Less Inflation Gives Fed Room to Pause

The Fed made lots of headlines last week. Evidence mounted that following another likely rate hike at the FOMC meeting on December 18-19, the monetary policy committee might pause during the first half of next year to reevaluate the course of monetary policy. Not as widely noticed last week was that inflationary pressures may be ebbing, which would also argue for a pause. Consider the following:

(1) PCED. While the labor market continues to tighten and wage gains are picking up, price inflation remains subdued according to the most currently available data. For starters, the core PCED rose 1.8% y/y during October, the lowest such pace since February (Fig. 1). Over the past three months through October, this measure is up just 1.1% (saar), the lowest reading since May 2017 (Fig. 2).

(2) Goods. The core PCED for goods fell -0.6% y/y during October (Fig. 3). The US import price index excluding energy has been moving higher since early 2017 after falling the previous two years. Nevertheless, it was up only 0.7% y/y during October, as a strong dollar this year mostly offset Trump’s tariffs.

(3) Services. The PCED for services excluding energy rose 2.6% y/y during October, an eight-month low (Fig. 4). Wireless telephone services prices fell sharply during 2017, but stabilized this year. So some of the upward pressure on inflation this year simply reflected much less deflation in this services category (Fig. 5).

(4) Rent. More importantly, the rate of inflation for rent of primary residences has been moderating over the past two years after rising sharply during most of the current expansion (Fig. 6). It was still high at 3.6% during October. But the boom in multi-family housing construction in recent years may be closing the gap between the demand and the supply of rental housing units.

(5) Medical care. Of even greater importance may be what is happening to prices in the health care industry. They aren’t rising much at all (Fig. 7). Over the past 12 months through October, the PCED for medical care is up just 1.3%, with hospital and physician services up only 1.5% and 0.7%, respectively, and prescription drug prices up just 0.8%! The moderation in the latter might reflect pressure from the Trump administration on drug companies to keep a lid on their prices. The services components of health care may finally be experiencing long-overdue upturns in their productivity, which may be a long-term phenomenon as new competitors—most notably Amazon—enter the field.

(6) Regional price surveys. Five of the Fed’s regional district banks include questions on prices paid and prices received in their monthly surveys. I monitor the averages of each of these two series (Fig. 8). Both peaked during July and have been edging down since then through November.

(7) Oil. Helping to moderate inflationary expectations has been the recent 31% plunge in the price of a barrel of Brent crude oil since October 3 through Friday (Fig. 9). Technological innovation continues to disrupt the global oil industry, as US frackers are now producing almost 12.0mbd (Fig. 10). US crude oil exports have doubled since mid-January 2015 to 7.4mbd currently (Fig. 11).

(8) Real wages and productivity. Average hourly earnings rose 3.2% y/y during October, while the overall PCED rose 2.0% over the same period. As a result, inflation-adjusted wages rose to yet another record high (Fig. 12). This measure has been on a solid uptrend since the mid-1990s, blowing away the myth that real wages have stagnated for decades.

This couldn’t have been happening unless productivity has also been performing better than suggested by the data, which were revised higher for the late 1990s and may be revised higher for the current expansion, in our opinion. Another reason to believe that productivity is underestimated is that the S&P 500 profit margin, which we calculate from industry analysts’ consensus estimates for S&P 500 companies’ earnings and revenues, has been soaring to new record highs since late last year (Fig. 13). How did that happen if productivity has been as weak as widely believed? (It can’t all be explained by the cut in the corporate tax rate at the end of 2017.)

In an 11/27 speech, Fed Vice Chairman Richard Clarida acknowledged as much when he rhetorically asked: “What might explain why inflation is running at or close to the Federal Reserve's long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust?” He concluded that the answer might be that while “growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year's growth in actual aggregate supply.” The explanation is better-than-expected growth in productivity. If this keeps up, we will all be supply-siders.

Analysts Still (Too) High on S&P 500 Earnings

The latest earnings reporting season seemed to contribute to the sharp selloff in stocks during October, as some companies reported bullish earnings that were more than offset by bearish guidance about future earnings prospects. Collectively, however, the S&P 500 companies’ Q3 earnings results reported through the 11/8 week were 4.9% better than analysts had expected during the 9/28 week, i.e., just before the start of the latest earnings season (Fig. 1). As I’ve noted many times before, this pattern is par for the course. (The pattern shows up on our “earnings squiggles” data series as a hook at the end of the line—see our S&P 500 Earnings Squiggles Annual & Quarterly.)

In aggregate, the negative guidance corporate managements provided during earnings conference calls somewhat deflated analysts’ consensus earnings estimates for Q4-2018 and the quarters of 2019 (Fig. 2). However, the 2018 estimated earnings growth rate held steady during the 11/1 week from the week before at 23.6%, the highest reading ever for this data series (Fig. 3 and Fig. 4). The 2019 estimated growth rate edged down to 9.4%. The 2020 projected growth rate remained solid at 10.2%.

In other words, the Q3 results didn’t curb analysts’ enthusiasm for earnings growth this year and the coming two years. I, however, curbed my enthusiasm for the earnings outlook on October 30. Here’s more on why I did so:

(1) Me vs them. I lowered my estimates for earnings growth during 2019 and 2020 to 4.9% and 5.3% from 6.8% and 8.8%. I am predicting S&P 500 earnings per share will be $162 this year, $170 next year, and $179 in 2020 (Fig. 5). During the 11/8 week, the comparable analysts’ consensus estimates were $162.67, $177.69, and $194.55.

(2) Revenues slowdown ahead. The growth rate of S&P 500 revenues has been remarkably strong this year, which has contributed—along with the corporate tax rate cut at the end of last year—to the strength in earnings growth. Revenues per share rose 11.2% y/y during Q2, the highest growth rate since Q2-2011 (Fig. 6).

Industry analysts are expecting a slowdown in revenues-per-share growth from 8.5% this year to 5.5% in 2019 and 4.4% in 2020 (Fig. 7). That makes sense to me, since the trend growth rate of revenues has been roughly 4.0% (Fig. 8).

In addition, the global economic outlook is deteriorating, as evidenced by the weakening trends in recent months in both the OECD Leading Indicators and the Global Composite PMI (Fig. 9 and Fig. 10).

(3) Profit margin unlikely to set new records. What doesn’t make sense to me is the implication of analysts’ consensus earnings and revenues estimates that the S&P 500 operating profit margin will continue to rise to record highs. Their latest numbers imply that the profit margin will rise from 11.9% this year to 12.4% next year and 13.1% in 2020 (Fig. 11). For perspective, Thomson Reuters data show that the operating profit margin rose to a record-high 10.9% at the end of 2017 before the corporate tax cut. After the cut, it rose to fresh record highs of 11.9% during Q1 and 12.3% during Q2 (Fig. 12).

During the Q3 earnings season, many company managements warned that, in addition to their revenues growth being weighed down by the global economic slowdown, their profit margins were likely to be squeezed by higher labor costs as well as the impacts of tariffs, which were raising their materials costs and disrupting their supply chains. They didn’t say whether they expected to offset some of those higher costs with productivity gains.

So I don’t expect the S&P 500 profit margin to rise further from here. If it remains flat in record-high territory over the next two years, then earnings growth will match revenues growth. And if that happens, then industry analysts will be lowering their heady growth rates for earnings.

Fed’s R-Star Is A Black Hole

President Donald Trump must regret that he didn’t renew Janet Yellen’s contract to head the Fed for another four years. She probably would have been more accommodating to his supply-side policies. They both are populist do-gooders at heart. They want as many people to get jobs as possible.

Instead, Trump appointed Jerome Powell to be the new Fed chairman at the start of this year. Powell had been the vice chairman under Yellen. Trump appointed Richard H. Clarida to fill Powell’s vacant position after he was promoted. Both Powell and Clarida are all for continuing to raise interest rates. Both see strong economic growth and a tight labor market as potentially inflationary. So they want to raise interest rates to avert this scenario, by slowing the economy down.

No wonder that the 10/23 WSJ reported that President Donald Trump directly accused Powell of endangering the US economy by raising interest rates: “I’m just saying this: I’m very unhappy with the Fed because Obama had zero interest rates.” He also complained that “[e]very time we do something great, [Powell] raises the interest rates.”

