February 7, 2015


The environment in the global financial markets continues to grow more interesting as it deals with extreme monetary policies, deflationary pressures in the real economy and the competition for global trade in the midst of overall muted growth.  This month let’s take a look at the increasing challenges the Federal Reserve is facing and a few new bizarre developments in the financial markets.


First, let’s see how this brilliant central bank of ours continues to box themselves into a more challenging position.  Over the past five years they have kept interest rates at zero and have printed trillions of dollars and the rest of the world central banks have followed their strategy at an increasing pace.  This month I won’t go into all the reasons why they never should have printed all this money or cut rates to zero, much less why they should have raised rates earlier.


So, the unemployment rate stands at 5.7% and job growth from the government numbers was pretty strong in January.  Wage growth was much better as well.  The Fed is starting to feel pressure from some of the economic numbers in the U.S. to move rates higher since most would think that zero interest rates is more indicative of an environment like the financial panic in 2008.  As a result, many are forecasting that the Fed will begin to raise rates starting in June.  Since the Fed tends to rely more on coincident economic data points like the monthly payroll numbers rather than leading indicators, more Fed members have recently confirmed that a rate hike is likely to come mid-year.


It is our central bank that started the competitive devaluation game that is being played around the world.  Since global growth is slow and may be slowing, countries are increasingly trying to devalue their currency to make their goods cheaper and capture more global trade.  The European Central Bank recently announced that they are going to print a trillion dollars over the next year, smaller developing countries are cutting rates and it even looks like China may start targeting their currency more aggressively as they are struggling with slowing growth. 


While many countries around the world are following our lead and moving more forcefully toward devaluing their currency, our Fed is now facing pressure to raise rates and this has been reflected in the rapid rise in the U.S. dollar.  Here is a chart to illustrate the rise.




Just in the last seven months, our currency has risen by over 20%.  Now, what do you think we are likely to hear from our companies in the U.S. who are competing for global trade?  This earnings season we have heard more and more companies talking about the challenges they are facing from the rising dollar.  We are likely to start hearing more opposition to the Fed’s plan to begin raising rates from more of our corporate leaders.




Just in the last week, two high profile leaders in the corporate world have voiced their opinions on this; Jack Welch, former CEO of GE, and Warren Buffett.  Welch was interviewed this week on CNBC and said, “The Federal Reserve would be crazy to increase interest rates in the near future.  It would be insane.  Your exports would fall off the table even more.”


Then, Warren Buffett chimed in as reported in an article by CNBC.  “With the rise of new international conflicts and foreign countries diluting their currencies, Warren Buffett said it would not be feasible for the Federal Reserve to increase rates.  ‘If Europe's got them at zero, and you get higher rates in the United States, that would exacerbate a problem with the stronger dollar and funds flow,’ the Oracle of Omaha said on Wednesday.”


This week the U.S. trade balance for December was released.  Our trade deficit was much higher than expectations and soared 17.1%.  This will cause notable downward revisions to 4th quarter GDP.  Corporate America will increasingly apply pressure to the Federal Reserve not to raise rates due to the currency impact.  Once you start down this game of competitive devaluations, it becomes more and more challenging to exit the game.  It is the roach motel of monetary policy.


So, on the one hand, you have Welch and Buffett leading the charge from corporations warning the Fed they had better not raise rates due to the currency issues, and then on the other hand, you have economists jumping up and down over the “wonderful” January employment report and claiming that the Fed better start now in raising rates or they are going to get behind the curve.    Let’s dive a little deeper to see if the economists have much of a case relating to the job gains and wage increases in January.




First, let’s take a look at an article by Jim Clifton, CEO of Gallup.  “Here's something that many Americans -- including some of the smartest and most educated among us -- don't know: The official unemployment rate, as reported by the U.S. Department of Labor, is extremely misleading.  Right now, we're hearing much celebrating from the media, the White House and Wall Street about how unemployment is ‘down’ to 5.6%.  The cheerleading for this number is deafening.  The media loves a comeback story, the White House wants to score political points and Wall Street would like you to stay in the market.”


