Is the Economy Actually Growing? It's a Reasonable Question

Is the Economy Actually Growing? It's a Reasonable Question
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Is the economy growing? Setting aside any idea it may be booming, as many now claim, there are legitimate questions as to whether it is actually advancing to any significant degree. This wouldn’t be any different than at any point since 2007. And you don’t have to take my word and analysis for it.

People are only now (the last nine or ten months) talking about the yield curve. They should’ve been paying attention to it for the last decade. The bond market is where everything happens. The mainstream and the media are fixated on the stock market. Stocks are nothing in the grand scheme of things, a minor toy for the unserious, monetarily speaking.

This is not a US problem alone. The UST curve continues to frustrate policymakers and Economists (redundant), a predicament that is widely shared. If you think the US curve is flat and unappealing you should see Germany’s. And Germany is supposed to be head and shoulders above the rest of the world right now in economic terms.

In short, the global bond complex has continuously rejected the idea that the economy is improving meaningfully anywhere. Sorry, Mr. President, the biggest, deepest, most complex and, most often, correct market in the world vehemently denies the US narrative. There is no decoupling, just variable shades of convergence.

These interrelated markets are now increasingly pricing scenarios where rate and curve obscenities become even more extreme. Out in front is the eurodollar futures curve, the very nemesis FOMC officials ten and eleven years ago did their best to discredit. In doing so, however, the only thing they ended up discrediting was their entire worldview as the world suffered the first global panic in four generations (if only the 2007, 2008, and 2011 FOMC transcripts when released had received a fraction of media attention the constant boom narrative does).

This phenomenon has reappeared in 2018, with the long end of the bond market being questioned by Economists. The same people who couldn’t figure out the same problem thirteen years ago (Alan Greenspan’s “conundrum”) are now repeating their same strange emphasis. The bond markets, they say, are all wrong.

This rejection is more pervasive than it may otherwise seem. And fundamentally it is repugnant. If anything, the yield curve has for this lost decade been gently nudging central bankers to wake up and change their ways. It has been their friend more than any other space on Earth. They simply reject its extended hand of friendship each and every time, like now, it is offered.

The latest FOMC minutes, those written up and released this week regarding the policy meeting held on July 31 and August 1, contained this stunning contradiction:

“They suggested that policymakers should pay close attention to the slope of the yield curve in assessing the economic and policy outlook…A number of global factors were seen as contributing to downward pressure on term premiums, including central bank asset purchase programs and the strong worldwide demand for safe assets. In such an environment, an inversion of the yield curve might not have the significance that the historical record would suggest; the signal to be taken from the yield curve needed to be considered in the context of other economic and financial indicators.”

You have to admire their audacity. “Strong worldwide demand for safe assets” is what you find when and where there is no economic growth. US central bankers are trying to claim that the long end of the bond market is very badly mispriced because mostly global banks are holding onto their UST and bund stock as if nothing else matters. And adding to it whenever confronted by the unofficial bumps that keep coming up.

In my mind there is no doubt as to why the FOMC chose this last opportunity to add this sanitized version of a likely very real discussion to the official minutes. May 29.

Everywhere we look, May 29 keeps showing up. The eurodollar futures curve, the one already inverted, began its journey toward this kind of negative distortion on May 29.

What happened that day?

In the media it was portrayed as nothing more than the Italian defects of elected populists. There were some questions surrounding something the establishment-hated government in Italy was confronting. The actual details don’t really matter because it had very little to do with market movements.

In reality, May 29 was a worldwide collateral call. It’s difficult for anyone unfamiliar (including central bankers) with how the global monetary system actually works to understand what that actually means. In a nominally capitalist system, there are no such questions about ownership and title. That’s not how this thing works, though, and it’s been this way for half a century.

If ten years ago AIG failed on its securities lending business, and it did, May 29, 2018, as October 15, 2014, was the ongoing legacy of the same mistake. There are large pools of securities on the one hand and huge demand away from those holders for those same securities on the other.

Repo markets work on collateralization as do most derivatives markets. If positions don’t go your way in FX, for example, you may be asked to post more collateral as the contract value(s) moves against you at its daily mark. What if you don’t have any? You can rent some, much cheaper and more efficient than buying. It doesn’t matter that you wouldn’t actually own it (though it really should).

There are any number of “silos” out there where for the right price (spread) someone will go into the market and find it for you. The securities lending business remains every bit as crucial now as before, only it isn’t as fluid and dynamic as it was when AIG was king. The reason isn’t the silos, though they’ve sure changed in the last ten years (central banks holding huge stockpiles now). The problem is how collateral flows from those silos to whomever might be in high demand for it.

As with most monetary affairs, the trick isn’t really supply or demand. The biggest factor is almost always matching supply with demand. In monetary collateral, same thing. The places where it is, and where you can get it, are those where it isn’t needed for these purposes. AIG the insurance company didn’t need to repo its own corporate bond holdings, it was AIG the subprime speculator that did.

To move collateral out from the silos requires effort, and a whole lot of it. Even in what little academic literature exists on the topic of securities lending, very little attention is paid to this redistribution function. It is just assumed that if spreads are sufficient, it will happen without fail. Economists think prices are the only influence (except, of course, if it’s the price of a long UST bond).

Collateral flow doesn’t happen without dealers. They are, essentially, the redistribution function matching demand for collateral with the supply of acceptable securities (the latter including other processes dealers contribute, like collateral transformation). Because of these mismatches, the dealer system presents a potential bottleneck where if for whatever reason they don’t fully participate it can lead to often desperate shortages.

In small “e” economic terms, a shortage has a very simple effect on the commodity’s price: it rises sharply.