I am convinced that last month’s stock market rout started on October 3, when Fed Chairman Jerome Powell said in an interview with Judy Woodruff of PBS: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore.” CNBC also reported that Powell said: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” The CNBC article was alarmingly headlined as follows: “Powell says we’re ‘a long way’ from neutral on interest rates, indicating more hikes are coming.”

The S&P 500 dropped 9.1% from the close on October 2 through last Friday’s close as Fed officials continued to hammer home Powell’s narrative (see top chart).

For example, in his first public speech as vice chairman last week on Thursday, Clarida explained why he thinks higher interest rates are in order. Sadly, it’s the same old party line that Fed officials have been spouting for a while to explain their gradual normalization of monetary policy. Here it is in brief:

(1) Star struck and star stuck. Clarida along with other Fed officials are star struck. They are stuck on the fanciful notion that the federal funds rate should be set relative to “the longer-run neutral real rate,” often referred to as “r-star,” or “r*.” Clarida acknowledges that it is an “unobservable and time varying” variable. However, fear not: It is “computed from the projections submitted by Board members and the Reserve Bank presidents.” The real rate is the nominal rate minus the inflation rate. Adjusting an overnight rate using a one-year inflation rate is just one of the many mind games Fed officials like to play.

It gets even worse: Clarida admits that r* “must be inferred as a signal extracted from noisy macro and financial data. That said, and notwithstanding the imprecision with which r* is estimated, it remains to me a relevant consideration as I assess the current stance and best path forward for policy.”

He then goes on to quote a reputable authority on matters of economic astronomy (astrology, actually): “The reason for this is because, as Milton Friedman argued in his classic American Economic Association presidential address, a central bank that seeks to consistently keep real interest rates below r* will eventually face rising inflation and inflation expectations, while a central bank that seeks to keep real interest rates above r* will eventually face falling inflation and inflation expectations.” (Friedman, of course, was the father of monetarism, which has been mostly relegated to the dustbin of economic history.)

By the way, unobservable stars tend to be black holes!

All this suggests that the best measure of whether the real (and nominal) federal funds rate is too low or too high relative to the phantom r* is the actual inflation rate. So by Clarida’s own logic, if inflation remains subdued around the Fed’s 2.0% target, as it continues to do, why should the Fed raise interest rates at all?

(2) The new abnormal. That’s a good question. The Fed’s house view is that monetary policy has been set on a course of “normalization,” with the aim of raising the nominal federal funds rate to a more normal and neutral level of 3.00%, after interest rates were near zero from 2009 through 2015. The problem is that no one really knows if that’s the right level after so many years of abnormally easy monetary policy. What if the neutral federal funds rate is 2.00% rather than 3.00%? In that case, further rate hikes will be restrictive even though inflation remains subdued. (See our FOMC September 2018 Summary of Economic Projections, September 2018-2021 & Beyond tables.)

That’s why the stock market plunged in October. Instead of setting the course of normalization on autopilot with 25bps hikes following the March, June, September, and December meetings of the FOMC, why not try a more gradual pace of increases with longer pauses to assess whether the course of normalization needs to be recalibrated?

(3) Accommodative or not? Recall that the latest, 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. In his press conference that same day, Powell minimized the import of this development, saying that the language simply had outlived its “useful life.” He contradicted that assessment on October 3, helping to set the stage for October’s stock market meltdown.

Furthermore, how does that square with Clarida saying that the federal funds rate needs to be raised some more because it is still below r*? There certainly is a big inconsistency between the change in the 9/26 statement and Clarida stating, “However, even after our September decision, I believe U.S. monetary policy remains accommodative.”

(4) Phillips’ disciples. Now that the unemployment rate is down to 3.7%, the lowest since December 1969, Fed officials seem most concerned that the tight labor market will boost inflation. They’ve mostly admitted that the Phillips curve trade-off between unemployment and inflation has flattened out. Yet they still fear that it will make a big comeback unless they continue to raise interest rates. Granted, wage inflation has risen recently to 3.0%, but it might very well be justified by a long-awaited rebound in productivity growth.

Nevertheless, Fed officials figure that by raising the nominal federal funds rate to a neutral rate of 3.00%, they will keep price inflation around their cherished 2.0%. However, their latest dot plot shows that the FOMC’s median estimate of the longer-run unemployment rate—a.k.a. “NAIRU,” the nonaccelerating inflation rate of unemployment—is 4.5%.

In other words, they are saying that to keep a lid on inflation, they have to raise the federal funds rate—up to a restrictive 3.40%, they currently reckon according to the latest dot plot—until the jobless rate rises back from 3.7% to 4.5%! That would imply a sharp economic slowdown indeed. So they figure that they could then lower the federal funds back down to their cherished 3.00%, i.e., the nominal version of r*.

Yet Clarida admits that NAIRU might be lower than 4.5%. So far, it certainly seems to be lower given that a 3.7% jobless rate isn’t boosting inflation much at all (see bottom chart). In his speech, Clarida said that NAIRU “may be somewhat lower than I would have thought several years ago.” He added: “With unemployment falling and wage gains thus far in line with productivity and expected inflation, the traditional indicators of cost-push price pressure are not flashing red right now.” You think?

(5) Raising rates to lower them. I believe that Powell is more of a pragmatist than Yellen. His unspoken game plan may simply be to raise the federal funds rate to 3.00% or even 3.50% so that when the next recession occurs, the Fed will have 300-350bps of leeway between the federal funds rate and zero. That’s fine, but longer pauses between rate hikes may increase the odds of raising the federal funds rate that high without triggering a financial crisis and a recession.

(6) Trump’s regrets. It’s no wonder that in the 10/23 WSJ interview linked above, Trump said: “To me the Fed is the biggest risk, because I think interest rates are being raised too quickly.” As for why he thought Powell was raising rates, Trump said: “He was supposed to be a low-interest-rate guy. It’s turned out that he’s not.” Does Trump regret nominating Powell? It’s “too early to say, but maybe,” the President said. Think of Powell and Clarida as Trump’s regrettables.

I was on CNBC last Friday. My message was: “We need the Fed to pause here and just take a breather. Let’s see how the economy plays out, and that will help the stock market a lot.” I concluded: “Fed officials have been talking like mission accomplished—that it’s the best economy that we’ve ever had. If it’s the best economy that we ever had, why raise interest rates? Why not leave it be if it’s growing with low inflation?”

Fed’s Restrictive Chatter Rattles Stocks

Some Fed officials have signaled in the weeks since the September 25-26 FOMC meeting that the economy may be so strong that they might have to raise the federal funds rate higher than they had mentioned doing in the past. That would be unfortunate given how well they’ve prepared the financial markets for a federal funds rate raised to 3.00% by the end of 2019. Now they’re talking more about 3.40% in 2020. Is that really necessary? A “gradual normalization” of the federal funds rate to what they’ve claimed is a “neutral” rate (3.00% in 2019) has been clearly telegraphed and is widely anticipated. Why suddenly speculate about turning restrictive in 2020?

It was widely noted that the 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. Some interpreted the omission to mean that the Fed is setting up for more aggressive rate increases. On the contrary, at his 9/26 press conference, Fed Chairman Jerome Powell reassuringly said that the language simply had outlived its “useful life.” So the Fed will continue its gradual rate increases toward a neutral stance.

Nevertheless, the markets are starting to fear that the Fed may be heading toward restricting economic growth. Consider the following:

(1) The dot plots. The Fed’s quarterly dot plot has become the semi-official playbook for the FOMC. It showed that on March 21, the committee’s median forecast for the federal funds rate was raised from 3.1% in 2020 to 3.4%, further above the “longer-run” forecast of 2.9%, which had also been raised from 2.8%, as shown in Table 1.

(2) The latest minutes. Despite the March 21 increase in the 2020 federal funds rate forecast, the S&P 500 rose 13.6% from this year’s low on February 8 to a record high on September 20. It’s down since then, partly because Fed officials have upped the ante by signaling that their policy might have to turn from accommodative to neutral to outright restrictive given the strength of the economy. That gave the 3.4% forecast for 2020 more credibility. So, for example, the word “restrictive” appeared in September’s FOMC minutes for the first time during the current economic expansion as follows:

“Participants offered their views about how much additional policy firming would likely be required for the Committee to sustainably achieve its objectives of maximum employment and 2 percent inflation. A few participants expected that policy would need to become modestly restrictive for a time and a number judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level in order to reduce the risk of a sustained overshooting of the Committee’s 2 percent inflation objective or the risk posed by significant financial imbalances. A couple of participants indicated that they would not favor adopting a restrictive policy stance in the absence of clear signs of an overheating economy and rising inflation.”

