The Fed on hold for a year according to the futures market

Futures markets have shifted expectations for the Fed's liftoff further out in time. The July-15 Fed Funds futures contract is only pricing a 12bp Fed Funds rate increase from the current levels - not enough for a full hike.

Source: barchart

In fact the mean expectation for the rate increase timing priced into the Fed Funds futures market is roughly a year from now.

Source: CME

This should slow the appreciation of the US dollar, as the Fed tries to avoid getting too far ahead of other developed economies in its normalization strategy.


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The Bank of Japan may put further easing on hold

Expectations of Bank of Japan accelerating securities purchases at the October meeting have fallen considerably. Majority of economists now expect any type of change in policy to take place no earlier than December/January, if ever. In fact an increasing proportion of Japan watchers are suggesting that faster securities purchases are unlikely to take place at all. The chart below shows the percentage of those who believe further easing is imminent.

Source: Credit Suisse

This relatively sudden change in views is not due to any significant economic improvements in Japan. Japan's consumption tax hike has created a material drag on growth, with industrial production starting to decline again.

The BoJ in fact admitted that a substantial slowdown is taking place and the tax hike is to blame.

WSJ: - The Bank of Japan said Tuesday that industrial production was showing signs of weakness, acknowledging for the first time since the sales tax was raised in April that the move has had a notable negative impact on a key driver of economic growth.

The admission confirms what private economists have been stressing for months—that the higher tax rate has taken a significant toll on the economy. It also comes as a separate government indicator pointed toward the possibility that Japan may have already entered a recession.

In a statement released after a two-day meeting, the BOJ’s policy board maintained its assessment that the economy “continues to recover moderately as a trend,” but that “some weakness, particularly on the production side, has been observed.”

Moreover, the central bank's 2% inflation target remains elusive. Inflation expectation (breakeven) implied by the 10-year JGBs is barely above 1%.

Source: Japan Bond Trading Co

So why do many economists now think the central bank is not going to accelerate QE - at least not in the nearterm? The reason has to do with the increasing uncertainty around the benefits of a weak yen (discussed here). While large exporters benefit from currency depreciation, smaller businesses and consumers are hurting.

Bloomberg: - Debate is increasing over the costs and benefits of the weakening yen, which is increasing costs for importers and households while it bolsters profits for some companies. Further depreciation could risk support for the Bank of Japan’s unprecedented stimulus program, even as the government says there is no gap with the BOJ in its stance on the yen. ...

Exchange-rate depreciation has raised the cost of imported products including energy, something that’s helped end Japan’s deflation and stoked profits for companies with earnings abroad. Smaller businesses have become increasing vocal in opposing the fall, even as Kuroda says that the negative effects are outweighed by the positive.

Kuroda was told by business leaders in the industrial city of Osaka last month that the yen’s slide was boosting costs of imported fuel and raw materials and may spell trouble for the economy. 

With wage growth remaining sluggish (particularly for non-union workers), rising import costs could undermine consumer demand - particularly in the face of higher consumption taxes. Given these headwinds, there may be sufficient political pressure to put the BoJ into a holding pattern.

It is important to point out however that even without adjusting its policy, the BoJ's current QE effort is by far the most ambitions monetary expansion program by a developed economy in recent history.

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China's local government debt binge curtailed

Over the years China's local governments have become dependent on financing themselves via land sales and more recently the so-called Local Government Financing Vehicles (LGFV). Times were good, as property developers grew wealthy via sales of new urban housing while enriching local governments and often government officials. But over the past three years growth in the nation's property markets has cooled. This slowdown is clearly visible in the decline of prices for steel rebar which is primarily used in construction. This slowdown has accelerated this year.

Source: barchart

At the same time Beijing started scrutinizing the banking system (including state-owned banks) where the volume of bad loans had been on the rise. Moreover, many of the earlier infrastructure projects initiated as part of the 2008 stimulus have not yielded the revenue levels that were originally projected. With slower land sales, more stringent bank lending, and a taste for credit, China's local governments increased their borrowing via LGFV as well as other non-traditional sources (see chart).

Source: Scotiabank

This borrowing by municipalities, combined with growing corporate debt (a great deal of it from developers), resulted in China's total debt-to-GDP ratio increase of over 70% since 2008. Worried about local governments' growing large-scale credit bubble, Beijing  has recently decided to put an end to these forms of financing. Here is a comment from Beijing's mouthpiece, the People's Daily:

People's Daily: - Funding sources for local governments will change dramatically. Shadow banks and corporate bonds are out: local government bonds are in, for both existing and new debt. This will immediately cure the maturity mismatch risk for local government debt, as local government debt has a longer maturity. The interest burden will also be reduced: Yields on municipal bonds are close to treasury yields and much lower than bank lending rates or trust yields. In the long run, this could strengthen market discipline for local government borrowing, as municipal bonds tend to have stricter requirements on disclosure of fiscal balance sheets and monitoring than shadow banks.

