May 2004

The Character Of Slack

The Character Of Slack...To suggest that the financial markets have been on heightened alert recently in terms of anticipating potential forward movement in the Fed Funds rate is an understatement.  Moreover, in today's world, participants in the fixed income markets are more financially levered in aggregate than ever before.  In all fairness, the markets have a perfect right to be worried about forward rates.  Alternatively, we think it appropriate to take a broader look at economic "slack" at the moment relative to historical experience in an attempt to gauge the total picture the Fed may be contemplating as we speak.  Although Greenspan has now stated that deflation concerns can officially rest in peace, and although absolute interest rate levels remain anomalistically low, will a few months of strong payroll gains or CPI readings push the Fed over the edge into the beginnings of a significant and prolonged rate tightening cycle?  And although this is clearly a topic for an entire discussion, it is important to remember that the markets look ahead.  By the time the Fed gets around to actually beginning to physically raise the Fed Funds rate, the markets will have already discounted the beginning of this process.  In fact, it seems more than clear that this discounting is underway right now.  Ultimately, speed and magnitude of rate increases remain the important unknowns in our mind.  Hence, our belief that the historical "character of slack" will ultimately determine, or help determine, the speed and magnitude of what is to be the inevitability of the Fed response ahead.  Clearly important both for equity and fixed income markets near term.  For the purposes of the following discussion, we will not be addressing important issues that can and do influence interest rate movements such as currency differentials and global flows of capital.  The following is purely fundamental economic statistics of the moment relative to historical experience as it applies to the initiation of Fed Funds tightening cycles of the past.

INDUSTRIAL PRODUCTION

Despite a better tone to manufacturing oriented diffusion indices lately (ISM, Philly Fed, NY Empire State Manufacturing, etc.), the recovery in headline industrial production remains subdued for now.  A few weeks back we saw an unexpectedly weak industrial production showing for March.  The headline number showed a contraction, but it was largely driven by the fact that utility output in warmer than expected weather was soft.  Nonetheless, manufacturing only output was unchanged for March, completely consistent with the fact that manufacturing average hours worked declined for the period.  Below is an update of a chart we have shown you before that equates the low point in industrial production for each of the last four major recession and post recessionary periods.  It is clear that only in our current experience have we not yet reached a level of production above the prior pre-recessionary peak two-plus years after the conclusion of the last official recession.  
      

Over the past four decades, there have been nine Fed Funds tightening cycles of note.  Importantly, a few of these were very short lived.  In other words, a few of these tightening cycles were abruptly aborted very shortly after takeoff.  The following is the history of the year over year change in industrial production seen at the initiation of Fed Funds tightening in each of these prior cycles.
      

Is the current 3.4% year over year gain industrial production enough to get the Fed to move fast and furious?  In most historical cases, industrial production growth has been a lot faster at the initiation of each tightening cycle.  Really the only times it has been lower were during aborted tightening cycles such as 1971 and 1986.  Certainly 1994 was a bit closer to our present experience in that the Fed Funds rate had been held artificially low in prior years in order to reliquify and allow balance sheet healing in the banking system at the time.  The bottom line is that the current annual growth rate in industrial production is telling us that there is still a fair amount of slack in the broader economy.  Relative to history, current industrial production is anything but on fire.

CAPACITY UTILIZATION

And this sense of slack is completely corroborated by the capacity utilization component of the industrial production report.  In fact, although the consensus was not expecting miracles, capacity utilization actually ticked down modestly in March.  Once again, the following chart chronicles capacity utilization experience during each of the last four major recessionary and post-recessionary periods (twelve months prior to official recession end and twenty six months in post recession).  For now, capacity utilization remains well below prior post recessionary experience.
       

The following table tells the story of capacity utilization and Fed Funds tightening cycles.  As you can see, in every case of the last four decades where the Fed began tightening interest rates prior to capacity utilization hitting at least 82 was ultimately a very short lived tightening cycle.  An aborted adventure.  For now, capacity utilization at 76.5% is below any initial tightening experience on record over the last four decades.  Once again, this data suggests current slack in the domestic economy is more than plentiful.
      

