yield curve inversion, external shock and recession

Stock markets around the world sold off yesterday in wicked fashion after the yield on the 10-year Treasury “inverted,”  that is, fell below the yield on the 2-year.  This has very often been the signal of an upcoming recession.  Typically, though, the inversion happens because the Fed is raising short-term interest rates in an attempt to slow too-rapid economic growth.  So it’s first and foremost a signal of aggressive Fed tightening, which has in the past almost always gone too far, causing an economic contraction.

In the present case, this is not the situation.  The Fed is signalling ease, not tightening.  Arguably, arbitrage between long-dated US and EU government bonds is suppressing the 10-year.

While trading robots, unleashed by the inversion, may have been behind the negative stock market action yesterday, my sense is that this is not all that’s going on.  I think the market is beginning to step back and focus on the bigger economic picture.  It may not like what it sees, namely:

–worldwide, economies are now being hit by a significant negative external shock.  It’s not a tripling of the oil price, as was the case in the 1970s, nor a collapsing financial system, as in 2008.  Instead, this time it’s the Trump tariffs, which appear to be reducing growth in the US by more than expected (not that anyone had extremely precise thoughts)

–the 2017 tax bill is not paying for itself, as the administration claimed at the time, but is adding to the government deficit instead–implying that further fiscal stimulation is less likely.  Giving extra cash to the ultra-rich, who tend to save rather than spend, and keeping tax breaks for industries of the past hasn’t bought much oomph to growth, either

–channeling his inner Herbert Hoover, Mr. Trump is trying to export the weakness he has created by devaluing the dollar.

 

Stepping back a bit to view the larger picture,

–pushing interest rates near to zero, depreciating the currency and defending the politically powerful industries of the 1970s all seem to mirror the game plan that has produced thirty years of stagnation in Japan and similar results in large parts of the EU.  Not pretty.

–on a smaller scale, this brings to mind Mr. Trump’s fundamentally misguided and ultimately disastrous foray into Atlantic City gaming, a venture where he appears to have profited personally but where those who supported and trusted him by owning DJT stock and bonds were financially decimated.

 

It seems to me that Wall Street is starting to come to grips with two possibilities:  that there may be only impulsiveness, and no master plan or end game to the Trump trade wars; and that Congresspeople of all stripes realize this but are unwilling to do anything to thwart the president’s whims.  In other words, the real issue being pondered is not recession but Trump-induced secular stagnation.

 

 

 

productivity diffusion

Happy Friday the thirteenth!

The Financial Times has an article today that talks about productivity diffusion, referencing a prior FT article and an OECD study on the topic, both of which I somehow missed.

In its simplest form (which suits me fine), economic growth can be broken down into two components:  having more workers (or having existing workers put in more hours); or being more productive, meaning investing in machines, new business processes or worker training.

One of the bigger economic issues facing the world (US included) is the sharp dropoff in productivity growth over the past ten years or so.  The OECD report that sparked the FT articles argues that the problem isn’t a drop in innovation across the board.  Rather, the most productive firms in the world continue to show strong productivity growth.  What’s changed is that the once-fast followers are only adopting best practices today at a much reduced rate.

Why is this?  The OECD answer, which best fits the EU, I think, is that big banks are protecting low-growth, heavily indebted “zombie” firms.  Their reason?  The banks keep the zombies afloat (mixed metaphor, sorry) so they won’t have to write off the dud loans–calling into question the banks’ own financial viability.  What’s scary about this analysis is that it calls to mind the experience of Japan in the 1990s, the first of that country’s three lost decades.  Given that the Tokyo government actively protects managements from the consequences of failing to innovate, the problem of economic stagnation still afflicts Japan today.

To me the real relevance of the current lack of productivity diffusion for the US is that it speaks to the thrust of Donald Trump’s macroeconomic ideas.  However well intentioned, the effect of dissuading firms from adopting productivity enhancing measures for fear of being publicly shamed and of shielding non-competitive firms from import competition will likely be the zombification of the affected portions of American industry.  That is not a long-term outcome anyone wants.

 

the Employment Situation, September 2016

At 8:30 edt this morning, the Bureau of Labor Statistics released  monthly Employment Situation report for September.

The ES estimates the US economy created +156,000 new positions last month.  While enough to absorb the average number of people leaving school and entering the job market for the first time, the figure is below the average of +192,000 jobs created over the past three months.  Revisions to the prior two months’ estimates were also negative, subtracting a total of -7,000 from prior tallies.

For what it’s worth (not much, in my opinion), labor economists had been predicting the figure would come in at +172,000.

It’s important to remember, though, that the unemployment figures are the result of subtracting the number of job gainers from the number of job leavers.  The monthly figure for each is around 3.5 million; the difference between the two is statistically significant only +/- 100,000.

