I spoke with BNN on September 17, 2015 ahead of the FOMC decision.
The decision on whether to raise rates or not was a close one but the Fed choose not to hike rates.
I spoke with BNN on September 17, 2015 ahead of the FOMC decision.
The decision on whether to raise rates or not was a close one but the Fed choose not to hike rates.
Disastrous models are built on simple assumptions.
That idea in central banking is to target inflation in goods and services. The consumer price index is the holy grail of inflation watchers.
Here is the assumption, here is the part where it works in the model, heck it even worked in practice in the 20th century world. The assumption is a rising CPI is driven by domestic demand. The assumption is that workers are making more in a hot economy and buying up scare goods. Because the economy is expanding those workers will be asking for wage hikes and before you know it you have a wage-price spiral.
In a globalized world, that assumption is wrong. Inflation is coming from currency weakness, bubbles like housing and commodity shortages. Almost any non-commodity good can be produced in near-unlimited quantities at far below the cost of manufacturing. A factory in China can re-tool to produce more in a month so there’s hardly even a lag.
Meanwhile, inflation is non-existent in wages. Real median household income in the US is 8.3% lower than in 2007 — that’s wage deflation at more than 1% per year.
Central banking models work great in a localized economy when central bankers could choke out domestic inflation or spur the local market with interest rates. The idea of low interest rates is that it gives companies and incentive to borrow and invest. Globalization has changed the model: borrowing is done in the US and investing in China and the developing world.
Picture yourself owning a corporate in the United States: the Fed cuts rates so now your borrowing at cheaper levels. You’re ask workers to take a pay cut because the economy suffering or you announce layoffs.
You refocus on selling globally where economies are stronger and eventually the economy picks up. Soon you have some pricing power for your product and business is good. You raise prices and that creates some domestic inflation.
In the meantime you’ve opened new markets. It’s time to invest so what do you do? Borrow money in the US and expand where there is growth and where wages are cheapest. One thing you don’t do is hire back those workers or give them a raise. No way, no how, no chance. If the Fed burns another $3 trillion to knock 80 basis points from long-term rates it doesn’t change the equation. If you need to replace skilled workers, hire a new graduate with $100K in debt and train him. He’ll work for whatever you want with those monthly payments looming.
The Fed has the power to create inflation but it can’t create wage inflation in a globalized world. At the same time, Fed-fuelled bubbles have pushed up the prices of hard assets and devalued the currency so it hits workers on both sides.
Japan has been fighting this conundrum for more than 20 years. The only way the central bank has been able to stimulate the economy with quantitative easing is by devaluing the currency. Even then, a 30% decline in the yen last year only created 1.7% growth and 0.3% inflation.
They have tried everything to create inflation and prices are still well below 2008 levels.
What’s Japan doing now? It’s targeting wage inflation. In the spring tax package Prime Minister Abe will offer tax breaks for companies that increase total wages of workers by more than 2%. The government is also trying moral and nationalistic persuasion.
For sure these are clumsy first attempts but they will be the future of inflation targeting.
The bond market flashed warning signals on Friday and we look at what it could mean for FX. Last week, the pound was the top performer while the Canadian dollar lagged badly on 5 consecutive days of declines. The Asia-Pacific calendar is light to start the week.
USD/CAD continued to move higher in early-week trading, hitting 1.0910 from 1.0888 at the open. Otherwise, action has been light as the week gets under way.
Last week ended with US non-farm payrolls casting doubt on the strength of the US economy heading into 2014 and the report sparked some sizeable moves across assets, including a slump in the US dollar. The moves that really stood out were in the bond market as yields tumbled.
Five-year yields fell 13 basis points to 1.62% and 30s fell 8 bps to 3.80%, below the yield when the Fed announced a taper on Dec 16. The magnitude of the declines in yields should not be taken lightly, it’s either a squeeze on of over-ambitious shorts or it’s signaling a flight to quality that could spill over and lead to declines in stocks and USD/JPY.
The market is complacent in the view that economic growth will pick up toward 3% in 2014, businesses will begin to invest and inflation will track higher. That’s a reasonable line of thinking but it hasn’t been confirmed by data and significant risks remain.
Weekend news was mostly inconsequential but there was positive news from Iran where negotiators struck a nuclear deal that lifts restrictions on oil exports. The move could weigh on oil prices, especially Brent.
Commitments of Traders
Speculative net futures trader positions as of the close on Tuesday. Net short denoted by – long by +.
EUR +14K vs +31K prior
JPY -129K vs -135K prior
GBP +18K vs +23K prior
AUD -57K vs -57K prior
CAD -61K vs -58K prior
CHF +5K vs +11K prior
The market has struggled to build any significant positions in euros because of the lack of consistent trend. The move toward neutral came after the break of the 55-dma but Friday’s rebound likely confused traders further.
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On Nov 1, St Louise Fed President James Bullard lauded the US labor market and said the decline in labor force participation that has improved unemployment is a result of natural demographic changes. That simply isn’t the case.
I wrote about why the Fed is wrong about unemployment in a post in October.
Canadian unemployment is listed at 6.9% while in the US it’s 7.3% but that vastly understates the differences in the health of the relative jobs markets.
First of all, if you go back to pre-crisis times, Canadian employment was around 6% which is something akin to full employment by Canadian standards. Before the crisis in the US, unemployment was at 4.5%. Differences in how the countries measure unemployment, helps to explain the gap.
Skipping ahead to the present, Canada is now 0.9 percentage points away from pre-crisis unemployment levels while the US is 2.6 percentage points off.