Before going any further, we are fully aware that manufacturing only accounts for about 13% of total GDP.  It's common knowledge that consumption contributes approximately 70% of the sparks to the total GDP bonfire.  Who cares about production and utilization when we're a service based economy, right?  As a counter argument, we'd suggest that interest rate movements are perhaps more meaningful to the service side of the economy given the important role financial companies play in terms of overall contribution to S&P total profit, achieving top dog sector weight status in the S&P equity index, and the incredible asset based financing activity that underpins a good portion of current GDP (housing and the financing related to housing).  In our minds, it all comes down to a very key question, if not the central question.  Is what we are current living through a normal economic cycle, or is it a historically anomalistic credit cycle?  Which is the proper characterization of the economy of the moment.  In calendar 2003, cash out refi's and home equity loans totaled approximately $203 billion.  That number equals roughly 29% of nominal GDP growth last year, and remember it was a bang up year.  That statistic alone tells us that interest rates were terribly important to the economy in 2003.  Before dismissing slack in the manufacturing side of the economy as meaningless, think about what interest rates and leverage really mean to the non-manufacturing side of the economy.  The historical beauty and attractiveness of the US economy is its ability to adapt and survive.  It has adapted to world wars, a depression, incredible inflationary shocks, and a good deal many other affronts.  In our minds, over the last decade at least, the US economy has fully adapted to and become dependent on a once in a generation credit bubble.  Simple question.  How does the economy eventually adapt to a post credit bubble environment without asset price dislocations in at least some, if not many asset classes?  In all sincerity, we simply don't have even the semblance of an intelligent answer.

The following is a little chart that we hope helps put things into perspective.  Unquestionably, the bond carry trade (borrowing at short rates and reinvesting in longer dated, higher yielding, and perhaps more risky assets of all types) has created tremendous financial profits for the large brokers who are more truly hedge funds, the actual hedge community themselves, and many others in the broader financial arena.  In essence, large profits for a meaningful portion of the broader economy - financial services.  Do you believe interest rates are an issue to these "service providers"?  Couldn't be, right?
        

PAYROLL EMPLOYMENT

We ask you, what look at aggregate economic slack in the system would be complete without a quick peek at payroll employment?  Important in that the Fed has publicly and vocally made folks aware that payroll employment gains would be a trigger for abandoning current rate setting "patience".  Again, the following is simply an update of a chart we have shown you on numerous occasions.  Even inclusive of the recent month's strength, payroll employment gains in the post recessionary environment of the moment remain well below not only prior recession peak levels, but also well below the trajectory of payroll gains in the major economic recovery periods of the last thirty years.
       

In the following table, we're only looking at the historical periods where the tightening cycle was not temporary or aborted.  These were meaningful interest rate tightening experiences, and coincidentally meaningful recoveries in payroll employment experience.  For now, despite recent strength, domestic payroll employment remains approximately 1.5% below the level of the absolute body count payroll employment peak in late 1999.  As you can also see, the average gain in payrolls from the prior peak in past cycles that corresponded with the initial Fed Funds rate increase showed growth well in excess of what we have seen in the current experience.  Our current payroll recovery, so to speak, looks absolutely nothing like prior periods of extensive Fed Funds tightening and significant expansion in payrolls.  
        

If we had already lived through just average 3.03% payroll employment growth relative to the prior pre-recessionary peak in today's environment, we'd have 5.97 million more jobs than we now experience in the current economy.  An overnight 4.6% increase from where we are today.  It is clear that labor market slack of the moment remains meaningful.  There is no question that 300,000+ monthly payroll adds ahead would shake up the fixed income markets in a big way, we're just not so sure the Fed would rush headlong into meaningful, immediate or prolonged monetary tightening in response.  At least not yet.  We'll see what the numbers for April bring in just a few days.  

AVERAGE HOURLY EARNINGS AND WAGES

Fact:  The Fed is currently conducting one of the greatest reflation campaigns of any central bank in US history.  It's working in that prices are observably rising.  Prices of everything.  Fact:  Never before in US history have US corporations had the ability to arbitrage wages globally as they do today.  Fact:  Never in US history have average households been as levered as is the case at the moment.  Fact:  Never in the history of US wage and salary records has the year over year change in this measure hit the low that was just revealed in last weeks 1Q 2004 GDP report.

Question:  Just how is the Fed going to raise interest rates both persistently and significantly while year over year compensation growth for labor, otherwise known as US consumers, is registering one of the lowest numbers seen in four decades at least?  Just how can interest rates go meaningfully higher without crushing consumption, while simultaneously wage and salary growth remains below the lowball headline inflation rates of the moment?

HEADLINE INFLATIONARY PRESSURE

It is clear that over the last few months, upward pressure is finally showing up in headline inflation statistics.  After months of waiting, we finally received the fully massaged YTD PPI numbers a few weeks back.  In the following table we again chronicle dates of the Fed initiating rate increases alongside year over year readings for headline CPI, core CPI (ex-food and energy), PPI intermediate materials and crude prices.  As you'll see, never in the last fours decades has the Fed begun a tightening cycle with the year over year change in core CPI at the current level.  Never.  And only once (1986) has the year over year change in headline CPI been as low as we now experience when the Fed began to tap on the monetary brakes.  In 1986, the year over year change in headline CPI was 1.28% when the rate tightening started, but importantly in that year, crude prices dropped over 50% and yet core CPI still expanded  a year over year 3.8%.  Yes, we know all of the problems with current CPI reporting.  There is no question that the owners equivalent rent component is skewing headline numbers to the downside, but the numbers are what they are historically.  Moreover, unprecedented liquidity creation of the past three to four years courtesy not only of the Fed, but also due to interventionist activities on the part of Japan and China, has left the global economy with a significant expansion in total capacity.  The clear result of too much cheap capital chasing lower and lower returns based in part on the remarkable unleashing of low cost global labor pools.
        

