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Tuesday, August 04, 2009

Fed Watch: Is a Jobless Recovery Your Best Friend?

Tim Duy on how the Fed is likely to respond to "the cyclical turn in the US economy":

Is a Jobless Recovery Your Best Friend?, by Tim Duy: Never underestimate the power of money. Especially lots of money coming on top of a cyclical recovery that is almost textbook at least as far as the timing is concerned. To be sure, you can question the sustainability of the recovery, the breadth or health of the recovery, and the nature of job growth. I have questioned all repeatedly and fail to see that the conditions that have dominated the US economic story for the past 25 years - primarily, a continued reliance on consumer spending to propel growth - can continue in the face of massive household debt burdens and stiffer (or, more accurately, realistic) underwriting conditions. But regardless of these concerns, evidence is clearly pointing to a shift in economic conditions for the better. Moreover, I suspect it will take at least two more quarters at a minimum - and maybe closer to two more years - before the more pessimistic or optimistic visions of the future will come into clear view. Until then, it seems likely the appetite for risk will continue to climb, and all the liquidity - liquidity fueled by new guarantees that massive financial institutions are too big too fail - has to go somewhere.

Which is to say that no matter how pessimistic you are in the medium and longer term, you need to recognize the potential for massive moves in markets as risk taking perpetuates more risk taking. And as long as that risk taking flows in directions that do not fundamentally change the US jobs and, by extension, wage picture, it is difficult to imagine the Federal Reserve will do anything but let the party roll on.

The second quarter GDP report (Jim Hamilton and Menzie Chinn at Econbrowser discuss the details) confirmed what was already well known - the pace of deterioration slowed markedly, setting the stage for a growth rebound in the second half of this year. The game now is upping near term growth forecasts accordingly - not a fool's errand at all, considering the inventory correction is running its course and new residential construction is mostly likely at the bottom (seriously, we were never moving to an economy where zero houses would be built). Moreover, as Calculated Risk reports, it looks like we hit the bottom of car sales, with no small boost being provided by the Cash for Clunkers program.  Say what you like about the economic wisdom of this program or its potential to magnify a double-dip by borrowing from future growth, it will goose the third quarter numbers and advance the pace of inventory correction in the auto industry. And, let's be honest, buying new cars is a whole bunch more fun than just writing massive checks to keep the industry afloat.

The July ISM manufacturing report only adds to the cyclical rebound story. The headline number is flirting with the all important 50 mark, while the new orders component surged into expansion territory. Production, export, and import components all gained. Even the employment reading rose higher, although it continues to signal ongoing job declines. All in all, a report that is predicting recovery in a time frame consistent with the deep cyclical plunges of late last year.

On a more somber note, labor market weakness continues to weigh on paychecks, a phenomenon confirmed by the employment cost index for the second quarter. Wages and salaries for private workers climbed a scant 0.2%. To be sure, this raises concerns about the durability of consumer spending going forward, especially when combined with fears of a jobless recovery. Indeed, I have argued that most if not all of the jobs in the manufacturing sector simply are not coming back. My suspicion is that firms will use the recession to expand overseas supply chains wherever possible. Moreover, firms will not be in a rush to hire back without a clear resurgence of growth, which seems unlikely to occur given precarious household debt burdens.

Now comes the tricky part - what does the evolving economic dynamic imply for financial markets? I am increasingly of the mind that although a jobless recovery will be a dreary fate for the American people, it offers the best outcome for financial markets for one simple reason: The jobless recovery offers the greatest probability that the Fed remains on the sidelines. The jobless recovery is what keeps the Fed goose laying the golden eggs.

True, one should be cautious about reading too much into near-term market action. Macro man puts it succinctly:

The problem that some so-called perma-bears have is is recognizing the temporary importance of such asset flow, and how far it can push asset prices. By the same token, the problem that some of the flow-of-funds, risk-on crowd have is is failing to recognize that buying something just because other people do is nothing more than an exercise in greater fool theory. And while the market may well be a voting machine in the short run, as Benjamin Graham observed it is a weighing machine in the long run.

With the Armageddon trade off the table, market participants need to move the mass of money provided by the Fed somewhere, and it is showing up in all the predictable places. US equities, commodities, oil, and foreign exchange. Indeed, without the Fed threatening to raise rates, there is no rush to exit Treasuries, which could explain the failure of the ten year bond to retake the 4% mark even as equities sure higher.

To be sure, these trades might collapse under their own weight, but the probability of finding a self-sustaining move, like the US housing boom earlier this decade, is higher the longer the Fed keeps rates at a rock bottom level. And the farther that money flows from the US the better for financial market participants; too much money close to home would raise the prospect of stronger growth and tighter monetary policy. Andy Xie (hat tip to Big Picture) believes he has found one such place in China:

Chinese stock and property markets have bubbled up again. It was fueled by bank lending and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter. However, both might flare up again sometime next year. Fluctuating within a long bubble could be the dominant trend for the foreseeable future. The bursting will happen when the US dollar becomes strong again. The catalyst could be serious inflation that forces the Fed to raise interest rate.

When will that bubble burst? Possibly 2012, after the Fed can no longer keep interest rates low:

It is not too hard to understand when the bubble would burst. When the dollar becomes strong again, liquidity could leave China sufficiently to pop the bubble. What’s occurring in China now is no different from what happened in other emerging markets before. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in 1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market for seven years. The current dollar bear market began in 2002. The dollar index (‘DXY’) has lost about 35% value since. If the last bear market is of useful guidance, the current one could last until 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The odds are that another technological revolution is needed for the dollar to enter a sustainable bull market.

However, monetary policy could start a short but powerful bull market for the dollar. In the early 1980s Paul Volker, the Fed Chairman then, increased interest rate to double digit rate to contain inflation. The dollar rallied very hard afterwards. Latin American crisis had a lot to do with that.

The current situation resembles then. Like in the 1970s the Fed is denying the inflation risk due to its loose monetary policy. The longer the Fed waits, the higher the inflation will peak. When inflation starts to accelerate, it would cause panic in financial markets. To calm the markets, the Fed has to tighten aggressively, probably excessively, which would lead to a massive dollar rally. This would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing.

Bottom Line: Incoming data continue to confirm the cyclical turn in the US economy. But that cyclical turn is supported by a massive amount of government intervention, in and of itself a testament to the fragility of the recovery. The Fed will be in no rush to withdraw that liquidity - especially if a jobless recovery emerges. Indeed, it is easy to tell a story where the Fed holds rates near zero into 2011. That also means the Fed will not rock any boats. Thus, the jobless recovery is almost a dream come true for those trades dependent on easy Fed policy - which seem to be virtually all trades at the moment. Although there has been talk of the Fed acting preemptively to curtail bubbles, I am skeptical that any such action would be taken with US unemployment staring at double-digits. And there certainly would be no rush to react if low US interest rates fueled bubbles outside US borders; that, after all, would be the responsibility of foreign policymakers.

    Posted by on Tuesday, August 4, 2009 at 01:01 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (50)


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