Mixed signals from the Fed is causing bond and stock markets to interpret our economic prospects in a wildly different way.
The Fed is responsible for setting short term interest rates. Normally, that’s the main tool the Fed uses for having the economy speed up or slow down. But what do you do if short term interest rates have been lowered pretty much to zero, and when you repeatedly say you’re going to leave them there for a while ?
You could lower the interest rate you pay banks for parking their cash with you. That would encourage them to make loans, rather than just sitting on the money. Normally, that would help get the economy going. But the problem banks face now is they’re more concerned with not losing money than with making money. US consumers have managed to pay down their debt from 133% of income to 120% in the past 3 years, but banks know that a 120% debt level is still a basket case and not someone you want to lend to. Plus, a large portion of consumers with solid balance sheets – the only ones banks will lend to — don’t want to borrow more. All consumers want to do is pay down debt and re-finance their mortgage if interest rates are lower. There’s no economic growth from that. So having the Fed lower the interest rate it pays banks for parked cash won’t stimulate the economy.
What else can the Fed do in order to stimulate the economy? They can do something I’ve mentioned previously: quantitative easing. Quantitative easing is when the Fed buys Treasury bonds or mortgage backed bonds from Fanny, Freddie and GNMA. The Fed did this last year in order to lower mortgage rates and put a floor under house prices. $1.2T later, the plan was for the Fed to stop buying mortgage backed bonds and let them gradually disappear over the course of years as the underlying mortgages are paid off.
There seems to be a change of plan in the works. Two Fed governors — so far – have been recently quoted supporting the Fed in buying Treasuries because they’re concerned about deflation. Unlike the previous example, this Fed action might actually stimulate the economy. But it comes with a steep price. Quantitative Easing is the proverbial printing press. It means the government is printing more money with one hand, and then borrowing it with the other.
This de-values the currency. If you’re one of the roughly 50% of buyers of US Treasury Bonds, you live outside the US. If you see the US government openly de-valuing it’s dollar, you’re going to be upset and concerned that they keep printing money because it means you’re going to be paid back in dollars that are worth less. Sooner or later, you may reach the conclusion that you’re throwing good money after bad when you keep buying US Treasury Bonds in the weekly Treasury auctions we have. Sooner or later you will start looking for something else to put your ongoing savings in, and you may even begin selling your existing US Treasury Bonds if you’re worried they’ll lose enough value. They’ve always worked out in the past. Could now be different?
Back to being a US consumer and investor. Now ask yourself: is this (quantitative easing / printing press) something the Fed would do if it were confident the economy was growing on its own and in a normal recovery? Or maybe does quantitative easing sound like a desperate move with a real risk of de-valuing the US dollar and therein cause interest rates to rise from a weak or failed Treasury auction because foreign buyers stop showing up?
While you ponder that question, also think about this: we need to dramatically increase our exports to help drive the economy. Any ideas on how to do that? OK, you could spend more on R&D and innovate more than everyone else. The US is very good at that. But that’s time consuming and difficult. Why not just de-value your currency? That’s the fastest way to make your exports more competitive and is what all our trade partners have been doing for years. That’s how the German economy improved so much in the past few months. Remember the European Banking crisis earlier this year? It caused the Euro currency to drop and thereby caused German exports to be cheaper and more competitive. Maybe that’s what we’re just about to do here in the US. That’s what quantitative easing will do.
This week the Commerce Department released a report for June’s Consumer spending and saving. Apparently, it comes as a surprise that consumer spending stopped expanding in June. Also in the report, the savings rate went up – to 6.4%. It needs to rise to the 8-9% level and stay there for several years in order for the consumer to reduce their debt load to a manageable level and have any hope at being able to get a bank loan with reasonable terms. Banks aren’t making a lot of loans these days because many consumers are still the worst credit risk that banks have seen in decades. Despite being demonized -admittedly sometimes by me — banks are a business and won’t make loans unless they’re pretty sure they’ll be paid back. I don’t blame them.
This week also saw reports updating the state of US manufacturing. One of the key reports is from the Institute for Supply Management -the ISM. The ISM report for July showed that new orders fell to their lowest level in 14 months. It also showed a pronounced slowing in the rate of growth of the manufacturing sector to a near flatline — certainly not what any economic recovery since the second world war looks like. Echoing the same pattern, the Commerce Department report for July showed factory orders continued to drop as they did in June. The data from both sources indicates the sudden growth in manufacturing that began last summer ended in May this year. If so, that’s the end to the famous inventory rebuild we hear so much about in economic circles.
Most if not all of the economic growth we’ve seen in the US over the past year has been driven by federal government incentive programs of historically large proportion that spurred consumers to spend. This increased demand for goods and services which in turn caused manufacturing to ramp up and inventories to be rebuilt. In a normal recovery, this kick starts the economy and it then takes off on its own.
Let’s look at a brief comparison of what our current economy is showing versus a normal recovery. By the 4th quarter into a normal recovery, the economy is expanding at a 6% clip, not 2.4% –which I also point out is apparently subject to be lowered by the government at some point in the future when no one is looking. This is what the government did in the GDP report 2 weeks ago by revising down 2007, 2008, and 2009 economic growth. In fact cutting it in half.
In a normal recovery at this point the economy is 8% larger than when we entered recession. How about now? The US economy is still 1% smaller than it was in late 2007 when the recession began. As for employment, an average recovery would have generated enough jobs to gain back all the jobs lost in the recession and added over 700,000 new ones. Any guess as to how that metric looks now? Try this. Not only have we not gained back all the lost jobs like other recoveries, we’re still down over 7M jobs compared to when the recession began. So we’re down 10X the number of jobs that a normal recession would have gained.
Clearly this recovery doesn’t resemble any other recovery since the second world war. Government fiscal steroids are being turned off and we’re seeing the consumer and manufacturing clam up over the past couple months. The bond market has figured this out, but the stock market hasn’t. This is the reason 2-year Treasury’s are paying less than half a % interest, and 10-year Treasury’s are paying 2.8%. When 10 year Treasury pays less than money market did four years ago, you know you’re in a different world. The Fed’s remaining ammo is less effective when interest rates are already this low.