Of course shifting to muni bonds is not going to be easy. Demand for muni paper is limited precisely because of lower yields and the fact that the market remains heavily regulated. Furthermore, Beijing is prepared to allow local governments to fail - an outcome that is becoming increasingly possible.

WSJ: - Local governments have had a tough time this year repaying debt as fiscal revenue growth has slowed in the face of a weaker national economy and China’s property market downturn. China’s combined central and local fiscal revenue rose 6.1% in August from a year earlier, compared with a year-over-year increase of 9.2% in August 2013, data from the finance ministry showed.

Almost 40% of the 17.9 trillion yuan in local government debt and guarantees will mature by the end of this year, placing huge pressure on local governments to make repayments, according to a report released by the state auditor late last year.

In fact many municipalities are already bankrupt and survive only on their ability to "roll" exiting debt. Numerous infrastructure projects financed by local governments are being curtailed, creating a drag on the nation's growth. There will also be a hit to funding for education, healthcare, and other services provided by local authorities. While this restructuring is a positive development in the long term, the immediate effect will materially raise the risks to China's (and ultimately global) near-term growth.

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The FOMC takes dollar strength into account; liftoff expectations shift to a year from now

The Fed is finally expressing unease with the world outside the US borders and its impact on the US economy.

FOMC Sep-14 Minutes: - "During participants’ discussion of prospects for economic activity abroad, they commented on a number of uncertainties and risks attending the outlook. Over the intermeeting period, the foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants ex-pressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector. Several participants added that slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal."

In a single paragraph the FOMC minutes conveyed the concerns about the rising US dollar and risks of further dollar appreciation due to economic weakness across major economies. Strong dollar hurts US exporters and reduces dollar denominated revenues for firms that conduct a great deal of business abroad. It also puts downward pressure on inflation (see post), elevating disinflationary risks. This is clearly visible in TIPS-based inflation expectations (breakevens) that continue to decline.

The FOMC's projections for US GDP growth a couple of years out have shifted lower in part because of slower economic expansion around the world.

Source: FRB

The markets interpreted the minutes as a clear signal that the Fed is in no hurry to normalize rates. Even though the US foreign exchange policy is under the control of the US Treasury (instead of the Fed), the FOMC would clearly like to avoid a significant dollar appreciation and will remain on hold should the rally continue. With events in the rest of the world now becoming a greater part of the FOMC's playbook, the expectations for liftoff have shifted further out in time. The chart below shows the July-2015 Fed Funds futures spiking after the release of the minutes (reducing Fed Funds rate expectations for next summer). The markets are now pricing in the first hike taking place about a year from now.

Source: CME

Equities, treasuries, many commodities, credit - all rallied in response. The FOMC is telling us that with the rest of the world in relatively poor shape economically, the stimulus party in the US continues for a while longer.


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Labor supply/demand imbalance in the United States

The number of US job openings is now running materially above the pre-recession levels. One would think the nation's unemployment rates should be at pre-2008 levels as well.

But the decline in unemployment has significantly lagged job openings in recent years. The mismatch between all those new positions and all those people without work (including those who had left the labor force altogether) persists. Here is the updated Beveridge curve.

The US clearly has the jobs but not the people to fill them. Part of the reason is that a good proportion of those unemployed and marginally employed are not the people companies want. The skills gap continues to plague US labor markets.

Another way to look at the US Beveridge Curve is to plot job openings vs. the duration of unemployment. The logic here is that as job opportunities improve, the average time spent between jobs for those who have been laid off should shorten. But with US job openings now at highest level in 13 years, the average duration of unemployment is still higher than in any post-WWII period prior to the Great Recession (see chart). This disconnect is staggering.

After speaking with some folks who currently don't have work (and not much in terms of skills), it seems that prior to the housing crisis, many of those who got laid off, quickly found temporary work in construction or other housing related areas. A great number of those jobs are gone and with them went some of the safety net - dramatically lengthening the duration of unemployment. That's why it's so troubling to see growth in construction spending slowing this year (see chart). At the same, increasing numbers of job openings now remain unfilled while over 9 million people live on unemployment benefits.

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Volatility returning to currency markets

Today the dollar gave up much of its Friday's gains that were driven by stronger than expected US employment situation report. We haven't seen such volatility in currency markets in some time. What happened?

Source: Investing.com

On one hand we have a developing story in the Eurozone as a number of economists continue to believe that the ECB will have to undertake government bond purchases. The central bank will probably need to increase the Eurosystem balance sheet by at least €1 trillion in order to be credible. But it will be impossible to purchase enough ABS and covered bonds without drastically distorting the markets. These markets and the TLTRO program just aren't sufficiently large to achieve such balance sheet expansion without a more traditional QE program that involves purchases of government bonds.

