A few thoughts on financial conditions

Apparently, that was enough doom and gloom for the time being.  It would seem difficult bordering on pointless to try and distill too many deep insights from yesterday's data; yes, CPI was a bit higher than expected (though still zero on a headline basis) and claims were great, but the Empire and Philly surveys were generally disappointing.  Bill Dudley, meanwhile, managed to defuse any controversy by saying more or less nothing- to wit, that he would favor a 2015 liftoff if his forecast is met.   That's a bit like saying the lady down the street will be rich if her lottery forecast is met; without knowing Dudley's (or anyone else's) near-term forecasts, any qualified comment on the timing of rate moves is more or less worthless.

Following on from yesterday's post, Macro Man would like to address the issue of financial conditions and potential downsides to maintaining ZIRP.   He will readily concede that this is largely of intellectual interest rather than an effort to glean insight onto the likely future direction of the market; if you're more interested where the AUD or Spooz might be going today, feel free to cut straight to the comments section.

One of the criticisms advanced towards a potential Fed lift-off is that financial conditions have already tightened, thus precluding the necessity for any actual rise in the Fed funds rate.   Of course, there's a bit of a catch-22 embedded here; if markets hadn't believed that the Fed's intention to raise rates was credible, financial conditions would likely not have tightened as much; if the Fed then reneges on the de facto commitment, then their credibility is eroded.  In any event, it is clear that conditions have tightened, though there is a debate as to how much.   Consider the differing messages sent by the GS financial conditions index and that of the Chicago Fed:

One measure (the GS one) says that conditions are tighter than they were during the US downgrade/Greek meltdown fiasco of 2011, back when Spooz were below 1200 and 3m LIBOR was above 0.50%...and the other says that they're nowhere near as tight.  Breaking things down, it looks like a lot of the argument in favour of the "conditions are really tight" view is the widening of corporate credit spreads; the spread of the Moody's BAA index to the equivalent maturity Treasury, for example, is at its widest level since the crisis.

On the one hand, that makes a lot of sense.  On the other, however, it seems like stuff and nonsense; after all, the rate that matters for corporates is the actual rate they borrow at, not the rate at which credit traders can spread to Treasuries.   Viewed through that prism, a modest back-up is evident, though the actual borrowing lending rates remain very, very low by historical standards.  Indeed, this yield is still below the earnings yield of the S&P 500, which remains an anomaly in the modern financial era.

Ah, Macro Man can hear you say, but corporate treasuries are sophisticated!   They do swap their debt to take advantage of low short-term yields, so spreads do matter!  This is true, but spreads work both ways.   Yes, the spread of the underlying debt to swaps is wide; however, given the steepness of the yield curve, so is the spread of the swap rate to 6 month LIBOR.  Macro Man constructed an index to proxy the all-in cost of swapping corporate debt to LIBOR, calculated as simply the Moody's BAA yield plus the spread of that yield to swaps, less the spread of swaps to 6 month LIBOR.  As you can see, conditions have tightened somewhat...but remain extraordinarily accommodative by historical standards.

Let's shave with Occam's Razor for a moment.   According to all of these charts, financial conditions started tightening in the spring of 2014, with the tightening accelerating in the spring of this year.   If this were really binding to the degree that some adherents claim, we should expect to see this in corporate borrowing levels, shouldn't we?  Macro Man pulled up a chart of quarterly corporate bond issuance from the Fed's flow of funds data:

Well, whaddya know.   The two strongest quarters of non-financial corporate debt issuance in history were the first two quarters of this year, with the last data point obliterating the previous record by a massive margin.  Not only does this not suggest that tighter financial conditions are binding, it warns of (dare we say) irrational exuberance in the corporate debt market!   This is particularly the case when one considers that this issuance has been accompanied by tepid capital expenditure but rampant stock buybacks, thereby a) underwriting corporate financial engineering with profits as a percentage of GDP already at record highs, and b) exacerbating income inequality.  One might also credibly raise financial stability concerns, insofar as 1) buybacks come and go, but debt lasts forever (or until it's paid back)  and b) market liquidity for corporate debt is almost certainly going to be worse than in previous down cycles.

What about households?  This is where it gets really interesting.   Demand for and provision of consumer credit (credit cards, auto loans, etc.) has been robust, suggesting that households have an appetite to borrow:

However, the total debt of the household sector has yet to reach its pre-crisis peak.

While it's difficult to be too upset about households failing to add to a mountain of debt, it is important to recognize that the credit boom has not reached them in aggregate.   Of course, much of this is to do with the mortgage market, where lending remains way, way below pre-crisis highs.  This is not, of course, because mortgage yields are too high; quite the contrary.  However, in contrast to the low interest rate environment prevailing in the early portion of the last decade, this has spurred little activity in the mortgage market.  A large part of this, of course, is that many would-be borrowers' current housing situation precludes them from moving house.  However, this should not impact would-be refinancers to the same degree, particularly as the number of negative-equity borrowers has more than halved over the past three years...and yet in aggregate, mortgages are still not getting written.  If mortgage credit decisions are not being allocated on the basis of price, therefore, it is difficult to see how a fairly modest uptick in the price is going to have a substantially deleterious impact upon activity.

Moreover, if we look at the "other domestic loans" category for the entire economy, we see a picture of tepid growth after a meaningful decline after the crisis.