(3) Brainard & Powell open to overshooting neutral. During the Q&A of his press conference, Powell was asked whether the Fed might end the tightening cycle in a “restrictive posture,” as Fed Governor Lael Brainard had suggested in a 9/12 speech. Powell responded: “It’s very possible.” He added: “Maybe we will keep our neutral rate here [i.e., at 3.00%], and then go one or two rate increases beyond it.” If the US economy continues to perform as the Fed expects, we expect that the Fed will stop tightening at around 3.25%-3.50% during 2020. That would be two 25-basis-point hikes above the SEP’s longer-run projection of 3.00% for the federal funds rate.

In her speech, Brainard explained: “In the latest FOMC SEP median path, by the end of next year, the federal funds rate is projected to rise to a level that exceeds the longer-run federal funds rate during a time when real GDP growth is projected to exceed its longer-run pace and unemployment continues to fall. The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis.”

Now let’s review the FOMC’s other economic projections. For real GDP growth, Table 2 shows that the median forecast of the FOMC has increased from 2.5% at the end of last year for this year to 3.1% in September’s SEP. Growth is expected to decelerate to 2.5% next year, to 2.0% in 2020, and to only 1.8% in 2021, which is deemed to be the long-run potential of the economy.

That’s a fairly dour outlook. FOMC participants aren’t buying the supply-side story that tax cuts may boost productivity. So they feel compelled to raise rates to slow the economy back down to its long-run potential to keep inflationary pressures from rising as a result of the short-run stimulative impact of Trump’s tax cuts. No wonder Trump isn’t happy with Powell. He probably regrets not having extended Janet Yellen’s employment contract.

The SEP also shows that the median forecast for the unemployment rate fell from 3.9% at the end of last year for this year to 3.7% last month. Next year, it is expected to fall to 3.5% and stay there through 2020. But then it is projected to edge back up to 3.7%. The long-run jobless rate is deemed to be 4.5% (Table 3). No wonder Fed officials are talking about turning restrictive: They believe the unemployment rate is already well below its non-accelerating inflation rate of unemployment (NAIRU)!

What if they are wrong and inflation remains subdued, as I expect? If that happens, then Fed officials may have to acknowledge that NAIRU might be lower than they currently believe. The Congressional Budget Office (CBO) estimates that NAIRU is currently between 4.5% and 5.0% (Fig. 1). The actual unemployment rate fell well below that range, to 3.7%, during September, yet inflation hasn’t accelerated. Could it be that NAIRU, which is unobservable, might be lower than the CBO’s model estimates? I think so. By the way, the CBO’s model also shows the ratio of actual real GDP to potential at 1.0 during Q2, the highest since Q4-2007 (Fig. 2).

Finally, the SEP’s median inflation forecast, based on the core PCED, is remarkable. For this year, it was raised from 1.9% at the end of last year to 2.0%. Over the next two years, it is expected to be 2.1%. FOMC participants believe that, thanks to their monetary policymaking, inflation will remain right in line with their 2.0% target for the foreseeable future (Table 4).

Could it be that Fed officials have too much free time on their hands, and that’s why they concoct all sorts of cockamamie theories? For example, consider the 10/18 speech by Fed Governor Randal K. Quarles titled “Don’t Chase the Needles: An Optimistic Assessment of the Economic Outlook and Monetary Policy.” He starts with two Hamletesque questions:

“How long can this strong growth be sustained? The answer depends largely on what form growth takes. Growth that is supported by increases in the productive capacity of the economy should be durable. However, if growth primarily reflects strong demand that stretches production beyond its sustainable capacity, the economy will run into constraints that will result in slower growth, higher prices, or a potentially destabilizing buildup of financial imbalances. So, which is it?” He isn’t sure, which is why he supports the Fed’s gradual normalization of monetary policy.

Quarles hopes that there is still enough slack in the labor market and that technological innovations will boost productivity growth enough to boost potential output without reviving inflation. He fears that if that doesn’t happen, then strong demand could lift inflation.

He acknowledges that “potential output is unobserved and can only be inferred from the behavior of other measured economic indicators.” He states that inflation is “the primary indicator of the economy’s position relative to [its] potential.” Now put on your thinking caps:

“Perhaps inflation is just sending a signal of people’s trust in the Fed’s ability to meet its inflation objective. If so, no complaints here. That is a good thing. However, a problem does arise if the Fed remains reliant on inflation as our only gauge of the economy’s position relative to its potential. There are risks in pushing the economy into a place it does not want to go if we limit ourselves to navigating by what might be a faulty indicator. Anchored inflation expectations might mask the inflation signal coming from an overheated economy for a period, but I have no doubt that prices would eventually move up in response to resource constraints. The ultimate price, from the perspective of the dual mandate, would be an unanchoring of inflation expectations.”

I hope no further explanation is required, because I’m not sure there is much more I could add to explain this head-spinning concept.

Trump’s Poison Pills for China

A week ago I wrote about “China’s Syndromes.” I noted that aging demographic forces, which were significantly exacerbated by the Chinese government’s one-child policy, are already depressing the growth rate of real retail sales in China (Fig. 1 and Fig. 2). As a result, the government is scrambling to expand its overseas military and economic power to counter the structural weakness at home.

I argued that President Donald Trump is implementing policies aimed at either slowing or halting China’s drive to become a superpower. He wants to reduce America’s huge trade deficit with China by forcing US and other manufacturers to move out of that country. In the process, the US would no longer be financing China’s ascent with our trade deficit and providing technological know how that has been either stolen or extorted.

I didn’t have to wait long to get confirmation of my working hypothesis. Consider the following fast-paced developments:

(1) The President’s speech. In his 9/25 speech before the United Nations General Assembly, Trump said only the following about China, focusing on trade: “The United States lost over 3 million manufacturing jobs, nearly a quarter of all steel jobs, and 60,000 factories after China joined the WTO. And we have racked up $13 trillion in trade deficits over the last two decades. But those days are over. We will no longer tolerate such abuse. We will not allow our workers to be victimized, our companies to be cheated, and our wealth to be plundered and transferred. America will never apologize for protecting its citizens. … China’s market distortions and the way they deal cannot be tolerated.”

(2) The Vice President’s speech. In a 10/4 speech at the Hudson Institute, Vice President Mike Pence discussed the administration’s policy toward China in far greater detail. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.”

He accused the Chinese Communist Party of using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment. These policies have built Beijing’s manufacturing base, at the expense of its competitors—especially the United States of America.”

He specifically berated the party’s “Made in China 2025” plan for aiming to control 90% of the “world’s most advanced industries including robotics, biotechnology, and artificial intelligence. To win the commanding heights of the 21st century economy, Beijing has directed its bureaucrats and businesses to obtain American intellectual property—the foundation of our economic leadership—by any means necessary.” He accused the Chinese of stealing US technology including cutting-edge military blueprints. “And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale,” he said.

He point-blank accused China of economic and military aggression abroad: “[W]hile China’s leader stood in the Rose Garden at the White House in 2015 and said that his country had, and I quote, ‘no intention to militarize’ the South China Sea, today, Beijing has deployed advanced anti-ship and anti-air missiles atop an archipelago of military bases constructed on artificial islands.” The result has been provocative and dangerous near misses between our two navies in the South China Sea.

Pence also documented instances of China using so-called “debt diplomacy” to expand its influence: “Today, that country is offering hundreds of billions of dollars in infrastructure loans to governments from Asia to Africa to Europe and even Latin America. Yet the terms of those loans are opaque at best, and the benefits invariably flow overwhelmingly to Beijing.”

The US has responded by boosting defense spending and slapping tariffs on China. These “exercises in American strength” explain why China’s largest stock exchange fell by 25% in the first nine months of this year. Got that? The US is targeting China’s stock market!

Pence accused the Chinese government of oppressing its own people at home. He railed about the Great Firewall of China “restricting the free flow of information to the Chinese people.” Even more frightening, he said, is the “Social Credit Score,” which, according to the official blueprint, will “allow the trustworthy to roam everywhere under heaven, while making it hard for the discredited to take a single step.” It will be implemented in 2020.

Pence also attacked the Chinese government for meddling in US politics in an effort to weaken America. He claimed that in June, “Beijing itself circulated a sensitive document, entitled ‘Propaganda and Censorship Notice.’ It laid out its strategy. It stated that China must, in their words, ‘strike accurately and carefully, splitting apart different domestic groups’ in the United States of America.”

