The Fed is not under pressure to hike

Outlook:

The dollar’s slide can be attributed to an absence of nasty trade war talk from the White House, yesterday’s deeply negative housing price index, and a growing sentiment that the Fed will be pulling back on the reins a lot less next year and is “dovish.”

Two of these three things are not true or not useful. A hiatus in nasty trade talk is temporary. Tigers do not change their stripes and it won’t be long before Trump begins making demands on the Chinese again, without regard for the consequences.

As for the Fed becoming less aggressive, this derives from Fed chief Powell and others naming the trade war as slowing global growth and thus triggering a reconsideration of the pace of the upcoming hikes in 2019. The December hike—29 days away—is still considered baked in the cake. The probability of that move is now 70.6% (although it was 78.4% a month ago). But the three hikes dot-plotted in for next year are getting a reduced probability in the Fed funds futures market. See the table from the CME’s FedWatch page.

If the Fed funds target is 2.00-2.25% now and December is a done deal, the starting point for next year is 2.25-2.50%. Three hikes would take it to 3-3.25%. But the probability of all three getting done by December of next year is a measly 1.8%. Worse, it was higher a month ago, 5.6%. In a nutshell, the Fed funds futures market lacks confidence the Fed will follow through on the dot-plot, whether from stock market woes, slowing global growth, or fending off Trump.

In the absence of inflation and with unemployment at historically low levels, the Fed is not under pressure to hike. Hiking is part of the whole normalization process and also a way of adding a few arrows to a now nearly empty quiver—in case the Fed has to cut rates to fend off a recession. But a key side-effect of the Fed becoming dovish, if that’s what is happening, is a further loss of confidence in the Fed. Trump has been hacking away at confidence in US institutions ever since he took office—NATO, WTO, NAFTA, the CIA/FBI, the Justice Department, the EPA, etc. The Fed is not immune. But like the Justice Dept, the Fed is supposed to be independent and free from political pressure. It’s a fragile independence and Trump is a bull in a china shop.

The one factor of the three that is true and useful is the drop in the housing index. As we have warned before, a housing market crash is probably not going to happen again, at least on the financial institutional side. Guardrails put in place after 2008-09 will likely suffice. But a drop in housing—building, sales—that also brings down prices, perhaps dramatically—is a big fat negative for households, whose chief asset is their houses. For the moment, though, house prices are still rising faster than incomes. There is an inventory shortage and mortgage rates are rising. Buyers are priced out of the market and existing homeowners are stuck in place, reducing the famous American labor market mobility even more.

This one has a lot of moving parts. Housing is a lesser percentage of GDP than before the crisis—about 4% now vs. 6.7% before the crisis--but the WSJ reports “The housing industry has been a drag on the overall economy in five of the last six quarters….  Now with a new tax law that that reduces incentives for homeownership and the Federal Reserve raising interest rates, ownership is even more of a stretch.”

We get housing starts and permits today, with starts down to 1.201 million in Sept, down 5.3%, and Bloomberg forecasting a small rise to 1.225 million. Tradingeconomics reports the average from 1959 to 2018 is 1.433 million. See the chart. Remember that Trump fancies himself a real estate guy and one who likes low mortgage rates.

On the trade front, a Reader sent us a link to a report from German research institute IFO on the costs of the US-China trade war. We all imagine the consumer pays the price so that tariffs are like an income tax hike, but IFO sees something different: “Contrary to public opinion, the greatest share of the tariff burden falls not on American consumers or firms, but on Chinese exporters. We calibrate a simple economic model and find that a 25 percentage point increase in tariffs raises US consumer prices on all affected Chinese products by only 4.5% on average, while the producer price of Chinese firms declines by 20.5%.“

IFO says the tariffs are designed to hit goods with “high import elasticities.“ This is a term barely heard outside of Econ 101, but it means the tariff burden falls about 75% on the Chinese exporter and reduces US imports by about 37%. It will reduce the deficit by 17% and generate revenue of about $22.5 billion.

Bottom line, the Trump tariffs are worse for China than they are a drag on the US. We doubt very much that anyone in the Trump administration designed the tariffs according to elasticity, but never mind. And here’s what counts—a big drag on the Chinese economy, already showing some signs of slowdown and pressure on overindebted companies. See the tidbit below.

Fun Tidbit: Scare-mongerers point to GE’s travails and extrapolate crushingly high debt to the entire corporate world at about 45% of GDP. But it ain’t so. In September Moody’s reviewed the charge and deduced that yes, corporate non-financial debt is indeed about 45%, but that’s gross, not net. Add in the vast hoard of cash these companies have, and the problem vanishes. See the chart (from https://www.moodysanalytics.com/-/media/article/2018/weekly-market-outlook-middling-ratio-of-net-corporate-debt-to-gdp.pdf).

As of March 2018, liquid assets grew 11.4% while debt grew by almost half, or 6%. Net corporate debt to GDP was 32.4% in March 2017 and a tad lower at 32.3% in March 2018, or merely matching the long-term median. The liquid assets are not evenly distributed, of course. There might be some scary-big losers in there. And net debt-to-GDP is indeed a harbinger of defaults with a lag but about a 77% correlation. Moreover, the high yield spread is an excellent predictor of defaults.

If you are getting be-afraid emails trying to panic you into an investment of time or money, they are really easy to resist with a little fact-checking. We like crackpot emails as much as the next guy and try to check out as many as time permits. We hardly ever find a gem among the dross, but hey, you never know.

Now consider China. Bloomberg has run a series of scare stories about debt in China, and last July Martin Wolf at the FT joined in. See the chart. The statistics vary and none can be trusted as much as the Fed’s data that Moody’s used, but the point is that non-financial corporate debt is over 150% of GDP and the biggest segment of the four debt types shown. An “unsafe” credit boom of this magnitude hardly ever ends well, historically. A crisis is likely. “The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all these features.”

But is a crisis inevitable? China’s financial market control and relative isolation from foreigners is a protector. “The strongest reply is that the government is powerful and has a well-run central bank, effective control over the banking system, ownership of vast domestic and foreign assets, untapped fiscal capacity and tight controls over transactions with, and by, foreigners. If it were determined to protect the financial system from collapse it could do so. But if gross debt were to rise above 400 per cent of GDP over the next decade, even that would be less certain.” It’s at 300% now.

A crisis with a hard landing means devaluation. To avoid that and get a soft landing, government spending on infrastructure (while corralling the banking sector, include shadow banks) is needed. In a way, this is backsliding… and the trade war with the US “may make such backsliding inevitable.” In other words, China has to increase debt to keep growth and the yuan under 7.

Fortunately, China is leery of overindebtedness as a matter of principle. Public figures are startint to say deleveraging should be a priority. China should also acknowledge nonperforming debt and take care of it. “China has a choice between a whimper today and a destructive bang tomorrow. It can curb the debt surge and allow growth to slow now, or risk a crisis followed by a more severe slowdown later.”

Hmm. We await China’s initiatives at Buenos Aires. Gee, what can China import most usefully from the US? Auditors.

 

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