Now, one might argue that this last chart suggests that credit is finally beginning to flow, and that a rate hike could crush it- look how things have flat-lined for the last couple of quarters during the tightening of financial conditions.  Then again, if that were the case, why was corporate issuance so robust during the same period?

Macro Man chooses to view the credit market as bifurcated.  If you have access to credit, things are fantastic, as it's still incredibly cheap to borrow if you have the wherewithal to do so.  If you do not, however, you are stuffed, regardless of how attractive you find the borrowing rate.  The supply curve has shifted, and the demand for credit does not necessarily imply the access to credit.

None of this, of course, touches on another cohort impacted by ZIRP: savers and holders of cash and interest-bearing instruments.  The Fed has (rightfully, in your author's view) come under some pressure for rewarding (already wealthy) borrowers at the expense of savers, though the likes of Bernanke brushed this criticism aside with a casual wave of the hand.   Ah, the life of an academic!

What's remarkable is that despite the very low level of interest rates in the US, the interest income entry in the personal income accounts is actually very robust indeed.  It's not at the pre-crisis highs when you actually used to get interest for your cash (yes, it's true, kids!)....but it's surprisingly close.  This is in sharp contrast to the previous two rate cycles, when interest income reached local lows right before the Fed started hiking.

How the hell is it possible to earn that much interest income in ZIRP-world?  Obviously, savers are not literally getting zero on their holdings....and clearly, they must have increased the size of their portfolios.   By a lot.  Macro Man constructed a stylized model to attempt to gauge the magnitude.   Please bear in mind that the outputs are not to be taken literally, but the shape of the line can yield some insights.  He assumed that lenders earn the average of the 3m Treasury bill, the 30 year Treasury bond, and the Moody's BAA corporate bond yield.   Taking the annualized interest income as a given, he then figured out what face amount of this portfolio would be required, given the prevailing yield at any given point, to generate the required income.  The results are set out in the chart below.

As you can see, the amount held is currently about 60% higher than that prevailing at the onset of the crisis.  Admittedly, the output is lumpy, no doubt because of mismatches in market movements and the income reports.   Nevertheless, the trend is a clear one- households are holding a LOT more money in (presumably safe) interest-bearing accounts and securities than they did before the crisis.

Some of this may reflect a risk/asset allocation preference that has little do do with the return on offer- just look at yields in the front end of Germany!  However, given where the US is demographically, some of it also no doubt reflects a desire for retiring baby boomers to procure a given level of a fixed income.   The lower the yield on the portfolio, the bigger the portfolio needs to be.   By maintaining such low interest rates, the Fed is essentially forcing these savers to hold cash in unproductive investments paying low rates of interest, rather spending it or putting it to more productive use.   Small wonder the velocity of money is so low!

Finally, one more speculative question: could the Fed actually be keeping inflation low on a secular basis by keeping monetary policy artificially easy?  Regular readers will by now know Macro Man's argument that there is a secular global trend of disinflation thanks to excess global manufacturing capacity and firms' willingness to shift production to low cost producers (at the possible expense of quality.)

Michael Gapen at Barclays has produced an interesting set of calculations, disaggregating US inflation into domestic and tradable CPIs.  Lo and behold, after dipping during the crisis, domestic inflation popped to 2% and has been treading water ever since.  Tradable inflation, impacted by both commodities and the dollar as well as foreign goods prices, has been up and down and is currently negative.

Now, Macro Man would argue that the Fed can exert a lot more influence on domestic inflation than that from tradables, and in point of fact the trend there looks pretty healthy and in no way deflationary.   Obviously, in the near term putting rates up would likely exacerbate the trend in tradables via lower commodity prices and a higher dollar.

In the long run, however, the biggest issue for tradable prices is excess capacity.   Maintaining a super-easy monetary policy does little to disincentivize producers in other countries to continue to invest in productive capacity, of which there is already too much.  It'd difficult to find good data on global capacity utilization, but Macro Man found a series for global CapU in the chemicals industry, which would seem to be a reasonable proxy for global industrial CapU.  (Again, it's the shape of the line rather than the level that is worth watching here.)    Note the contrast with CapU in the US, which isn't exactly setting the world on fire in its own right.

That, in a nutshell, is why there is no inflation globally...and why there's not a damn thing the Fed can do about it.  Any policy that encourages even more investment in productive capacity is just going to make the problem worse down the line.

So, in sum:

* Financial conditions have tightened, though more modestly than some well-known indices would have you believe

* For those with access to credit in the US, conditions remain exceptionally easy and is encouraging behaviour that may threaten financial stability while appearing to confer few trickle-down benefits to Main Street

* For those currently without access to credit, the price is largely irrelevant anyways.  Housing, the classic "interest rate sensitive sector", is not currently very sensitive to interest rates

* ZIRP may in fact be tying up large amounts of otherwise usefully-deployed cash in low-yielding fixed income investments

* Domestically generated inflation in the US actually looks OK, and there's not much the Fed can do about tradable inflation anyways, given the dramatic excess capacity in the global economy.

These are among the reasons why Macro Man would prefer to see the Fed lift rates to some non-zero yet still generally accomodative level.  Of course, per yesterday's post, this is not a forecast.  None of this is particularly relevant for market strategy, therefore, but what's the point of having a blog if you can't go off on the occasionally geeky tangent every so often?  Normal service resumes next week.