns turned yellow overnight.  Camel rides may come next?

Seriously though: non-technical people may be excused of ignoring dire warnings from scientists when they say "average global temperatures will rise 2 C"  over the next few decades.  After all, how bad can a couple degrees be?  It can be very bad...

The "average" rise is completely misleading, and this is why: engineers design systems, structures, etc. to operate safely within a defined range of environmental parameters, plus a safety margin.  For example, a metal bridge is designed to withstand a certain amount of stress from expansion/shrinking cycles, in turn calculated from expected temperature extremes. When those are exceeded by far - even once! - the bridge could fail catastrophically, even as "average" temperatures only rise by 1 or 2 degrees (look up Hammersmith bridge covered in aluminum foil).

Back to finance.

Remember the CDO market based on home mortgages? Yes, on "average" single family home mortgages only defaulted by 2-3% historically, so tranching using this average was supposed to be "safe". The extra default risk was sequestered to the riskiest tranches, while the rest were rated investment grade all the way to AAA. All it took was a sudden rise in defaults to over 6-7% (and eventually to 11%) for the debt market to collapse and produce the Great Recession of 2008-09. 

Today, we are experiencing a spike in inflation, produced by a spike in money printing. Inflation may subside at some point, but the damage has already been done.  In my daily experience I see companies still operating as if inflation is still at 2% or less.  Yes, they are concerned but they cannot believe that they should be raising prices by over 5-10%% to cover their future operating cash flow needs.  Their finance people are simply not used to operating in a high inflation environment.  In a word, they are clueless.

What is going to happen very soon is that corporations are going to hit a brick wall, or two actually.

  • As their input costs continue to spiral upwards and their FIFO accounting runs out of cheap material in stock they will face a choice of (a) raise prices significantly or (b) accept much lower profit margins. Or both.
  • Labor will demand wage increases much larger than in recent memory.  There is inertia in the labor pool, but once they get going wage and salary demands will become a wave.  It is already happening in Europe, where strikes are becoming much more common than in years past.
I will repeat ad nauseam: the only way to kill inflation is for central banks to remove money from the system via QT.  Lagarde and Powell should just go on TV and say three words: "Whatever it takes".

Monday, July 18, 2022

A Rather Surpising Chart

I've got to admit the chart below surprised me at first.  Employee wages and salaries (blue line) are rising faster than headline inflation (red line): 11.20% vs. 9.1% - I thought the opposite was happening.  Sure, it's a narrow statistic for employee total compensation, but it is still significant, particularly since this is the fastest increase since the late 1970s.

On a second reading of the situation, rising wages and salaries must be what is driving inflation: people have a lot more money to spend, despite rising prices for basic necessities like gas, electric and food.

Seems to me that a jobs-destroying recession may indeed be in the cards, if inflation is to be tamed.

Compensation of Employees And Inflation

Thursday, July 14, 2022

Inflation Woes - It Ain't Rocket Science

US CPI inflation for June was reported yesterday, came in at an "unexpected" 9.1% - a 41 year high.  Made me nostalgic to be honest, I was still a grad student back in 1981 :)

But.. why is inflation so high?  With energy, food, housing and transport prices soaring as much as 30-40%, surely there must be some demand destruction going on?  Yes, there is - but not as much as necessary, and certainly not very fast.  Why?


1. People will rather spend their money than save it.  Inflation is at 9.1 % and 3 month Treasury bills are at 1%.  Do the math, it pays to consume! (see chart below). 

CPI Inflation (red line) And 3-Month Treasury Bills (blue line)

Right now real interest rates in the US are at a record negative 8.1% (see chart below). That's a very strong dis-incentive to save your money.  If anything, the Fed is urging you: "stock up on heating oil, gas, food and everything else that is non-perishable" ... and thus drive up prices through extra demand.

Real Interest Rates At Record Negative 7.5%

2.  Is there money to spend instead of save and thus keep stoking inflation?  Of course there is - because the Fed is really, really dragging its feet on removing the ocean of liquidity it created during the pandemic.  Looking at the chart below, the annual percent change in M3 money supply has to go negative before liquidity is reduced. Unfortunately, M3 is still rising at 7.5-8% annually.

Annual Percent Change In M3 Money Supply

Loud message to the Fed - and even louder to the ECB: sharply raise interest rates to promote saving instead of chasing higher priced goods/services, and sharply reduce money supply so there is less money to spend in said chasing.

It ain't rocket science!!

Saturday, July 9, 2022

More On US Employment

 Continuing from yesterday’s post, more on US employment.

Average hourly earnings in the US have been beating inflation for over 10 years - see chart below, earnings in blue, CPI in red. (Yes, “average” is a dirty word but let’s ignore it for now.)

Since 2020, however, inflation has increased faster than earnings: the slope of the red line is steeper than the blue line.

Average Earnings And CPI (Index 6/2006=100)

How much faster? Transforming the data into annual percent changes we get the chart below.

Average Earnings And CPI (Annual Percent Changes) 

Inflation is at 8.6% but earnings are lagging behind at only 5.1%, ie working people are losing a very substantial 3.5% of their purchasing power. This is the worst real earnings performance since at least 2006 - and it can’t last much longer. Unless inflation drops well below 5% immediately, workers will demand sharply higher wages to make up for their losses, particularly since the labor market is still very strong.

Back to averages: US inflation is 8.6% on average. But as I’ve pointed out before, inflation on consumer essentials like housing, energy, food and transportation is much higher at 11+%. These expenses make up nearly 100% of expenses for low to lower-middle income households, precisely those that will very soon be demanding hefty pay raises. We already see strikes in Europe and unionization drives in the US, in sectors like airlines, retail and leisure services. 

Reports coming from large retailers point to a sudden collapse in consumer demand for non-essential items like electronics and clothing, to compensate for higher expenses for gas, food and housing.  Looks to me like a repeat of the 1970s stagflation, but with a twist: this time the labor market is super tight and can drive wages higher, even under slower economic conditions.

Result: lower business earnings. The downturn in the business cycle is still in its early stages, I’d say.

Friday, July 8, 2022

Fundamental Shift In US Employment

 The pandemic accelerated a fundamental shift in US employment patterns towards jobs in  the gig and "alternative" economy.  The chart below is revealing: the number of job openings (blue line) is much higher than the number of unemployed (red line).

Assuming the statistics are accurate - and I believe they are - we are witnessing the early stages of a revival of bargaining power for the working class.

It is also a headache for the Fed: it can't lift its foot off the monetary brakes, even if braking will result in a recession.  

Repeating my mantra: the ONLY way to deal with this inflation is to significantly reduce money supply via Quantitative Tightening.  And no matter what it says, the Fed hasn't started QT-ing yet - its balance sheet assets are still very near their all time high of $9 trillion, waaaaay higher than the $4 trillion in early 2020.