Doug Noland: Epic Stimulus Overload

Ten-year Treasury yields jumped 13 bps this week to 2.48%, the high going back to March. German bund yields rose 12 bps to 0.42%. U.S. equities have been reveling in tax reform exuberance. Bonds not so much. With unemployment at an almost 17-year low 4.1%, bond investors have so far retained incredible faith in global central bankers and the disinflation thesis.

Between tax legislation and cryptocurrencies, there’s been little interest in much else. As for tax cuts, it’s an inopportune juncture in the cycle for aggressive fiscal stimulus. And for major corporate tax reduction more specifically, with boom-time earnings and the loosest Credit conditions imaginable, it’s Epic Stimulus Overload. History will look back at this week – ebullient Republicans sharing the podium and cryptocurrency/blockchain trading madness – and ponder how things got so crazy.

From my analytical vantage point, the nation’s housing markets have been about the only thing holding the U.S. economy back from full-fledged overheated status. Sales have been solid and price inflation steady. And while construction has recovered significantly from the 2009/2010 trough, housing starts remain at about 60% of 2004-2005 period peak levels. It takes some time for residential construction to attain take-off momentum. Well, liftoff may have finally arrived. As long as mortgage rates remain so low, we should expect ongoing housing upside surprises. An already strong inflationary bias is starting to Bubble. Is the Fed paying attention?

December 22 – Reuters: “Sales of new U.S. single-family homes unexpectedly rose in November, hitting their highest level in more than 10 years, driven by robust demand across the country. The Commerce Department said… new home sales jumped 17.5% to a seasonally adjusted annual rate of 733,000 units last month. That was the highest level since July 2007… New home sales surged 26.6% from a year ago.”

And from Bloomberg’s Shobhana Chandra: “…The number of [new] properties sold in which construction hadn’t yet started increased almost 43% to 258,000 in November, the most since December 2006… Supply of homes at current sales rate fell to 4.6 months from 5.4 months.”

December 20 – Bloomberg (Shobhana Chandra): “Sales of previously owned U.S. homes rose in November to an almost 11-year high, indicating demand picked up momentum heading into the end of the year… The results show broad strength, with particular firmness in the upper-end market where inventory conditions are ‘markedly better,’ the group said. Forty-four percent of homes sold in November were on the market for less than a month. At the current pace, it would take 3.4 months to sell the homes on the market, the lowest in records to 1999 and down from 3.9 months in the prior month.”

December 19 – Bloomberg (Sho Chandra): “Groundbreaking on single-family homes proceeded in November at the strongest pace in a decade, driving U.S. housing starts to a faster-than-estimated rate… Single-family starts jumped 5.3% to 930,000, highest since Sept. 2007; South and West regions also were 10-year highs. The latest results make it more likely that residential construction spending — which subtracted from economic growth in the second and third quarters — will add to the pace of U.S. expansion in the October-December period, which is already shaping up as a solid quarter.”

U.S. and global growth surprised on the upside in 2017, explained by monetary conditions that somehow became only more extraordinarily loose. The Fed, with its dovish approach to three baby-step hikes, failed to tighten conditions. Led by the Bank of Japan and the European Central Bank, it was another year of massive global QE. Meanwhile, Chinese “tightening” measures couldn’t restrain record Credit growth. At the “periphery,” EM were the recipients of huge financial flows, spurring domestic Credit systems and economies around the globe. It’s been a huge year for Credit on a global scale.

December 19 – Financial Times (Eric Platt and Robin Wigglesworth): “A borrowing binge by companies and governments has reached a new high this year, providing bumper fees for Wall Street but raising questions ahead of a year of expected tightening of cheap money by the world’s most important central banks in 2018. Blue-chip corporate borrowers such as AT&T and Microsoft have led the way, as companies accounted for more than 55% of the $6.8tn raised in 2017 through bond sales organised by banks, according to… Dealogic. Countries from Argentina to Saudi Arabia also took advantage of an almost decade of low interest rates in developed economies, which forced investors to chase returns in the bonds of emerging market governments and their companies. ‘In 2017, there was such an influx of capital coming into high-quality fixed income. It’s a demand-fuelled story,’ said Gene Tannuzzo, a portfolio manager with Columbia Threadneedle. ‘If you are a sovereign or corporate, with interest rates where they are, you are supposed to borrow now.’”

Bloomberg’s Michael McKee: “Is the bond market telling the President he’s wrong about the potential for increasing the growth rate of the United States.

Federal Reserve Bank of Minneapolis President Neel Kashkari: “Well, I think the bond market is saying a couple things to me. One, inflation expectations are drifting lower. They have drifted lower, and that’s in large part, I believe, because of the Fed – because we’ve been sending these hawkish signals by raising interest rates in a low inflation environment. Second, I think the markets are also pricing in a lower neutral real interest rate. So the interest rate that balances savings and investment in the economy is set by broader economic forces. It’s been trending down over the last few decades. I think markets are embracing that concept and pricing in a lower, what we call “r-star”, which then caps where bond yields are, and at the same time can explain some of the appreciation in the equities markets, as they’re discounting cash flows at a lower rate. So those are the signals that I take away from the bond market right now.

