Will the Fed ever get inflation?

Outlook:

We get the usual jobless claims today, plus housing starts and permits. We usually don't much care about claims but this time the Daily Shot has a fascinating chart showing the labor force against CPI. Let's not quibble about exactly what data is being used—the chart is a stunner.

The thesis is that Debt, Demographics, and Disruption will prevent the Fed from getting what it so desperately wants, inflation. Instead we will continue with deflation or at least low-flation. The author of this doomsday scenario is BofA's chief investment strategist Michael Hartnett, who postulates the struc-tural risk of excess liquidity and AI-inspired wage disruption will lead to a tech and credit bubble that the Fed will feel compelled to burst. Before then the 30-year yield will drop to 2%.

Be careful what you deduce. The Fed adopted a policy in the Greenspan years of accepting it cannot determine what is a bubble until after the market had burst it. Do we have any evidence Powell will be a different kind of Fed chairman? For the Fed to say it can determines what's a bubble and what's ex-cess animal spirits would be a gigantic violation of free market ideas. Besides—see below—yields are rising on possibly false inflation expectations but also on rising debt-to-GDP ratios that make investors demand a risk premium.

All the same, Hartnett is on to something with this chart.

Today everyone will have time to contemplate some big-picture issues. Unfortunately, there is plenty of ill-informed, sell-newspaper stories out and about, like the one about the falling dollar inspiring re-serve diversification. France and Germany just added some Chinese yuan to their reserve hoard, for example. Golly, if the world starts liking other currencies more, how will the US afford to run such gi-gantic deficits? Besides, if Trump breathes down China's neck too hard, maybe China will reduce its dollar holdings.

A little perspective, please. As a BoA ML strategist points out, reverse diversification moves glacially slowly. Even if the yuan share rises to the level of the pound or yen, that's still only about 4.5% of global reserves (from less than 1% now). Besides, US markets have the size and variety that no other currency can begin to compete with. The US is the hegemon.

What about the report yesterday that China cut its Treasuries holdings by 1.1% in November to a four-month low of $1.18 trillion. This simply doesn't pass the "So what?" test. Go back and look at the FX prices for November—the dollar fell against the other majors. There's size and then there's price.

We got the TICS report yesterday (Treasury International Capital System). We don't always check it out at the source because the Treasury makes it hard to read-- tiny type, squashed columns, dates orga-nized six different ways from Sunday and definitions so dense you can't make some entries foot properly. For example, for notes and bonds alone, private parties were sellers of $12.1 billion in Nov and official entities sold $6.7 billion for a total of $18.8 billion. But never mind, that's just one month. For Nov, foreigners owned $3.7165 trillion in notes and bonds vs. $3.4727 trillion in Nov a year ago, or a year-over-year gain of $2.438 billion.

All the same, in Nov foreigners bought a net $33.8 billion in US securities, with private buyers adding $49.7 billion and official outflows at $15.9 billion. (Meanwhile, US residents dumped foreign securities to the tune of $22.7 billion.) Hmm, official outflows at $15.9 billion. Should we be worried about re-serve diversification? Probably not--$15 billion is not a big number in the grand scheme of things. The biggest holders of US notes and bonds (http://ticdata.treasury.gov/Publish/mfh.txt) are China, Ja-pan, Ireland (Ireland?), Cayman, Brazil, Switzerland, UK, Luxembourg, Hong Kong, Taiwan and Saudi Arabia. That's eleven names but we didn't want to leave off Saudi Arabia. If you have the patience and a magnifying glass, you could find out which of these holders was cutting down, but it wouldn't be very helpful because so many of those places are fronts that conceal the true home country of the hold-ers.

Good luck searching for some experienced statistics guy to tease out what's important and useful here. Evidently nobody much looks at the TICS data anymore. This may change, if China gets some more central banks to diversify, if Europe gets more interesting as a destination and the ECB stops hogging all the paper, or if the world rejects the US for political incompetence, although it hasn't done that be-fore. Given what we do have, the lesson here is that on the whole, capital flows are largely independ-ent of the ups and downs of the dollar. This is what the French named "extraordinary privilege" at work.

We are probably safe on the reserves front, but there is an emerging problem—the $1 trillion in new debt coming this year. Deutsche Bank estimates 2018 debt issuance will be closer to $1.15 trillion, dou-bling the $559 billion from last year. Market Watch reports the bank, among others, worries that "in the face of this dramatic unfurling of supply, it's not clear if bond-buyers have the wherewithal, let alone the appetite, to take down the flood of issuance without seeing yields climb higher." Demand has to rise in pace with issuance or long yields must rise, credit spreads widen, equity prices drop and the dollar decline. Besides, investors just won't like the increased riskiness and become vulnerable to being lured to other high-yielders.

See the Deutsche Bank chart. Is this a frightening thing? The answer depends on the pace of global ac-cumulation of investible capital. Even if the US gets a fractionally lower share, there is enough to go around. We see no evidence so far of any exodus from the US Treasury market. If rising yields start getting diminishing inflows, then it will be time to worry. The WSJ has a scare story about US debt reaching 100% of GDP by 2027. The good thing about scare stories like this is that Congress has staff that read them. We can expect a backlash against the Trumpian spending spree. Bottom line: too soon to worry.

Finally, consider what happened to the CAD yesterday when the BoC did, in fact, pull the trigger, if also warning about the risks of Nafta. The market skittered around all over the place. We expect spikes, but this was excessive and failed to deliver the expected post-hike bar pattern. See the 30-minute chart. Gov Poloz said it all: NAFTA is"is the biggest issue in the forecast space." If Nafta survives, more hikes to come. If Nafta gets gutted, rate cuts are not out of the question. The chart tells it all—indecision to the point of paralysis. Many analysts like to dismiss Trump's boorish, clownish behavior as not relevant to the work of serious, intelligent people. Well, it ain't so north of the border.

 

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