Chair Yellen is widely lauded for her accomplishments at the Federal Reserve. For the most part, her four-year term at the helm boils down to four (likely soon to be five) little rate hikes over 24 months. Most lavishing praise upon Janet Yellen believe she calibrated “tightenings” adeptly and successfully. Yet financial conditions have obviously remained much too loose for far too long. This predicament was conspicuous in the markets this week. A test of a North Korean ICBM that could reach the entire U.S. modestly pressured equities for about five minutes – then back to the races.
Bubble Dynamics are in full force. The Dow gained 674 points this week. The Banks were up 5.8%, the Broker/Dealers gained 4.5% and the Transports jumped 5.9%. The Semiconductors were hit 5.6%. Bitcoin traded as high (US spot) as $11,434 and as low as $9,009 in wild Wednesday trading. Curiously, the VIX traded up 15% this week to 11.43.
It used to be that markets would fret the Fed falling “behind the curve,” fearing central bankers would be compelled to employ more aggressive tightening measures. Not these days. Any fear of central bank-imposed tightening is long gone. There is little fear of anything.
I recall writing similar comments back with the Bush tax cuts: “I’m as much for lower taxes as anyone. Yet I question the end results when tax cuts exacerbate late-stage Bubble excess.” And I seriously question the merits of aggressively slashing corporate tax rates when the federal government is $20 TN in debt. One of these days the bond market is going to wake up and impose some much need fiscal discipline. In a different era, the Treasury market would be forcing some realism upon Washington politicians (and central bankers).
Moreover, there’s a paramount issue that goes completely undiscussed. It’s presumed that lower taxes will spur economic growth and resulting booming tax receipts – that tax cuts will prove largely self-financing. Yet this fanciful notion ignores a critically important unknown: What role will the financial markets play? As we saw in the last downturn, faltering Bubble markets weigh heavily on both economic growth and government finances. I would go so far as to suggest that never has our nation’s fiscal prospects been as dependent on ongoing equities, bond market and real estate inflation.
Nine years of extreme monetary and fiscal stimulus fueled quite a boom. Interest rates were pegged way too low for too long. The seemingly obvious risk now is that market yields surprise to the upside. Despite the boom and artificially suppressed debt service costs, the federal government has nonetheless posted ongoing large budget deficits. I never bought into the late-nineties notion that budget surpluses were sustainable – that our nation would soon pay down all its debt. It was all a seductive Bubble Illusion.
Today’s delusion is so much more spectacular. I’m all for efforts to revitalize the U.S. manufacturing and export sectors. But to continue to aggressively employ system-wide fiscal and monetary stimulus at this late cycle stage comes with great risk. I’m surprised the bond market remains so sanguine. There’s a (not low probability) scenario that has consumer and producer inflation surprising on the upside, interest rates and market yields surprising on the upside, the stock market buckling to the downside, and fiscal deficits exploding to the unmanageable. The Powel Fed would confront serious challenges (in contrast to the cakewalk enjoyed by Yellen).
November 27 – CNBC (Jeff Cox): “Concern over stock market values is growing at the Fed, with one official worrying that waiting too long to tighten policy could have more serious effects later. In an essay released Monday, Dallas Fed President Robert Kaplan warned about ‘excesses’ in the economy, pointing specifically to stocks and the government debt. The S&P 500 market cap is at 135% of GDP, the highest since 1999-2000, just as the dot-com bubble was about to pop, the central banker said. ‘I am aware that, as excesses build, we are more vulnerable to reversals which have the potential to cause a rapid tightening in financial conditions, which in turn, can lead to a slowing in economic activity,’ Kaplan wrote. ‘Measures of stock market volatility are historically low. We have now gone 12 months without a 3% correction in the U.S. market.,’ he added. ‘This is extraordinarily unusual.’”
November 29 – Reuters (Ann Saphir): “The Federal Reserve should keep raising interest rates over the next couple of years, including about four times between now and the end of 2018, San Francisco Federal Reserve President John Williams said… ‘From today, four rate hikes through the end of next year is still kind of my base view,’ Williams told reporters… Williams rotates into a voting spot on the Fed’s policysetting panel next year. ‘We need to get from here to roughly 2.5% fed funds rate over the next couple of years.’”
One regional Fed president addressing stock market excesses and another talking four additional rate hikes before the end of next year. Whether monitoring the securities markets or economic data, the case for actual interest rate normalization gets stronger by the week. It’s worth noting that October New Home Sales blew away estimates to reach a 10-year high. Housing inventory remains tight and builders are getting gear up. A stronger-than-expected November reading from the Conference Board pushed Consumer Confidence to a new 17-year high. Q3 GDP was revised up to 3.3% annualized. The manufacturing sector remains strong and auto sales resilient (above 17 million SAAR).
Ten-year Treasury yields traded as high as 2.43% Thursday afternoon. Five-year yields rose to 2.17% Thursday, the high going back to March 2011. Longer Treasury yields have for the most part ignored the almost 50 bps rise in two-year yields over the past several months. It was interesting to watch 10-year Treasury yields sink a quick 10 bps Friday morning on reports of Michael Flynn’s plea agreement (and the Dow’s immediate 380 point decline). While stocks have grown content to disregard risk, Treasury bonds seem to embrace the Bubble Thesis – and trade as if trouble is right around the corner.
And speaking of trouble… U.S. markets fixated on tax cuts have been all too happy to ignore developments in China. Officials are taking an increasingly aggressive posture in reining in lending. In particular, Beijing is targeting the enormous “wealth-management product” complex and the booming Internet lending industry. Liquidity has tightened, especially within the corporate bond market (“Worst China Bond Rout Since 2013”). Are Chinese officials finally getting serious about their Credit Bubble? (See “China Watch” below)
The Shanghai Composite was down another 1.1% this week, with a 3.9% drop since the highs on November 14. China’s CSI index lost 2.6% this week. Chinese growth and tech stocks have been under notable pressure for two weeks. Yet equities weakness was not limited to China. South Korean stocks fell 2.7% this week, and India’s equities lost 2.5%. Both Brazilian and Russian equities were hit for 2.6%. The emerging markets, in general, notably underperformed this week. European equities were also under pressure again. Could it be that Credit tightening in China is initiating a global bear market, only Bubbling U.S. equities haven’t figured it out yet?
November 24 – Reuters (Gaurav S Dogra): “For years China’s top officials have touted their ambitious policy priority to wean the world’s second-largest economy off high levels of debt, but there is not much to show for it. On the contrary, a Reuters analysis shows the debt pile at Chinese firms has been climbing in that time, with levels at the end of September growing at the fastest pace in four years. The build-up has continued even as policymakers roll out a series of measures to end the explosive growth of debt, including persuading state firms and local governments to prune borrowing and tighter rules and monitoring of banks’ short-term borrowing… Reuters analysis of 2,146 China listed firms showed their total debt at the end of September jumped 23% from a year ago, the highest pace of growth since 2013. The analysis covered three-fifths of the country’s listed firms…”
Original Post 2 December 2017