There are lots more complaints about China in Pence’s speech. Clearly, the Trump administration’s policy toward China isn’t just about trade. A 10/5 NYT article critically stated that Pence in effect had declared a “New Cold War” with China. An alternative spin is that Pence was simply recognizing that China has launched an ever-expanding war against American interests.

(3) The poison pill placed in USMCA. A 10/5 CNBC article noted that there is a provision in the newly passed North American trade agreement, the United States-Mexico-Canada Agreement (USMCA, a.k.a. “the new NAFTA”), “which effectively gives Washington a veto over Canada and Mexico’s other free trade partners to ensure that they are governed by market principles and lack the state dominance.” In effect, that’s a “poison pill” aimed at China.

When Trump was elected, I observed that after eight years of government by community organizers, we were about to have a major regime change with government by dealmakers. US Commerce Secretary Wilbur Ross, a consummate wheeler-dealer when he was in the private sector, signaled on Friday that Washington may insist on including this poison-pill provision in future bilateral trade deals. “People can come to understand that this is one of your prerequisites to make a deal,” he said.

(4) JP Morgan’s bearish call. Last Wednesday, JPMorgan strategists wrote in a note that “[a] full-blown trade war becomes our new base case scenario for 2019” with 25% US tariffs imposed on all Chinese goods. They added, “There is no clear sign of mitigating confrontation between China and the U.S. in the near term.” In his 10/5 Barron’s column, Randy Forsyth noted that the bank’s strategists “estimate that 25% levies on all Chinese imports to the U.S. would trim earnings for the S&P 500 by $8 a share, from their original projection of $179 for 2019. ‘Such a downgrade would mark the first of the Trump era and potentially end the U.S. stock market rally, even assuming a forward [price/earnings] multiple of 17, unless some other offset materializes,’ they conclude.”

I agree that Trump will probably slap Chinese goods with an across-the-board 25% tariff. I think that the US economy will be strong enough to boost S&P 500 earnings by 6.8% to $173 per share, which has been our number for next year for a while. I don’t think that the escalating trade war with China will be the event that ends the bull market in the US (Fig. 3). However, it may already be marking the beginning of a severe and prolonged bear market in China (Fig. 4).

While financial markets were closed all last week in China for the Golden Week vacation, Hong Kong stocks fell for four consecutive days as investors grew increasingly concerned that the impact of the trade war is starting to show.

On Sunday, the People’s Bank of China slashed the reserve requirement ratio for large banks (currently 15.5%) and small banks (13.5%) by 100 basis points effective October 15 (Fig. 5). This is the fourth such cut this year. The prime rate is also likely to be cut soon (Fig. 6). Beijing has pledged to expedite plans to invest heavily in infrastructure projects as the economy shows signs of cooling further, with investment growth recently slowing to a record low.

CNBC reported yesterday, “On the back of the central bank’s announcement, China’s mainland markets traded in negative territory for much of their first trading day following the Golden Week holiday. Both the Shanghai composite and the Shenzhen composite fell more than 3.7% by the end of the trading day.” The two indexes peaked this year on January 24 and are down 23.7% and 25.0%, respectively (Fig. 7). China’s MSCI is down 26.0% from its peak on January 26. Hong Kong’s Hang Seng is down 21.0% from its peak also on that day (Fig. 8).

(5) Cyber war. The 10/4 Bloomberg Businessweek included a cover story titled “The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies.” The story is based on information from multiple intelligence and business sources who confirmed that Chinese spies attacked almost 30 US companies, including Amazon and Apple, “by compromising America’s technology supply chain, according to extensive interviews with government and corporate sources.” Operatives of the People’s Liberation Army inserted tiny microchips designed for spying in motherboards made in China and sold to American companies.

Both Amazon and Apple denied they had been hacked. Whether accurate or fake news, the story certainly could convince many companies to cut China out of their supply chains. That would fit in nicely with the Trump administration’s campaign to move production out of China back to the US.

(6) Bottom line. Trump’s fiscal, trade, and sanctions policies have boosted the dollar, oil prices, and interest rates. The risk, of course, is that these developments could punish not only China but lots of other emerging market economies as well. In the US, higher oil prices along with higher interest rates could also weigh on the US economy. Those are the major foreseeable risks. For now, I don’t see this all leading to a financial crisis or a recession. But I’m on alert: There sure are lots of poison pills out there!

China’s Syndromes

China I: Getting Trumped. I’m coming around to a new working hypotheses on the outlook for China’s economy. I think it could be much weaker much sooner than widely recognized. A significant slowing in the growth rate of inflation-adjusted retail sales over the past couple of years suggests that the aging demographic factor—attributable to the government’s previous population control measure—may be hitting consumer spending significantly already. As a result, Trump’s escalating trade war with China may very well hurt China’s economy much harder than widely realized.

Furthermore, what if Trump’s trade war with China isn’t just about trade? Yes, we all know it is also about intellectual property rights. But what if at heart it’s about China’s superpower ambitions—as evidenced by its moves to control the South China Sea, to build the “Silk Road” linking China to Europe by way of Central Asia, and to exploit the resources of Africa? The Chinese government, under President-for-life Xi Jinping, is intent on challenging America’s status as the world’s sole superpower. So why should the US continue to enable Xi’s geopolitical masterplan by allowing the Chinese to run a huge trade surplus with the US and to steal US technology?

The Trump administration’s overarching policy goal vis-à-vis China, therefore, may be first and foremost to use America’s economic power to slow, or even halt, the ascent of China into a superpower, which will challenge America’s interests around the world. If so, then any concessions that the Chinese make on trade and technology are likely to be rejected by the Trump administration. In other words, they have nothing to offer that would satisfy Trump other than an unconditional retreat from their geopolitical expansion plans, which they will never do voluntarily.

So Trump may very well raise the ante soon by slapping a permanent 25% tariff on all goods that the US imports from China. The goal isn’t to force concessions out of China but rather to get manufacturers out of China and into either the US (ideally) or to countries such as Mexico that do agree to the terms of bilateral trade deals with the US!

Of course, manufacturers who stay in China won’t be paying the 25% tariff: US consumers who buy China-made goods will be hit with that price hike. However, to remain competitive in the US, manufacturers are likely to scramble to other countries that can export to the US without having the US dollar price of their goods marked up by 25%.

I have one piece of anecdotal evidence that companies may be starting to move out of China already. A good friend of mine has a small business in Manhattan designing and selling high-end raincoats in the US. He has been manufacturing them in Vietnam. He stopped making them in China a few years ago because labor costs have been rising there, while they remain low in Vietnam. He told me he was shocked recently when his Vietnamese vendor had to lengthen delivery schedules from four months to six months because it was swamped with orders that used to be filled in China prior to Trump’s trade war.

Now consider the following recent developments before we review China’s depressing demographic outlook:

(1) Peter Navarro’s view. A Monday 9/24 CNBC article reported that Peter Navarro, director of the National Trade Council at the White House, said getting a trade deal with China will be tough: “The challenge is, they've engaged in so many egregious practices that it's far more difficult to make a deal with China than it would be with Mexico.” Navarro is a former economics professor and author of The Coming China Wars: Where They Will Be Fought, How They Can Be Won (2006).

A 6/24 Axios article quoted Navarro saying: “Since China joined the WTO [i.e., the World Trade Organization] in 2001, the U.S. has lost over 70,000 factories, more than five million manufacturing jobs, and suffered from substantially lower real GDP growth rates. As America’s manufacturing and defense industrial base has weakened, China’s has strengthened and we now face a strategic rival in places like the South China Sea whose military forces have been largely financed by the massive trade deficits the U.S. runs with China.”

Navarro had more to say on this subject in a 6/20 WSJ article titled “Trump’s Tariffs Are a Defense Against China’s Aggression: Beijing seeks economic and military domination by taking U.S. technology and intellectual property.” His opening paragraph said it all: “The Chinese government’s Made in China 2025 blueprint reveals Beijing’s audacious plans to dominate emerging technology industries. Many of these targeted sectors, such as artificial intelligence and robotics, have clear implications for defense. China seeks to achieve its goal of economic and military domination in part by acquiring the best American technology and intellectual property. President Trump’s new tariffs will provide a critical shield against this aggression.”

