Wednesday, June 15, 2016

Fed's True Mandate? Full Employment & Stable Prices OR Fat Spreads & Asset Bubbles?

To determine the Fed's true mandate, I'll show two different views looking at what the Fed says is it's mandate and what the Fed does where I believe it's true mandate lies.


Full Employment & Stable Prices:
Below, I show the total number of US full time employees since 1991.  During previous recessions, the recessionary loss of full time employment was quickly erased and significant net new full time employment was achieved.  Not this time.  In fact it has taken 9 years to finally breach the level of full time employees seen in 2007...just as the economy and job creation looks to be sputtering as it was in '07.


And gauging the growth of the population vs. the growth of full time employees...a true jobless recovery (not to mention continued declines among manufacturing employment for 5 decades now).

On the flip side, if we look from 2000 through 2015...the population of 55+yr/olds has risen by 23 million and all full time job growth has been among the 11 million older full time employees not retiring (due to insufficient savings, rising health costs, etc.).  Over a 15+ year period, the 25-54yr/old population has seen net full time job declines.

So much for the meme the massive growth in the "not in labor force" is just coming from the retiring boomers (below).  Clearly, there's an awful lot of young adults in there absent employment or means.


Regarding stable prices, the Fed and BLS have rebranded and rejiggered what inflation "is".  Its like goal posts have been moved from the end zones to the 50 yard line.  What is truly taking place is raging stagflation where income is flat vs. record high rents, insurance, education, medical care, food, etc is rationalized away as non-inflationary.  All these costs which are taking unusually high percentages of income are rationalized away as non-inflationary thanks to BLS "substitution", "quality improvements" or "hedonics".  If a steak costs more, substitute hamburger in the index and no inflation.  If a car comes standard with blue tooth instead of a cd player, it has "quality improvements" or hedonics which mean although it cost you more, the index may actually determine it's price went down.  This has been covered ad nauseam so enough said.


Fed's True Mandate...Fat Spreads and Asset Inflation:

I have shown the Federal Funds rate simply has mirrored the rising and decelerating US adult population growth for the last five decades (chart below).  And in the US, the population growth only continues decelerating for at least another decade so rate hikes into decelerating population growth (and consumption) seems unlikely.


In short, as the population growth decelerated, rate cuts have been enacted by the Fed with the intent to incentivize consumers, corporations, and government to substitute debt / leverage for organic growth, to maintain an otherwise unobtainable growth rate.

And I've shown on a very macro basis the baby boom and bust was very global.  That the Federal Funds rate also mirrors the rising and decelerating combined adult populations of the 34 OECD nations, China, Brazil, and Russia (below).

I show these charts again because they make it absolutely plain why the Federal Reserve will not be raising rates and why economic growth will only decelerate further, both nationally and globally.  Simply put, the likelihood of the Fed raising rates into the greatest global demographic decline since WWII is about zero and truthfully, the Fed misspent all it's ammunition before we even got to the main event.


In this article (HERE), I made it plain that the adult 15-64yr/old population among these nations begins outright shrinking next year...again, these nations consume 70% of global oil (and represent like amount of global consumer demand).  These nations adult populations grew as much as 30 million new consumers a year.  These adults had the highest average income, savings, and access to credit.  And now there will be millions fewer of them every year at an accelerating rate for decades.  Fewer home buyers, car buyers, fewer tax payers, etc. etc. vs. a massively swelling 65+yr/old population in need of selling stocks, homes, and assets to fund their retirement.  Why the Fed and central banks worldwide are levitating asset prices should be plain as well.  OK, so the Fed can't raise rates...got it.


So what was QE all about if not job growth and stable prices?  The only time rates actually fell during QE was during Operation Twist (below) and in the periods when there was no QE (chart below shows QE's impact on 10yr Treasury).  Rates rose during QE1, 2, and 3 and only fell as the Fed approached the stated completion date or was actively tapering QE3.  Interestingly, Operation Twist was a period when no net new money was being created as the Fed sold it's holdings of short dated T-Bills/Notes to purchase longer dated Treasury's.  So, strange that the Fed's stated purpose for QE was to push rates lower but the Fed's actions actually pushed rates higher?!?

In fact, once the Chinese and BRICS (as of 2012), the Fed, the SS trust fund, and all foreigners (as of 2014 year end) stopped buying US Treasury debt (on a net basis)...rates have fallen even faster since 80% of the bid since '00 has ceased buying (detailed HERE).  Curious beyond curious how rates at record lows and absent 80% of buyers would result in record demand and even lower yields?!?


And here comes the Fed's conundrum...lower 10yr rates are likely to mean lower spreads for banks.  Banks like fat spreads as their business model is premised on borrowing short and lending long...and fat spreads makes this very profitable.  However, the extent and duration of these very fat spreads since QE was begun were some of the sweetest of all the post WWII period (chart below).  And yes, likely not coincidentally the Fed is owned by the largest global banks who earn a 6% dividend along with profit from this wider spread outcome.

It is during Operation Twist that the 2yr-10yr spread fell rapidly from 2.8 to 1.3 and financial markets swooned...and thereafter QE3 was initiated pushing the 10yr back up and re-establishing the 2's/10's spread (above) and market nirvana.  Now the spread is again falling rapidly as the 10yr is declining (absent QE) and the 2yr rising since QE3 taper onset.  If something isn't done shortly to reestablish the spread, another asset collapse is likely dead ahead of the election as the spread likely inverts on continued 10yr declines vs. relative continued 2yr appreciation.


The chart below shows 3 simple variables.  Federal Funds Rate incorporating Wu-Xia shadow rates as outlined on the Atlanta Fed's website (light blue columns), 2yr. vs. 10yr Treasury spread (dark blue line), and logarithmic Russell 3000 (black line).  The vast majority of all market gains have come between the peak in spreads and the next spread inversion.  So while the Fed has not achieved its stated goals for employment nor stable inflation...it has achieved great profit-flation for banks and massive market-flation for asset holders.

A new QE or like program would likely push 10yr rates up (not down) and perhaps push the short end down into NIRP...helping to re-establish a juicy spread (where banks borrow at zero or even negative rates and lend at positive rates).  Otherwise, absent Fed "accommodative action", another spread inversion is likely upcoming and it's a very, very long way down from here. 


So the only question for investors, what do you believe in???
"Normalization" & "Free Markets" - You believe the Fed will maintain or raise rates, hiking the short end further with continued long end declines (as we have seen thus far) into the greatest national and global demographic decelerations and declines we have ever seen, and allow a return of "free markets".  Or perhaps that the markets are simply bigger than the Fed (& CB's) and thus a spread inversion with typical market mayhem is dead ahead?  Time for risk aversion (even if its about as effective as the '50's nuclear drills where children hid under desks from a potential nuclear blast).
-or-
Moral Hazard - You believe in the next installment of Fed "extraordinary accommodation" that is likely to juice spreads and asset values, likely significantly higher?  Time to fully benefit from the Fed's true mandate...and dance as long as the music plays.