Alone that’s an interesting story but it’s not even the kicker. The real story is in the participation rate. In Canada, the pre-crisis average was around 67.4% while in the US it was about 66.1%. Today, the Canadian participation rates has fallen by 1 percentage point while in the US it’s down 2.9 percentage points.
It’s been a much steeper fall in the US.
The nail in the coffin is demographics
The Fed has repeatedly pointed to demographics (ie older people retiring) as the reason for US workers exiting the workforce but US and Canadian demographics are very similar. What’s more is that based on demographics you would expect more Canadian workers to be leaving the workforce than the US.
The marginal worker leaving the workforce is 55-65 years old. In the US, the 55-59 year-old cohort is around 10% of the population; in Canada it’s 12%. In the US, 60-64 year olds are 9% of the total while they’re 10% in Canada.
What does it mean?
A conservative (albeit simplistic) estimate would put Canadian unemployment around 3.8 percentage points healthier than the United States, far more than the 0.4 percentage point difference in official rates.
More importantly for traders, it shows that the Fed is vastly overestimating the health of the US labor market. It suggests that far more workers are leaving the US jobs market for reasons other than retirement/demographics — they’re likely discouraged workers.
What’s more, despite the large differences in employment, Canada doesn’t have any signs of inflation. The Fed may (and probably should) taper due to the financial risks of holding a $3.6 trillion balance sheet but any argument about tapering due to improved employment or inflation risks is a canard.
If your gas or grocery bill is higher, it doesn’t matter to central bankers. What they dread is a wage-price spiral. That’s a fancy way of saying they don’t care about inflation as long as it doesn’t mean higher wages. If prices rise without corresponding demands for higher wages, it’s a finite move — consumers will eventually have no more money to spend. If wages rise along with prices the cycle can be endless and they need to halt it.
The thing that inflation bugs miss is that wages aren’t rising, in many cases they’re going to other way. MarketWatch profiles American Axle as a symptom of the Michigan manufacturing industry.
Base pay for new hires at Axle in Three Rivers is $10.50 per hour, half the going rate of 10 years ago.
Does that sound like inflation? The story also talks about ‘huge turnout’ at a company job fair for those positions.
Globalized manufacturing has been a tremendous force to keep consumer goods cheap but it’s also leading to major competitive pressures on US wages.
It’s a story that has been missed by almost everyone.
In short: Moving manufacturing and has allowed companies to reap tremendous profits but consumer prices have been sticky. As a result, a bubble in retail square footage has formed. Over time, it will slowly correct as companies compete for consumer dollars. It’s the great unseen long-term trend in developed economies.
Don’t believe me? Visit a dollar store and marvel at the quantity, quality and complexity of the things you can buy there. In addition, realize that dollar store margins are around 32%, meaning it’s only costing the company 68-cents to get those items on the shelves.
Today’s evidence the trend to lower prices is accelerating: A UK 99-pence store has just cut its prices to 97-pence.
On Thursday, US CPI is expected to fall to 1.3% y/y — the lowest since 2010.
My belief that we are in a long-term cycle of disinflation and deflation is one of the things that sets me apart. I have written about this theme frequently and wanted to preserve some of my commentary here. This was originally published Dec 5, 2012 at ForexLive.
The US has 23 sq feet per capita of retail space (but as much as 46.6 sq feet). It’s difficult to come by reliable numbers, but that compares to 14 sq feet in Canada, 6.5 sq feet in Australia, 2.3 sq feet in France and 1.1 sq feet in Italy.
It’s no coincidence that the spike in retail floor space coincided with the rise of cheap imports. The US has embraced globalization more than anywhere else.
The retail pharmacy business perfectly illustrates the change.
A pharmacy used to be a little shop that dispensed prescriptions. They have grown to 20,000 sq foot (1900 sq m) stores where you can get anything.
Conventional wisdom says get people into the store and you can sell them anything but there is more to it. It’s about margins. Cheap Chinese goods have made retail margins incredibly attractive.
Goods that once cost $4 to manufacture and sold for $10 now cost $0.50 to manufacture and still selling for $10. The rise in retail square footage has been all about ripping off consumers who have been slow to adjust.
This is part one of a series. In part two I will talk about how the coming years will be payback time and the enormous ramifications for the economy.
Note: Since I rarely update this blog, I will be using it to preserve and highlight some of my favourite posts from ForexLive. I’ll start with this one from April 24, 2013:
This shocking series of pictures were taken on a ‘clear’ day. The air is described as a noxious soup. Blow your nose and it’s black.
The problem didn’t happen overnight but air pollution indexes are up 30% in 2013, and that’s if you believe the government numbers.
Chinese officials are trying to curb pollution without hurting economic growth but those goals may be incompatible.
Change could come any day. Chinese politicians live in Beijing and their children are breathing the same air and getting sick. An unusual weather pattern could hit Beijing and cause a spike in pollution that sends hundreds of thousands of people to hospitals. That could be the tipping point for radical change and the consequences for the global economy are impossible to predict.
The prevailing winds from China blow toward the Pacific ocean but occasionally they shift Northward and Japan and Korea are covered by smog, and they’re increasingly unhappy. If a 10,000km ocean buffer didn’t separate California from China, the United States would never tolerate being poisoned by the people taking their jobs.
People are always asking me to recommend books about markets and trading. I have read many and there are many more on my list but for inspiration, readability and insight, few books can match the Market Wizards series by Jack D Schwager.
The latest is Hedge Fund Market Wizards, published on May 29, 2012. I want to talk about the great lessons in the first chapter, which is with macro trader Colm O’Shea. Most of the chapter can be read for free at Google books.
This chapter repeatedly resonated with me because we have a similar trading style and outlook. Let me share some of the best insights.
I explored another comment O’Shea made about the madness of current economic thinking in a post at ForexLive.