(2) Higher tariffs. Also on Monday 9/24, Washington slapped tariffs of 10% on $200 billion of Chinese products that include furniture and appliances, and the rate will increase to 25% by the end of the year. President Xi Jinping's government retaliated by imposing taxes on 5,207 US imports, worth about $60 billion. Products such as liquefied natural gas, coffee, and various types of edible oil will see a 10% levy, while a 5% tax will be imposed on items such as frozen vegetables, cocoa powder, and chemical products.

The US and China already had applied tariffs to $50 billion of each other's goods. Trump has warned that any retaliation by China would prompt Washington to “immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.”

Trump has overtly expressed his desire to narrow the US trade deficit with China significantly and to bring back manufacturing capacity to the US, so he may not declare victory in his trade war with China until Apple is making most of its iPhones in the US. It’s also conceivable that Trump may be mollified if Chinese leaders relinquish at least some of the country’s unfair trade practices, especially those related to foreign technology investment. But even if Trump’s negotiations with China and other countries don’t succeed in getting what he wants, they may succeed in providing more opportunities for the US to shop around for fairer trading partners.

Interestingly, cell phones and other household items is the largest category of imports to the US from China, according to the World Economic Forum. China isn’t the only place in the world to make cell phones, though. South Korean electronics giant Samsung is “now looking to fend off Chinese companies trying to dominate the market for inexpensive phones” by expanding manufacturing into India, according to an article in the 9/4 WSJ. The company’s new facility in a New Delhi suburb, to be completed in 2020, will eventually make 120 million handsets a year, or roughly one of every 13 phones in the world. Around 30% of those will be exported.

(3) Arms race. On Thursday 9/20, Washington imposed sanctions on a Chinese military unit for purchasing Russian weapons, claiming the transaction violated a US sanctions law known as “Countering America's Adversaries Through Sanctions Act,” which was signed by President Trump on August 2, 2017. The act imposed sanctions on Iran, North Korea, and Russia. The Chinese government summoned the US ambassador in Beijing over the matter and said Beijing would recall its navy chief from a visit to the US.

On 9/25, the US approved a $330 million arms sale to Taiwan in another sign of Washington’s support for the government in Taipei amid rising Chinese pressure on the country. In the latter years of George W. Bush’s presidency, Washington dropped annual weapons sales to Taiwan in favor of bundling sales every few years, a move that was seen as acquiescence to pressure from China. Under Trump, there may be a return to the routine sale of weapons to Taiwan, despite protests from China.

Meanwhile, China has sought to strengthen its claim to the South China Sea by building seven islands on reefs and equipping them with military facilities such as airstrips, radar domes, and missile systems. Five other governments claim territory in the oil- and gas-rich area, through which an estimated $5 trillion in global trade passes annually. Last Thursday, China called a recent mission by nuclear-capable US B-52 bombers over the disputed South China Sea “provocative.”

China II: Why Trump Won. Trump won on November 8, 2016 because he appealed to voters who lost manufacturing jobs after China entered the WTO and manufacturers left the US. Previously, I’ve shown a chart that clearly shows this development. It tracks US manufacturing production and capacity since January 1948 (Fig. 1). The two were on similar and solid uptrends—tracking at about 4% per year on average—until China joined the WTO during December 2001. Both have been flat ever since. I estimate that if the trend prior to December 2001 had persisted, US manufacturing capacity would be 77% higher than it was during August of this year (Fig. 2)!

We can also guesstimate China’s impact on jobs. Factory payrolls dropped 4.3 million from December 2001 (when China joined the WTO) through March 2010 to the lowest level since March 1941 (Fig. 3). They were still down 3.4 million through Election Day 2016 and 3.0 million through August of this year.

The ratio of US factory jobs to capacity has declined 24% since the end of 2001 through August of this year, presumably reflecting productivity gains (Fig. 4). If capacity had remained on its uptrend prior to China joining the WTO, factory employment arguably would be 53%, or 6.7 million jobs, higher than August’s level of 12.7 million. (We derived the percentage increase by subtracting 77% from 24%.)

So Trump’s victory on Election Day 2016 may largely reflect the hostile reaction of America’s manufacturing Heartland to China’s ascent, presumably at US factory workers’ expense.

China III: The Most Important Indicator. While manufacturing employment may be the key indicator explaining why Trump beat Clinton, inflation-adjusted retail sales in China may be the most important variable for tracking the impact of China’s increasingly dismal demographic profile on its economy. Consider the following:

(1) Real retail sales. Every month, the Chinese report retail sales and the consumer price index (CPI). We’ve been monitoring the yearly percent changes in both for many years (Fig. 5). The difference between the two is the growth rate in real retail sales. It has been on a downtrend since 2008-2010 when it typically exceeded 15%. During August of this year, it was down to 6.7%, one of the lowest readings since China joined the WTO at the end of 2001. It is down from 9.3% two years ago.

(2) Industrial production. Real retail sales has actually been growing faster than industrial production since early 2012 (Fig. 6). The latter has been growing around 6.0% y/y since 2015. It is likely to fall sooner rather than later if the downtrend in real retail sales persists (as suggested by the demographic trends discussed below) and Trump’s trade war weighs on exports.

(3) Credit. All of the above suggests that the Chinese government may have no choice but to continue propping up economic growth with debt-financed infrastructure spending. Bank loans (in yuan) have quadrupled in China since February 2009 (Fig. 7). Yet the Chinese are getting less and less bang per yuan. The ratio of Chinese industrial production to bank loans has dropped by roughly 50% since late 2008 (Fig. 8).

It’s possible that my analysis so far is too negative. Missing is the growing importance of services industries in China. Nevertheless, demography is destiny, and the Chinese government made an increasingly dismal global outlook on this front much worse in China.

China IV: Depressing Demographic Destiny. In Chapter 16 of my book, Predicting the Markets, I discuss China’s depressing demographic destiny. That discussion is especially relevant to today’s commentary:

“The fertility rate in China plunged from 6.1 in the mid-1950s to below 2.0 during 1996 (Fig. 9). Still below 2.0, it’s projected to remain so through the end of the century. Initially, the drop was exacerbated by the government’s response to the country’s population explosion, which was to introduce the one-child policy in 1979. While that slowed China’s population growth—to a 10-year growth rate of 0.5% at an annual rate in 2016 from a 3.0% pace in 1972—it also led to a shortage of young adult workers and a rapidly aging population.

“So the government reversed course, with a two-child policy effective January 1, 2016. Births soared by 7.9% that year with the deliveries of about 18 million newborns. But that was still short of the government estimates and might not be sustainable. At least 45% of the babies born during 2016 were to families that already had one child. [For more, see link.]

“Meanwhile, urbanization has proceeded apace, with the urban population rising from about 12% in 1950 to 49% during 2010; it was an estimated 57% in 2016 (Fig. 10). The urban population has been increasing consistently by around 20 million in most years since 1996 (Fig. 11). To urbanize that many people requires the equivalent of building one Houston, Texas per month, as I discuss in Chapter 2. I first made that point in a 2004 study.

“The move to a two-child policy is coming too late, in my opinion. China’s primary working-age population peaked at a record high of just over 1.0 billion during 2014 and is projected to fall to 815 million by 2050 (Fig. 12). By then, the primary working-age population in China will represent 60% of the total population, below the peak of 74% during 2010 (Fig. 13). The elderly dependency ratio will drop from 7.5 workers per senior in 2015 to 2.3 by 2050 (Fig. 14).

“In any event, despite the initial mini baby boom, the fertility rate is unlikely to rise much in response to the government’s new policy. Many young married couples living in China’s cities are hard-pressed to afford having just one child. An October 30, 2015 blog post on the Washington Post website, titled “Why Many Families in China Won’t Want More than One Kid Even if They Can Have Them,” made that point, observing that education is particularly expensive, as parents feel compelled to prepare their child to compete for the best colleges and jobs. Another problem is that most couples are the only offspring of their aging parents, who require caregiving resources that rule out having a second child. As it says in the Bible, ‘As you sow, so shall you reap.’”

Bear Traps for Stocks?

In the past, the worst time to buy stocks typically has been when the unemployment rate was making a cyclical low (Fig. 1). Needless to say, initial unemployment claims was doing the same at the same time—and screaming “Get out! Get out!” (Fig. 2). Buying stocks when the yield curve was flat and on the verge on inverting has also been a bad idea (Fig. 3). Buying stocks when the Fed is raising interest rates can work okay for a while, until higher rates trigger a financial crisis, which often turns into a credit crunch and a recession (Fig. 4 and Fig. 5). Rising bond yields aren’t always bad for stocks, until they are (Fig. 6). Those times late in an expansion when the profit margin exceeds its mean tend to set it up for a bruising reversion to the mean and even below, which is bad for profits and bad for stocks (Fig. 7). As for buying stocks when valuations are extremely high, anyone could tell you “fuhgeddaboudit!” (Fig. 8).