What this data tells us is that on a fundamental basis, there is still a considerable level of economic slack in the domestic economy.  Slack that is collectively unlike any broad character of slack seen at the initiation of any other Fed Funds tightening cycle of the last forty years at least.  Despite the very low absolute level of interest rates, is it realistic that the Fed is set to gun the Funds rate ahead?

The Rating Game...Certainly the collective numbers above cannot be viewed in isolation.  If they were to be viewed as such, we would be concluding that there will be no hiking of the Fed Funds rate anytime soon based on the current character of employment, production, utilization, wage gains and headline inflation readings.  BUT, and this is a big but, it virtually goes without saying that the current broader financial and economic landscape is truly unlike anything we have seen anywhere over the last forty years at least.  We continue to wander through a post equity bubble environment that is characterized by an unprecedented credit cycle accompanied by unprecedented fiscal and monetary stimulus.  Our current economic "recovery" is anything but what might be termed normal looking back at post recessionary periods of the last half century at least.  The perhaps unintended consequences of Fed and administration actions over the past three to four years has borne fruit in record fixed income market leverage, multi-decade rate of change highs in housing price inflation, record levels of household leverage, and spiking global commodity prices over the last few years.  Lastly, it is totally clear to US that the Fed made an all or none bet in lowering the Funds rate to 1% and implicitly encouraging the systemic growth of leverage.  As we have mentioned many a time, we simply do not know how they can gracefully retrace their steps while expecting highly levered asset markets really globally to remain calm or subdued.  Is this exact thought just what the markets have started to realize over the past month or so?  Although we certainly lived through a bit of this last year with the rise in 10 year Treasury yields from near 3.1% to approximately 4.6% in mid-summer, it sure appears that for the second time in twelve months, the US bond market is calling the Fed's bluff.

In looking back over Fed tightening experience of the last four decades at least, as we mentioned, it is clear that there were a distinct number of aborted interest rate tightening cycles.  Periods where the Fed began to raise rates only to meet up with an economy showing relatively immediate anecdotal signs of rolling over.  Tightening cycles of 1971, 1976 and 1986 are clear in their short lived message.  But in our minds, a potential near term initiation of a Funds rate tightening cycle ahead may have a lot less to do with slowing a runaway real economy than it will have to do with a Fed being dragged into action by a market finally recognizing, reacting to, and pricing in the consequences of profligate monetary and fiscal policy decisions that have been compounding for years.  Policy decisions whose intended or unintended consequences can no longer be ignored by either domestic or international investors.

Recently in the subscriber portion of the site, we penned a discussion regarding the bond market "vigilantes".  Our suggestion was that the vigilantes of yesteryear have been replaced by the global fixed income highwaymen of the moment - the carry trade crowd, the large interest rate swap derivatives players, and the global currency intervention cowboys.  Much like last summer, there is no question in our minds that a good portion of the backup in Treasury yields we are now seeing is the direct result of a larger unwinding of leverage, especially among the carry trade folks and the derivatives aficionados.  Of course it's easy for the mainstream media to suggest bond market machinations of the moment are the direct result of an explosion in payroll gains and heightened inflation alert.  It's a wonderful cover.  But the character of system-wide economic slack described above suggests the changing nature of perceptions regarding structural leverage in the system may have a lot more to do with the current directional momentum in rates than does the real economy.  Although it may sound like a toss away comment, isn't it fairly obvious that one of the most levered economic environments in history would hit a growth rate brick wall if interest rates were to rise meaningfully?  An economy that has become addicted to credit isn't going to run even faster when the dosage of its primary stimulant has been reduced.  Even as the Fed eventually reacts to where the market is obviously leading it at the moment, will we ultimately witness yet another of history's aborted Fed Funds tightening cycles?  Or will it be something a bit worse?  Of course only time will tell, but history suggests that meaningful tightening in the current environment of real economic slack relative to historical experience will stop economic growth dead in its tracks.  The irony, of course, is that by betting the ranch with anomalistic monetary policy over the last three to four years, the Fed has put themselves in a box.  To get out of the box, they necessarily will have to at least in part puncture the credit dependent economy they helped foster in the first place.  And certainly this should not be unexpected or some type of surprise.  The build up in systemic leverage has been clearly documented in each Fed Flow of Funds quarterly report for years.  In all sincerity, we take no pleasure at all in seeing a real economy exhibiting so much slack relative to historical post recessionary experience at what appears the exact time the markets are likely to force the Fed to deal with the unintended consequences of their remarkable actions of the recent past.  We all face judgment day at some point, now don't we?