Bloomberg’s David Westin: “…If you had your way, if you went from what the Fed is predicting now – three [rate] increases next year – to one, or maybe none, what would happen to the long-end of the yield curve, in your view?”

Kashkari: “In my view, I think that would take off some of the downward – the disinflationary pressure that I think the committee is putting on the long-end of the curve. In my view, by raising rates in a low inflation environment we are sending a signal that our 2% inflation target is not a target. We’re sending a signal that it’s a ceiling – that we’re not going to allow inflation to creep above 2%. And I think that’s putting pressure on the long end of the curve. If you look at how we’ve behaved – not at what we’ve said – we say it’s a target not a ceiling. If you look at how we’ve behaved over the past five or six years, we’ve been treating 2% as a ceiling. I think markets have figured that out and they’re pricing that in. So to me, the Fed is pushing up the front end with our rate increases and pushing down the long end by sending this very hawkish signal about the outlook for inflation.

“Very hawkish signal”? It’s been a while since radical dovishness was an impediment to career advancement at the Federal Reserve (or prospering thereafter).

Central bankers over recent decades have repeatedly found excuses for leaving monetary policy too loose for too long. In the face of history’s greatest expansion of global debt, central bankers have since the early nineties justified loose monetary policy by pointing to deflation risk. When the economy and markets were turning increasingly overheated in the late-nineties, chairman Greenspan claimed a New Paradigm of technological advancement presented the U.S. economy with a faster speed limit. When the post-tech Bubble reflation was spurring record Credit growth and rampant mortgage excess, Dr. Bernanke and others proffered the “global saving glut” thesis. Apparently, it was out of the Fed’s hands.

Now we have a historically low “r-star” “neutral rate” – and Fed hawkishness supposedly pressuring long-term yields lower. I really struggle with the notion that the Fed has been hawkish “over the past five or six years.” Do global central bankers not appreciate that decades of loose finance have been a major force behind disinflationary pressures? Moreover, employing open-ended QE fundamentally altered expectations and market pricing for sovereign debt and long-term financial assets. With myriad Bubbles flourishing around the globe, debt markets now price in QE forever. I believe global long-term yields would move sharply higher in the event of a stunning outbreak of central bank hawkishness.

December 18 – Wall Street Journal (Michael C. Bender): “Declaring that ‘economic security is national security,’ President Donald Trump aimed to reframe a national debate over his domestic economic and trade policies by thrusting them into a national-security context. ‘Economic vitality, growth and prosperity at home is absolutely necessary for American power and influence abroad,’ Mr. Trump said… as he unveiled his new national security strategy. ‘Any nation that trades away its prosperity for security will end up losing both.’ Recounting a year of stock-market gains and unemployment-rate decreases, Mr. Trump alleged that his predecessors prioritized nation building abroad over economic growth at home. He said his new national security strategy… provided a needed contrast, and included plans for cutting taxes, rebuilding roads and bridges and building a wall along the U.S.-Mexico border.”

December 20 – New York Times (Keith Bradsher): “It’s Xi Jinping’s economy now, and he isn’t too worried about debt. China signaled its economic priorities on Wednesday at the end of a meeting of top Communist Party economic leaders with a statement indicating that President Xi is fully in charge. Labeled ‘Xi Jinping Thought on Socialist Economy With Chinese Characteristics,’ the statement called for trimming industrial overcapacity, controlling the supply of money and other moves that have been staples of China’s other recent declarations. Barely mentioned: China’s surging debt. Despite downgrades this year by two international credit rating firms and warnings from institutions like the International Monetary Fund, the statement issued at the conclusion of the Central Economic Work Conference called for controlling borrowing by local governments, but it otherwise glossed over a vast borrowing splurge in recent years, driven in large part by Chinese companies.”

President Trump is now wedded to the U.S. Bubble. President Xi Jinping is wedded to the Chinese Bubble. I’ve posited a global “Arms Race in Bubbles.” With Trump in charge and the Republicans now pushing through aggressive stimulus, perhaps Chinese officials are rethinking the geopolitical risks associated with efforts to rein in their Bubble excess.

It’s been a long time coming. Yet I wouldn’t be surprised if this week’s jump in yields proves the start of something. Tax cuts coupled with an increasingly overheated economy creates a backdrop conducive to upside inflation surprises. Nice pop in commodities this week. And look at the housing data! And what if Beijing indulges yet another year of double-digit Credit growth in 2018? And while on the topic of 2018, what are the prospects for the Trump Administration turning its attention to trade competitor China? It’s another campaign promise and where things could turn really interesting.

For a moment, ponder this: an overheated U.S. economy, a surprising uptick in worker compensation and rising import costs. It’s been awhile since bond investors had to be concerned with anything other than (predicatively dovish) monetary policy. “R-star” trending down forever? Remember when the bond market used to intimidate?

Original Post 23 December 2017

Categories: Doug Noland, Perspectives