All of the above bear traps may be set to snare the current bull market. A 9/10 Bloomberg article was titled “Goldman Bear-Market Risk Indicator at Highest Since 1969: Chart.” The Goldman indicator neatly converts all of the major bear traps into one series:

“A Goldman Sachs Group Inc. indicator designed to provide a ‘reasonable signal for future bear-market risk’ has risen to the highest in almost 50 years. The firm’s Bull/Bear Index, which is based on measures of equity valuation, growth momentum, unemployment, inflation and the yield curve, is now at levels last seen in 1969. While the gauge is at levels that have historically preceded a bear market …”

So why does the stock market bull continue to charge ahead? Last Friday, the S&P 500 closed a whisker below its record high of 2930.75, hit on Thursday—rapidly approaching my 3100 target for this year (Fig. 9). It is up 9.6% ytd. It has recovered smartly from the nasty 13-day correction earlier this year with a gain of 13.5% since the year’s low on February 8 (Fig. 10). During the current bull market, I count five corrections (exceeding 10%), one near correction (that rounds up to 10%), and a total of 61 “panic attacks” that were followed by relief rallies.

The latest relief rally reflects mounting confidence that Trump’s trade war won’t escalate into one that depresses the economy and corporate earnings, which continue to soar. In addition, there is less fear lately that the Fed’s policy normalization will trip up the bull market. Earlier this year, there was fear that a 10-year US Treasury bond yield above 3.00% would be bearish for stocks. It recently rose back slightly above that level, yet it was widely deemed to be bullish for financial stocks. Go figure!

So what will it take to snare the bull in the bear traps? It will take a recession. That’s all there is to it. While Goldman and everyone else is on the lookout for this event, both the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI) rose to new record highs during August (Fig. 11). The LEI did so even though the yield curve spread, which is only one of this index’s 10 components, has been narrowing fairly steadily since 2013, but remains positive. It only subtracts from the LEI when it is negative. So it is still contributing positively to the LEI, though to a lesser extent. History shows that the CEI, which is a good monthly proxy for quarterly real GDP, falls when a financial crisis occurs, triggering a credit crunch and a recession. There’s no sign that scenario is about to play out again anytime soon.

I have argued that there was a growth recession during 2015 caused by the collapse in commodity prices. Credit quality yield spreads widened dramatically, especially in the junk bond market. Yet here we are at a record high in the S&P 500. Arguably, there has been an emerging markets crisis this year, yet here we are at a record high in the S&P 500.

Financial Crisis of 2008 Part VII: FEDDIE

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

WITH THE FINANCIAL crisis rapidly spreading during September 2008, US Treasury Secretary Henry Paulson proposed a plan under which the Treasury would acquire up to $700 billion worth of MBSs to relieve banks of these toxic assets. Only three pages long, the plan was called the “Troubled Asset Relief Program” (TARP). A longer version became the formal legislation enacted on October 3.

Just 10 days later, at a meeting with nine major US banks on October 13, TARP was changed. It became a program in which the Treasury would purchase individual banks’ preferred shares to inject capital into the banking system. Some of the bankers initially balked at the switch, but Paulson made them an offer they weren’t allowed to refuse.[1]

By the way, Paulson was the CEO of Goldman Sachs from 1999 until he became Treasury Secretary in 2006. He testified to the FCIC that by the time he became secretary, many bad loans already had been issued—“most of the toothpaste was out of the tube”—and that “there really wasn’t the proper regulatory apparatus to deal with it.” Paulson was on Time’s list and was blamed by the FCIC as follows: “Under Paulson’s leadership, Goldman Sachs had played a central role in the creation and sale of mortgage securities. From 2004 through 2006, the company provided billions of dollars in loans to mortgage lenders; most went to the subprime lenders Ameriquest, Long Beach, Fremont, New Century, and Countrywide through warehouse lines of credit, often in the form of repos.”[2]

More reassuring than TARP, which was poorly planned and executed, was the FDIC’s Temporary Liquidity Guarantee Program, implemented on October 14. It fully guaranteed all noninterest-bearing transaction deposits at participating banks and thrifts through December 31, 2009. The deadline was extended twice and expired on December 31, 2010. In addition, the FDIC guaranteed certain newly issued senior unsecured debt of the banks.[3] At its peak, the guarantee covered $345.8 billion of outstanding debt through the end of 2012. Sheila Bair, FDIC chair at the time, deserves credit for her role in ending the crisis.

The Fed lowered the federal funds rate from 5.25% in mid-2006 to nearly zero near the end of 2008, the so-called “zero lower bound.” Fed Chairman Ben Bernanke also responded to the crisis by flooding the financial system with liquidity. Under his leadership, the Fed was remarkably effective at creating numerous emergency credit facilities that helped to contain the crisis so that it wouldn’t turn into a full-blown contagion and collapse of the financial system. As the crisis popped up in various parts of the financial system, Bernanke masterfully played “whack-a-mole” using three sets of tools:

• Liquidity facilities for financial institutions. The first set was closely tied to the central bank’s traditional role as the lender of last resort for financial institutions. In addition to the Fed’s discount window, the traditional facility for distressed banks, these facilities included the Term Auction Facility, Primary Dealer Credit Facility, and Term Securities Lending Facility. Credit swap agreements were approved on a bilateral basis with several foreign central banks to relieve liquidity problems arising in global bank funding markets.

• Liquidity facilities for borrowers and investors. A second set of tools targeted distressed borrowers and investors in key credit markets, including the Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility.[4] Collectively, the Fed’s emergency loans rose from $391 billion during the first week of September 2008 to peak at $1.7 trillion during the week of December 10.

• Quantitative easing programs. In addition to these targeted facilities, the Fed expanded its traditional tools related to open-market operations. On November 25, 2008, the Fed announced the first round of a program of quantitative easing (QE). There were three rounds all told:

QE1 from November 25, 2008 to March 31, 2010. The first round entailed the purchase of the direct obligations of housing-related GSEs—Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—and MBSs backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Over the next several quarters, the Fed would purchase up to $100 billion in GSE direct obligations and up to $500 billion in MBSs. The program was expanded on March 16, 2009 to include purchases of $300 billion in US Treasuries. Under QE1, the Fed purchased $1.5 trillion in bonds, including $1.2 trillion in US Agency debt and MBSs and $300 billion in US Treasuries.

QE2 from November 3, 2010 to June 30, 2011. The second round entailed the purchase of $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. Under the program, the Fed purchased $826 billion in US Treasuries, while its holdings of US Agency debt and MBSs declined $246 billion as securities matured.

QE3 from September 13, 2012 to October 29, 2014. The third round was open-ended, with the FOMC committing to purchase $40 billion per month in Agency MBSs. No total was announced, nor was a termination date. On December 12, 2012, the program was expanded to include $45 billion per month in “longer-term” Treasuries. On December 18, 2013, QE3 was tapered to $35 billion per month in MBSs and $40 billion per month in Treasuries. It was terminated on October 29, 2014 after the Fed had purchased $832 billion in MBSs and $808 billion in Treasuries.[5]

Ben Bernanke had transformed the Fed into “Feddie,” supplementing and shoring up Fannie and Freddie. Because of the three rounds of QE from November 25, 2008 through October 29, 2014, the Fed’s holdings of MBSs increased from zero to $1.8 trillion, and the Fed’s holdings of Treasuries increased from $476 billion to $2.5 trillion.

Not widely recognized is that the Fed stepped in to buy Agency- and GSE-backed MBSs because overseas investors were bailing out of these securities. Their holdings soared from $264 billion during the first quarter of 2000 to a record high of $1.6 trillion during the first half of 2008. By the end of the fourth quarter of 2014, when the QE program was terminated, they had dumped $734 billion of their holdings. Some of the foreign holders were central banks parking their international dollar reserves in these securities because they yielded more than US Treasury securities and were deemed to be just as safe.

There wasn’t much the Fed could do for the ABS issuers directly. However, the Fed’s purchases of Agency- and GSE-backed MBSs certainly propped up these financial institutions and the underlying mortgages they held. Feddie had saved the day.