Positives in the report:  wages continue to rise at 2.6% annually; employment in the mining industry, which includes oil and gas, may be bottoming after two years of decline.

 

The real significance of the September ES is in its inoffensiveness.  There’s nothing in it that could even remotely be considered as a check on the Fed’s desire to raise short-term interest rates before yearend.

 

 

 

the traditional business cycle

The easiest place to start is at the low point of the cycle–and to talk about every place in the world except the US.

the target for government policy 

A typical rule governing policy action would be for a country to act so as to maintain the highest sustainable (that is, non-inflation-inducing) rate of economic growth.

the bottom

At its low point, activity in an economy is advancing at considerably less than that.  The economy may even be contracting.  The cause may be prior action by the government to slow the economy from a previous overheated state (policy actions are blunt tools:  most often they overshoot their objective) or the economy may have been hit by an out-of-the-blue event, like an oil shock or a financial crisis.

In either case, companies are laying off workers, reducing inventories, closing now-unprofitable operations  …all of which is causing the slowdown to feed on itself.

The traditional remedy to break the downward spiral is to lower interest rates–we might also describe this as lowering the cost of money by making a much larger quantity available to borrow.

What does this do?

In theory, and often also in practice, companies have a list of new capital projects they are ready to implement but which are unprofitable at the high interest rates/weak growth that accompany/trigger a slowdown.  By lowering rates, the monetary authority makes at least some of those projects into moneymakers.  So companies commit to new capital projects.  They hire planners and construction firms; they buy machinery; they hire workers to staff new plants.

As these formerly unemployed workers get paychecks, they begin to consume more–they buy clothes, and then houses and new cars.  They begin to eat restaurant meals and go on vacations again.  As consumer-oriented service industries see their businesses picking up, they begin to hire again, too–adding to the new wave of consumer spending.  At the same time, the supply chain begins to expand inventories to be able to satisfy rising demand.  Similarly, manufacturers hire more workers and begin to expand their own productive capacity.

In this way, self-feeding slowdown turns into self-feeding expansion.

the top

At some point, the economy reaches full employment.  Companies want to continue to expand because they now see many profitable investment projects.  But there are no more unemployed workers.  So firms begin to offer higher wages to bid workers away from other firms.  They begin to raise prices to cover their higher costs.  This activity doesn’t create more output, however.  It only creates inflation.

Either in anticipation of, or in reaction to, budding inflation the monetary authority begins to raise interest rates to cool down the now feverish expansion.  It keeps rates high until it begins to see signs of slowdown–inventory reductions, new project cancellations, layoffs.

 

The economy eventually reaches a low point   …and the cycle begins again.

observations

–in the model just described, industry recovers first, followed by consumers.  This happens in most of the world.  In the US, however, as soon as interest rates begin to decline, the consumer typically begins to spend again.  Business follows with a lag.

–conventional wisdom is that money policy actions need 12 – 18 months to take full effect.  In the current situation, short-term interest rates have been effectively at zero for eight years (!!) without seeing a sharp surge in economic growth in either the US or the EU.

–economists have been concerned for years that there’s been no oomph in capital spending in the developed world, despite low rates.  The traditional model explains he concern–business capital spending is thought to be a key element in any recovery.

 

More tomorrow.

 

 

 

interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.

 

At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.

 

More on Monday.

 

 

keeping nominal GDP growth above zero

A reader asked a question about this after my Stephen King post from last Friday.  I think the best place for an answer is here.

In most circumstances, what counts is real GDP, not nominal.  That latter is, after all, just real GDP + inflation.  However, what comes to mind when people start to look for instances where nominal GDP shrinks is the Great Depression   …or maybe Japan during the series of Lost Decades it has been experiencing since 1990.

A potentially huge economic problem during a period of declining nominal GDP is that virtually all borrowing contracts–bonds or bank debt–are written in nominal terms.    In many places, labor contracts are also framed the same way, with an x% increase in wages yearly over the term of the agreement.

The revenues that businesses generate to meet these obligations are a function of unit volumes and price changes.  If real GDP is falling by, say, 3% and prices rising by only 1%, overall revenues are contracting.  Given that operating costs are typically fixed over the short term, this means firms in the aggregate will have less income to meet debt repayments and salary obligations.  For highly operationally or financially leveraged companies, even small declines in revenues can be deadly.

If, on the other hand, volumes are down by 3% and prices are rising by 4%, then revenue growth will still be positive.  On the margin, at least, this means fewer layoffs and fewer insolvencies to act as an economic drag during a time  when governments are trying to stimulate demand.

 

The situation where nominal prices are actually falling–which we’re not talking about here– is far worse.  Consumer soon learn that waiting a month, or two or three, before buying will mean a lower price.  So they just stop buying.  Given that consumers make up the bulk of economic growth in developed economies, they can ill afford to get the idea in consumers’ heads that purchasing anything today is a bad idea.