On May 29, the price of UST’s and German bunds skyrocketed. Unlike October 15, 2014, which was an event of a similar type, this persistent buying was constant all day. Four years ago, it was a short, violent “buying panic.”

On May 17, the UST 10-year yield moved to its widely applauded multi-year high of 3.11%. It hadn’t been that far since summer 2011. At that particular moment, I doubt there was much official talk of the long end being mispriced; or, more likely, that it was still mispriced but at least moving in the right direction to become less so.

Seven trading sessions later, the 10s were instead 2.77%, falling 16 bps on May 29 alone (and it was more to the intraday low). These are not normal, healthy developments.

In Germany, the turmoil was even more pronounced. On May 18, the 10-year bund yield had reached 65 bps. That was down from a multi-year high of 79 bps set in February but up from the low of 50 bps in between. By the close on May 29, the rate was just 24 bps, falling 20 bps in the one day.

Any comments from the official sector about May 29? Nope. How could there be? Must be Italy. The FOMC minutes are the first real reference to it, this “strong worldwide demand for safe assets.” Central bankers may not want to talk about it any other way, but the global bond and money system is still buzzing three months on.

There aren’t a whole lot of statistics that we can turn to in times like these. That’s one reason why Economists are flying so blind all the time, they’ve often purposefully failed to develop first a good sense of what actually happens out there in the money world before creating necessary estimates for all these necessary functions.

This is standard practice for the discipline, though they’ve been careful over the decades to suggest they know all that is worth knowing. The federal funds market unexpectedly revived itself in the early fifties, but it wasn’t until 1957 the Federal Reserve finally got around to studying the thing. The report didn’t come out until May 1959, and the first crude federal funds statistics weren’t created until 1962.

They do their best to ignore monetary evolutions for obvious reasons. The constantly changing condition and pathologies of the system make it difficult if not impossible for central bankers to keep up. After the “missing money” seventies, they decided the money would stay missing. Ironically, it would be the federal funds market they would turn to as a bypass in deference of actual monetary competence.

By targeting nothing other than the federal funds rate, Economists believed they could have it both ways; they would control the monetary system from above while letting it do whatever it did underneath (or in the shadows). The central bank could therefore, in theory, produce predictable results even if they didn’t have any idea how (Positive Economics).

It raises, of course, the kind of questions that we struggle with still today. How would they know when these assumptions were no longer valid? What might happen if, say, the bond market began to reject them and more forcefully signal that things weren’t as officials believed?

We know the answer to that question because for eleven years central bankers keep telling us. Time and again they say markets are mispriced (including the corollary which involves “evil speculators” distorting what would otherwise be in the minds of Economists the “right” market price). The data dependent Fed depends on data that only indicates what they already think.

When analyzing the yield curve late last year, one of the more prominent academic inquisitions carried out by the San Francisco branch of the Fed reached the same sorts of conclusions as those printed in the latest FOMC minutes:

“Data and market commentary suggest that, since March 2017, investors have become increasingly worried about low inflation, and that this concern about downside inflation risk has likely pushed the inflation risk premium into more negative territory. Investors are paying a higher premium for nominal bonds because they value them as a hedge against low inflation.”

The researcher then steps right over the obvious implications of his own statement in order to suggest, again, the bond market is mispriced. According to the Fed, inflation is going to rise and stay that way (economic recovery). What the bond market’s nominal “premium” instead says is that these markets are very much acquainted with how central bankers all over the world keep saying this but that it hasn’t yet happened anywhere.

Since inflation is a monetary phenomenon, it’s all linked; central bank failure, constant monetary problems therefore deflation, and “strong worldwide demand for safe assets.” If you keep doing something and expecting X to result but only get Y, and then markets start to price only Y, who or what is mispriced?

The answer to economic questions that arise from these more technical considerations is pretty straightforward, and it addresses the one I opened with. Scenario Y is the world where economic growth not only isn’t happening today it is highly unlikely to occur up to and beyond the foreseeable future.

But GDP was 4%! Economic growth is not one quarter (or two, in the case of 2014) of what used to count as a decent one. Real growth is that and more each and every quarter, when 2% or as is common now 1% happen so infrequently they are rightly associated only with the onset of recessions. This can’t happen when even what could otherwise be the right conditions are met with constant monetary setbacks.

What keeps holding the economy back is right in front of us staring us in the face. The financial system’s “strong worldwide demand for safe assets” is the answer. Liquidity risks are still paramount even eleven plus years later because liquidity risks remain huge – and often enough realized!

How bad was May 29? Beyond published market prices, we can only appeal to a few other sources. One is the Treasury Department’s TIC series, though the delay in publishing the monthly statistics can be another source of frustration. In the subsection chronicling the cross-border dollar activity of US banks (and therefore their interactions with the offshore eurodollar market in several dimensions) last week Treasury reported for June 2018 a category five hurricane.

US banks apparently told the Department that in the immediate aftermath of May 29 their liabilities to foreign counterparties rose. To those classified as “other” (again, the problem with undeveloped statistics, so much of them is left to unhelpful miscellany), liabilities surged by an absolutely stunning $199.8 billion in just June. In what category? Only the one: miscellaneous short-term negotiable securities.

Economists sitting in Washington desperately trying to get everyone to forget the last decade are certain there is ample liquidity and accommodation in the dollar world for a “strong economy” and inflation. It “should” therefore lead to a bond market massacre the likes of which would make 1994 turn away in horror. They have no skin in the game. Bonds are mispriced only to their detached fantasy.

Those institutions out there in the real world holding down the long end of so many bond market curves all across the globe have to live with, and adapt to, this eurodollar system where May 29 happened, and happens in collateral and other places like FX almost regularly.


It’s a boom alright.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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