It was also a new day for central banks following the financial crisis. The Fed and the other major central banks evolved into central monetary planners, essentially grabbing more power to manage the economy via monetary policy—with tremendous consequences for the major capital markets around the world.

__________

[1] “How the Bailout Bashed the Banks,” Fortune, June 22, 2009.

[2] The Financial Crisis Inquiry Report, p. 142.

[3] “Temporary Liquidity Guarantee Program,” FDIC factsheet.

[4] “Credit and Liquidity Programs and the Balance Sheet,” Federal Reserve Board webpage.

[5] “Chronology of Fed’s Quantitative Easing,” YRI webpage.

The Financial Crisis of 2018 Part VI: FLAW IN THE MODEL

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

IN THE MOVIE Casablanca (1942), police Captain Louis Renault walks into the back room of Rick’s Café and asserts, “I’m shocked, shocked to find that gambling is going on in here!” As he shuts the place down, the casino manager hands him his recent winnings. Likewise, Alan Greenspan repeatedly professed his shock at what had gone on in the credit casino under his watch, and he certainly lost some of his public admiration when he did so—though Greenspan’s shock was a good deal more genuine than Renault’s.

In the prepared remarks for his October 23, 2008 testimony before the House Committee on Oversight and Government Reform, at a hearing on the role of federal regulators in the financial crisis, the former Fed chairman noted that subprime mortgages were the root of the problem but indicated that the real crisis stemmed from the uncontrolled securitization of those mortgages: “The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer.” He went on: “[S]ubprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world.” Greenspan noted that there had been a surge in global demand for US subprime securities by banks, hedge funds, and pension funds that were supported by “unrealistically positive rating designations by credit agencies.”[1]

Greenspan continued, “As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.” During his Q&A exchange, he said:

“I made a mistake in presuming that the self-interest of organizations, specifically banks and others, [was] such [that] they were best capable of protecting their own shareholders and their equity in the firms. . . . So the problem here is something which looked to be a very solid edifice and, indeed, a critical pillar to market competition and free markets did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out where it happened and why, I will change my views. And if the facts change, I will change.”

Then he admitted, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.” He added, “That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”[2]

In his prepared remarks, Mr. Greenspan said that the models used by Wall Street’s financial engineers were also flawed:

“In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”

Apparently, he was in so much shock that he offered the committee only one specific recommendation: “As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty surveillance.” Greenspan’s reluctance to force securitizers to have skin in their own game is just plain odd.

Committee Chairman Henry Waxman (D, CA) blamed regulators and Congress alike. “Congress is not exempt from responsibility,” he acknowledged. “We passed legislation in 2000 that exempted financial derivatives from regulation. And we took too long—until earlier this year—to pass legislation strengthening oversight of Fannie Mae and Freddie Mac. Over and over again, ideology trumped governance.” Politics, greed, and outright corruption trumped governance as well.

Many lay blame for the subprime crisis on the GSEs’ embrace of the low-end lending market—or, rather, their forced embrace. Former Senator Phil Gramm, the same fellow who had pushed for the law that outlawed regulating credit derivatives, drew such a linkage in a Wall Street Journal editorial on February 20, 2009. He observed that when the housing market collapsed, Fannie Mae and Freddie Mac had to deal with three quotas: 56% of their mortgage holdings had to be loans to people with below-average incomes, 27% had to be loans to families with incomes at or below 60% of the area median income, and 35% had to target underserved geographic areas. Consequently, the subprime portion of the mortgage market shot up from 5% (with 31% of that securitized) in 1994 to 20% (81% securitized) in 2006.[3]

Needless to say, Gramm was doing his best to absolve himself and his two signature pieces of legislation in 1999 and 2000 from any responsibility for the financial disaster that seemed to ensue from them. Instead, he blamed it all on the “politicization of the mortgage market.” He quoted from Greenspan’s October 23, 2008 testimony that “the subprime market . . . essentially emerged out of CRA.” In other words, the government made the lenders take on these riskier mortgages.

The GSEs initially resisted purchasing these risky mortgages. But they ended up going along for the ride. It was a win-win for everyone. Poor communities and their community organizers benefited from the surge in homeownership. Wall Street profited from increased sales of Fannie Mae, Freddie Mac, and guaranteed MBSs and derivatives. And the GSE heads were very richly rewarded, so they showered their political friends in Washington with campaign contributions.

In 2009, the renowned economist Henry Kaufman put the financial crisis into perspective in a book titled The Road to Financial Reformation: Warnings, Consequences, Reforms. A review of it in The Economist was titled “He Told Us So.”[4] The reviewer wrote that he felt “shortchanged” because Kaufman didn’t mention his role at Lehman and didn’t “shed light on the failings of corporate governance that contributed to the humbling of high finance.” Martin Feldstein, who had chaired the Council of Economic Advisers in the Reagan administration and was another paragon of financial conservatism, sat on AIG’s board when it collapsed.

On April 18, 2010, former President Bill Clinton squarely blamed two of Time’s “Three Marketeers,” Rubin and Summers, for their bad advice on the credit derivatives market, in an interview on ABC’s This Week program: “On derivatives, yeah I think they were wrong and I think I was wrong to take [their advice] because the argument on derivatives was that these things are expensive and sophisticated and only a handful of investors will buy them and they don’t need any extra protection, and any extra transparency. The money they’re putting up guarantees them transparency,” Clinton said. “And the flaw in that argument,” he added, “was that first of all sometimes people with a lot of money make stupid decisions and make [them] without transparency.”[5]

In response to the financial crisis of 2008, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Ironically, the sponsors were none other than US Senator Chris Dodd and US Representative Barney Frank, whom some believed should have been included in the list of people to blame for the crisis. The Act increases the amount of liquid assets and capital that banks must have to back up their activities. Large banks must pass an annual stress test administered by the Fed. The Act’s so-called “Volcker Rule” bans the big banks’ trading desks from proprietary trading, limiting them to making markets for their clients. The Trump administration is committed to easing some of the regulatory constraints imposed by the Act.

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[1] See “Testimony of Dr. Alan Greenspan,” October 23, 2008, before the US House of Representatives’ Committee of Government Oversight and Reform. The Q&A portion is available in an October 24, 2008 Washington Times article titled “He Found the Flaw?”

[2] Again, see Greenspan’s October 23, 2008 testimony and the October 24, 2008 Washington Times article for the Q&A.

[3] “Deregulation and the Financial Panic,” Gramm’s op-ed in The Wall Street Journal, February 20, 2009.

[4] “Henry Kaufman on Financial Reform: He Told Us So,” The Economist, August 27, 2009. Kaufman did have more to say about Lehman in Tectonic Shifts in Financial Markets (2016). However, rather than recounting his experiences at Lehman as board director, he blamed US Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke for letting the firm fail. See Appendix 3, Bernanke’s Fed and the Lehman Bankruptcy.

[5] “Clinton: I Was Wrong to Listen to Wrong Advice Against Regulating Derivatives,” ABCNews.com, April 18, 2010.

The Financial Crisis of 2008 Part V: FAULTY INSURANCE POLICIES

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

LLOYD BLANKFEIN, CEO of Goldman Sachs, wrote an article in the February 8, 2009 Financial Times titled “Do Not Destroy the Essential Catalyst of Risk.”[1] He observed that it should have been obvious something wasn’t right about CDOs: “In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A.” It was a belated warning, to say the least! “It is easy and appropriate to blame the rating agencies for lapses in their credit judgments,” Blankfein continued. “But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.” It’s easier to spout mea culpas after all the profit opportunity has dried up. What good do they do then, besides silencing critics with the same incriminating points to make?

As Blankfein admitted, the most obvious perpetrator of the 2008 financial crisis was the credit insurance industry. This industry emerged following the first of the three Basel Accords. In Basel I, the banking regulators of the major industrial nations agreed to impose uniform capital requirements on banks. Risky assets required more capital. The credit insurance industry employed an army of financial engineers whose innovations magically transformed subprime mortgages, junk bonds, liars’ loans, and other trashy debts into AAA-rated credits. Many of these products were defective. This financial engineering was a great business while it lasted. But it represented huge fraud at worst or negligent malpractice at best.

Among the major contributors to the debacle were the credit-rating agencies that had awarded AAA ratings to thousands of CDO tranches, as Goldman’s Blankfein belatedly observed. The FCIC’s January 2011 report was correct to call the rating agencies “essential cogs in the wheel of financial destruction” and “key enablers of the financial meltdown.” There were only three big rating agencies—Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings.

