Thursday, October 14, 2010
the task of depression is margin compression
today, the federal reserve is attempting -- brazenly -- to raise the general price level of the economy as a whole by exchanging financial assets with the private sector, substituting income-generating instruments for newly-created cash reserves. this is an effort to undo some of the tremendous balance sheet damage in the private sector, as well as improve terms of trade for american exporters (as the trade value of the dollar is expected to fall under such circumstances). an examination of the fed's h.4.1 will show that the size of the fed's balance sheet continues near an all-time high of $2.3tn. more asset purchases are likely underway -- the fed's POMO schedule of acquisitions continues relentlessly, and an explicit program of quantitative easing is expected in response to ongoing economic weakness.
here's why i think the fed may be forced to relent.
the leveraged asset market that the fed would like to raise from the dead it cannot touch. housing is titanically oversupplied, and the fed's efforts to cheapen rates have served mostly to increase the percentage take of the banks in refinancing rather than increase purchasing power of new buyers.
chris whalen spoke on this point sharply last week. banks used to take a half-point in loan-making; now they are taking 400-500bps in an effort to raise their income. little or no economic benefit is flowing to the borrower at this point from declines in long-end interest rates. moreover, because of ZIRP, the actual cash flow through the banks is declining precipitously -- while interest margins remain wide, dollars earned are shrinking. this as non-interest expenses -- the cost of foreclosing on millions of delinquent loans, which is turning banks into REITs -- is exploding. whalen forecasts the large banks (JPM, BAC, WFC) to actually go cash flow negative in the next six months (though the suspension of foreclosures thanks to the surfacing MERS lien perfection issue may delay this).
the upshot is that borrowers can no longer refi in large numbers to their benefit, and banks are in no position to make new loans to purchasers. there is little benefit from QE here except to the banks' balance sheet.
on the commercial side, with a large output gap, high unemployment and significant unutilized capacity, there is no prospect of wage inflation -- average hourly earnings have not rebounded. without real final sales approaching something like strong growth, companies that are in a position to borrow to either invest, hire or raise wages have little incentive to do so. what capex growth that has been seen recently has been largely self-funded and from depressed levels; what borrowing that exists is being done in the corporate bond market, largely refinancing to cut down the income stream to creditors.
the result is that systemic income growth is dependent almost entirely on government fiscal stimulus -- a significant portion of which has flowed overseas through our again-growing current account deficit. the lack thereof has aggravated the decline in systemic credit as few borrowers either want or have the cash-flow capacity to increase borrowing as income remains sparse -- quite the opposite -- and has pushed borrowers toward default.
but the effect of the fed's actions on inelastic raw inputs is another story altogether. anyone looking at the commodity markets can attest to the power of the fed to spark speculative fervor with zero rates, cash substitution and debasing intentions. in spite of record stocks in storage thanks to depressed demand, oil is trading over $80/bbl. yet less elastic agricultural commodities have put in a far more impressive advance. this is where the fed's activities have been felt, and a reflexivity loop all but ensures that, for so long as the fed continues, a large part of its liquefaction will flow into raw inputs. there is already talk of popular unrest and the prospect of food riots in emerging markets.
so this is what the fed is accomplishing. it can do little to overcome the continuing deleveraging of the private sector as banks shed loans, which continues to drive down property prices. it can do little to increase income in the economy -- indeed, by increasing the take of banks in an effort to offset their as-yet-unrealized losses, it is redirecting income from the private sector into loss cancellation to the tune of $750bn a year on whalen's estimate, with deflationary implications offset only by expansive fiscal deficits. but, by devaluing the currency and encouraging speculation in raw inputs, it has raised the operating costs of the private sector (households and businesses alike) significantly within the dollar economy.
in short, the fed seems to have become a vehicle of margin compression and profit destruction -- increasing costs relative to revenues, reducing income, amid a deleveraging cycle.
if this policy is pursued further, we may well see margins compress further as commodity prices rise relative to all else while income stagnates or falls, driving huge numbers of private sector participants cash-flow negative and into bankruptcy. i've sometimes said before, with respect to the inflationary implications of QE, "call me when the fed balance sheet gets to $10tn" -- and in light of the above reasoning it's frightening that, as noted by ed harrison, paul krugman gets into the same ballpark. taken up something on the order of that target, i don't expect quantitative easing to avoid or even curtail bankruptcy and depression. the work of depression is margin compression -- and QE may be less a deterrent to that than a facilitator.
and all the while, there remains the latent but significant risk scenario that such moves will spur capital flight from the united states.
Not sure if I understand this..why is a significant portion flowing overseas?
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because we run a significant current account deficit, a fraction of american spending ends up in foreign pockets. when someone buys a chinese toy, the producer in china ends up with dollars -- most of which his government then exchanges into yuan, recycling them into treasury bonds.
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Friday, October 08, 2010
LEI deconstructed, update
but, while theory is fine for hypothesis, there is no substitute for evidence. unfortunately there's been enough to convince me.
i last mentioned here the consumer metrics institute's GDP predictor in march. it has since marked out a horrifying path of collapse since peaking in october of last year (coincidentally about the time i last updated this study). CMI has helpfully overlaid the continuing contraction in their real-time transaction data atop the 2008-9 recession in this chart, to frightening effect. this is not theoretical exposition; a large decline in real transactions of consumer goods is behind this movement. i see this as confirmation of thesis.
a second confirmation emerges from a deconstruction of the ECRI's leading indicators on the methodology previously described. with a broken credit mechanism -- total loans and leases is still declining, as it has been for two years now -- and unprecedented federal reserve bank intervention in funding markets, i feel a handful of the LEI components -- yield curve, m2, stocks and the consumer expectations that largely follow stocks -- probably represent broken signals better designed for standard post-war recessions than the depression we're experiencing.
removing their contribution to the LEI reveals the weakness of the stimulus-fueled inventory cycle "recovery" of 2009-10. moreover, for much of this year, the "real" component aggregate was demonstrating outright contraction, with the level peaking in april 2010 -- a sharp warning of an impending return to recession, even as the ECRI LEI as reported set a new high in the last reading of the series. this of course mirrors the contraction reported in CMI data.
a number of regional manufacturing indeces (philly fed, empire state) has also shown a sharp slowdown in the last two months, with inventories again starting to build -- these being coindcident-to-lagging indications of economic activity, it would seem likely that contraction in consumer activity is starting to feed back into the manufacturing chain as CMI has for some time expected. house prices have continued to decline after a tax-credit-induced respite and jobs data has also disappointed, showing little or no recovery in the labor market. i expect these data series will now begin to show more severe deterioration through the end of the year -- following the CMI data and the rate of federal stimulus spending down -- and to remain very weak until the united states government is compelled to return to accelerating deficits in order to offset the debt deflation of the private sector.