However Mario Draghi dampened expectations for a full QE program at the last ECB press conference. The explanation seems to be that Germany continues to be heavily opposed to such efforts. In fact Jens Weidmann is even opposed to ABS purchases - particularly from periphery states such as Greece and Cyprus. And some senior politicians in Germany are saying that Draghi is turning the ECB into "junk bank". With such headwinds for the ECB, it is not at all clear if QE will even be possible in the nearterm. Questions about the ECB's programs' effectiveness have introduced increased uncertainty into the euro's trajectory, causing volatility to rise.

Similarly the uncertainty is increasing around the Fed's liftoff as well. Expectations of timing vary dramatically between as early as Q1 of next year and as late as a year from now. With rate uncertainty comes increased currency volatility.

The volatility is further helped by the fact that speculative accounts have jumped on the long-USD bandwagon (as can be seen from the CFTC commitments of traders futures data).

Source: Timingcharts.com

Now add to that sharp swings in emerging markets currencies of nations such as Brazil, Russia, South Africa and Turkey and we finally see volatility returning to FX markets.


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Dollar strength and inflation expectations

The ongoing strengthening of the US dollar could shift the FOMC further into dovish territory. While the labor situation continues to improve, the dollar's recent appreciation has contributed to declines in inflation expectations (based on TIPS breakevens) to multi-year lows.

Another way to think about this is that lower inflation expectations are equivalent to higher real interest rates - a form of "market-generated" tightening in monetary conditions. Central banks generally don't like to tighten policy when real rates rise sharply.

Part of the reason for weaker inflation expectations has been the decline in commodity prices - which to a large extent resulted from stronger US dollar (as well as slower growth expectations in China). A widely-tracked broad commodity indicator called the Continuous Commodity Index is now at the lowest level since 2010.

Source: barchart

Moreover, stronger dollar lowers prices of imported goods in the US. After a period of declines last year, growth in import prices finally turned positive this summer, providing support to the CPI. But as the dollar started appreciating, import prices began falling again, lowering US inflation and inflation expectations. We saw signs of that in August and are likely to see more declines in September (the report comes out in a couple of weeks).

Source: BLS

The Fed watches market-based inflation expectations quite closely and the dovish FOMC members may use this as an excuse to press for delays in rate normalization. If the US dollar appreciation continues at the current pace, the FOMC's dot-plot will begin to move lower.

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How close are the US labor markets to normalization?

As discussed here back in April, US labor markets continue to heal, with Friday's payrolls gains putting 2014 on track to be the best year for job growth since the late 90s. Now many are asking just how far is the employment situation from "normalizing". Of course it all depends on the metrics used. The chart below for example shows that the headline unemployment rate is now well within the normal range (based on long-term historical data).

Source: Credit Suisse

But as we know, that's only part of the story. A broader gauge of unemployment, the so-called U-6 rate, which includes marginally attached workers and those employed part time for economic reasons, suggests the labor markets have some room for improvement.

Within the U-6 metric it is particularly important to track the percentage of those employed part time for economic reasons. The current number of these workers (at just over 4.5% of the labor force) is not unusual by historical standards but is still quite elevated. It's not at all clear however if we are ever returning to the lows of the decade that preceded the Great Recession.

Another measure of labor markets' health is an estimate of the "job finding rate" from Credit Suisse. At least based on the data since 1990 (which may not be a sufficiently long range), that metric is currently far below average. We do see signs of significant improvements recently but the red line in the chart below may no longer be our target for what is "normal".

Source: Credit Suisse

We've also seen a great deal of focus on falling US labor force participation rate. The non-demographic component of the post-08 declines in participation rate is of particular importance. How much is due to aging US population vs. the discouraged workers exiting the labor force?

Source: Credit Suisse

There are hints that the non-demographic decline in participation has been halted, albeit at a relatively low level. The fact that the non-demographic participation level has fallen doesn't say much about what it will take to return to "normal". That's because the pre-recession housing bubble had generated unsustainable demand for labor (particularly unskilled labor). That demand isn't coming back any time soon as we look to establish the "new normal" in participation rate. We also see other factors impacting participation such as more disability claims and higher college enrollment rates.

Finally we want to take a look at wage growth as an indicator of demand for labor. Wage growth in the US remains remarkably steady, anchored at 2% per year. While this growth is certainly weak relative to recent history, it is quite respectable relative to other developed economies. Once again, how far is wage gowth away from "normal"? Most economists believe that if payrolls continue to increase at the current pace, wage growth will improve. Perhaps. But we are unlikely to see sustained wage growth at levels the US experienced prior to the recession. Given weaker wage inflation globally (and wage deflation in a number of EU states), the 2% or slightly higher may be the new "normal".

While many continue to insist that we are years away from normal labor markets in the US, it may be time to adjust our expectations. We could be much closer to the "new normal" than we had hoped.


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