The FCIC concluded: “The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”[2]

The securitization business brought the agencies huge fees. The raters were paid by the issuers to rate the CDOs that included bunches of tranched ABS. The more complex the security, the greater the fee generated. By the time Moody’s became a public company, structured finance was its top source of revenue. Gretchen Morgenson of The New York Times reported on December 6, 2008 that Moody’s fees for rating mortgage pools were four to five times more than fees for rating similarly sized municipal bonds.[3]

The rating agencies were operating as a government-sanctioned oligopoly without any government regulation—no federal agency was charged with oversight. Washington finally recognized that the rating agencies were running amok and needed to be reined in, so Congress passed the Credit Rating Agency Reform Act, and President George W. Bush signed it into law in late 2006.

Under the Act, the SEC filled the void and became the agencies’ regulator. While the new law gave the Commission new powers to inspect and punish the agencies, it also prevented the SEC from regulating how ratings were determined. The SEC had no authority to make rules governing the agencies’ business or to subject them to examinations as nationally recognized statistical rating organizations (NRSROs).

The Commission established its formal regulatory program for NRSROs in June 2007; seven firms applied to be registered, and all were approved. As SEC Chairman Christopher Cox testified on April 22, 2008, before the US Senate Committee on Banking, Housing and Urban Affairs, “as of the end of September 2007, seven credit rating agencies—including those that were most active in rating subprime RMBS [residential mortgage-backed securities] and CDOs—became subject to the Commission’s new oversight authority, and subject as well to our newly adopted rules.”[4]

But September 2007 was too late. When the delinquency rates of mortgages started escalating in early 2007, calling into question the AAA ratings on many CDOs with subprime loan exposure, the rating agencies didn’t fail to notice. The rating agencies lowered their credit ratings on $1.9 trillion in MBSs from the third quarter of 2007 through the second quarter of 2008, with dire implications for the credit quality of the CDOs composed of the downgraded MBSs. In other words, CDOs began to hit the fan.

Why hadn’t Moody’s noticed the rising delinquencies in early 2007? Moody’s did have a US residential mortgage bond team in place to track troublesome developments, according to the October 17, 2008 issue of the Financial Times.[5] But the rising delinquencies seen in January 2007 didn’t compel Moody’s to take action. That’s because rising delinquencies alone was only the first of three cautionary signals in Moody’s alarm system—which was still flashing a “green light.” True, the speed of delinquency escalation shocked analysts, but their system told them to sit tight. The Financial Times noted: “According to a report in March 2007, the risks of the defaults in subprime mortgage bond pools climbing further up the structured finance chain were ‘mild to moderate.’” Soon after, the amber light flashed when the number of delinquencies exceeding 90 days shot through the roof. Still, “[o]utwardly, the agencies were sanguine,” reported the Financial Times.

As US mortgages continued to sour at a breakneck pace, Moody’s analysts, upon inputting the new data, were stunned by the severity of the mortgage crisis. In the final few months of 2007, the rating agency downgraded more bonds than it had over the previous 19 years combined, reported the Financial Times. Similar revelations must have occurred in the offices of Standard & Poor’s and Fitch, which also began downgrading like mad.

Moody’s abundant AAA ratings on pools tainted with subprime allowed for little possibility that the housing boom might go bust—even though Moody’s very own in-house chief economist, Mark Zandi, had been warning of a US housing downturn since May 2006! According to the Financial Times, Zandi wrote in May 2006 that the housing market “feels increasingly ripe for some type of financial event.”

We now know that the 800-pound gorilla in the credit insurance industry was AIG. In the Mayfair neighborhood of London dubbed “hedge fund alley” were the offices of AIG Financial Products—the business unit from which AIG issued its credit default swaps. It had been run for 21 years by American Joseph Cassano.[6] Most of those years were great ones financially, for both the high-performing subsidiary and its highly compensated leader. That all changed at the end of 2007. Cassano had built the credit default swap business so successfully that AIG Financial Products provided guarantees on more than $500 billion of assets by that point, including $61.4 billion in securities tied to subprime mortgages.[7]

An accounting shift that affected how the Financial Products unit valued collateral resulted in the markdown of these credit default swaps—and poof went $34 billion. In contrast to standard practice, AIG Financial Products did not hedge its exposure to a possible fall in the CDS market. When AIG’s accountants asked the insurer to change the way it valued CDSs, the comparatively small base of capital on which AIG Financial Products had built a mountain of business became visible. This began the unravelling that led to AIG’s central role in sparking the globalization of the US financial crisis, because many European banks had purchased AIG credit derivatives to insure their loan portfolios and bonds.[8]

On September 16, 2008, AIG suffered a liquidity crisis when its credit rating was downgraded. To avoid a financial meltdown, the US Treasury Department extended an $85 billion credit line in exchange for just under 80% of its equity. On March 2, 2009, AIG announced fourth-quarter 2008 results representing “the biggest quarterly corporate loss in US history,” according to a March 4 Washington Post article: a loss of $61.7 billion.[9] The US government at about the same time re-restructured the terms of AIG’s total bailout package, which by then had swelled to $152 billion—providing another $30 billion in taxpayer funds, eliminating dividend payments, and granting the government stakes in two of AIG’s big insurance subsidiaries.

On Tuesday, March 3, 2009, testifying at a Senate hearing on the federal budget, Fed Chairman Ben Bernanke was really mad: “[I can’t think of] a single episode in this entire 18 months that has made me more angry . . . than AIG.” That was the first time the characteristically reserved central banker had publicly displayed any emotion about the financial crisis. What most got his goat reportedly was the way AIG had strayed from its core insurance business to take unmonitored and unnecessary risks; writing billions of dollars in exotic derivative contracts had nearly destroyed the company. “AIG exploited a huge gap in the regulatory system,” Bernanke said. “There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets—took huge losses. There was no regulatory oversight because there was a gap in the system.”

On the same day that the Fed chairman was castigating AIG before the Senate, Treasury Secretary Timothy Geithner was over in the House trying to defend the government’s ever-growing rescue of AIG to fuming lawmakers. The March 4, 2009 Washington Post quoted some of his testimony before the House Ways and Means Committee: “AIG is a huge, complex, global insurance company, attached to a very complicated investment bank hedge fund that built—that was allowed to build up without any adult supervision, with inadequate capital against the risks they were taking, putting your government in a terribly difficult position. . . . And your government made the judgment back in the fall that there was no way that you could allow default to happen without catastrophic damage to the American people.”

In his mea culpa article on behalf of the financial industry, Blankfein admitted that it was all about making lots of money: “We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us—especially when exuberance is at its peak.”

Blankfein didn’t mention that his firm had been dangerously exposed to AIG. In 2007, Goldman began marking down the value of CDOs on its books that had been insured by AIG against the possibility of default. When Goldman requested that AIG put up more collateral to cover those losses, the insurance company sometimes posted half or less of the amount demanded, disputing Goldman’s valuations. When the government took over AIG, its creditors, including Goldman, were made nearly whole. An April 15, 2009 editorial in The Wall Street Journal argued that the government’s takeover of AIG amounted to a bailout of Goldman, though the firm claimed it had “no material economic exposure to AIG” when the insurer collapsed.[10]

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[1] “Do Not Destroy the Essential Catalyst of Risk,” Blankfein’s Financial Times op-ed of February 8, 2009.

[2] The Financial Crisis Inquiry Report, p. xxv.

[3] “Debt Watchdogs: Tamed or Caught Napping?” Morgenson’s article in The New York Times, December 6, 2008.

[4] “Testimony Concerning Oversight of Nationally Recognized Statistical Rating Organizations,” Cox’s April 22, 2008 congressional testimony.

[5] “How Moody’s Faltered,” Financial Times, October 17, 2008.

[6] “AIG Trail Leads to London ‘Casino’,” The Telegraph, October 18, 2008.

[7] “AIG Said to Pay $450 Million to Retain Swaps Staff (Update1),” Bloomberg News, January 27, 2009.

[8] Again, see “AIG Trail Leads to London ‘Casino’.”

[9] “Bernanke Blasts AIG for ‘Irresponsible Bets’ that Led to Bailouts,” The Washington Post, March 4, 2009.

[10] “The Goldman Two-Step,” The Wall Street Journal, April 15, 2009.