“None of them will tell you this: If you, a family member or anyone is unemployed and has subsequently given up on finding a job -- if you are so hopelessly out of work that you've stopped looking over the past four weeks -- the Department of Labor doesn't count you as unemployed.  That's right.  While you are as unemployed as one can possibly be, and tragically may never find work again, you are not counted in the figure we see relentlessly in the news -- currently 5.6%.  Right now, as many as 30 million Americans are either out of work or severely underemployed.  Trust me, the vast majority of them aren't throwing parties to toast ‘falling’ unemployment.”


“There's another reason why the official rate is misleading.  Say you're an out-of-work engineer or healthcare worker or construction worker or retail manager: If you perform a minimum of one hour of work in a week and are paid at least $20 -- maybe someone pays you to mow their lawn -- you're not officially counted as unemployed in the much-reported 5.6%.  Few Americans know this.”


“Yet another figure of importance that doesn't get much press: those working part time but wanting full-time work.  If you have a degree in chemistry or math and are working 10 hours part time because it is all you can find -- in other words, you are severely underemployed -- the government doesn't count you in the 5.6%.  Few Americans know this.”


In a follow up interview, Clifton said, “The number of full-time jobs, and that’s what everybody wants, as a percent of the population, is the lowest it’s ever been…The other thing that is very misleading about that number is the more people that drop out, the better the number gets.  In the recession we lost 13 million jobs.  Only 3 million have come back.  You don’t see that in the number.”




So, Clifton addresses the quality of the government jobs data.  Now, let’s see what ECRI [Economic Cycle Research Institute] noted about the actual job and wage gains.  “Certainly, yoy [year-over-year] growth in the number of people with a single job has been trending up over the past year or so.  But the real surge was in yoy job growth for multiple jobholders, which remains near October’s 18-year high, accounting for a disproportionate share of the past year’s job gains, following the termination of extended unemployment benefits at the end of 2013.”


ECRI highlights that at the end of 2013, extended unemployment benefits were terminated.  “Surprisingly”, job gains as noted by the government picked up.  As people are cut off from payments from the government, they have more incentive to find something out there to earn some money.  Remember that if you work at least one hour a week and get paid at least $20 you are not counted as unemployed, since you found a “job”.  Also, ECRI notes that much of the jobs gains came from multiple job holders.  This indicates that the type of jobs that are being created are part-time or low quality since many are having to find multiple sources of work to support themselves. 


If we look back at December, wage growth was negative.  Subsequently, we saw wage gains in January which the economists were excited about since it gave them some hope regarding the deflationary pressures.  ECRI sheds some light over the wage gains this past month.  They noted that the boost in January coincided with a rise in the minimum wage in many states.  That indicates that the wage gains did not come from market forces and any gains in the near-term may be dependent on other states joining the minimum wage increases.  That is not the type of wage gains that suggest healthy economic growth or relief from deflationary pressures.




Next, let’s take a look at what may be more of a structural challenge for the economy as we move forward.  An article by Steve Goldstein, at MarketWatch, noted that the Labor Department tracked productivity growth in the economy at -1.8% for the 4th quarter of last year and that productivity grew only 0.8% for the year.  Also, since the last recession, productivity has not increased by more than 1% in any year. This is partly a reflection of the weak capital investment by corporations. 


Goldstein notes that a quick estimate of growth potential for the U.S. economy is the sum of productivity growth plus the growth in the working-age population.  The working age population is expected to decline from 0.5% currently to 0.2% in 10-years’ time.  In 2000, the last year that the economy grew over 4%, the working-age population grew 2.1%.  The muted productivity and working-age population growth is shown in the chart below.



The anemic economic growth that we have seen since 2008 is likely to continue.  This is further evidence of how Fed policy has been ineffective in helping the real economy.




It is also worth highlighting ECRI’s leading indicator for economic growth in the U.S.




Their weekly leading indicator suggests that growth may actually slow in the U.S. in the coming months and recouple with the weakness that is going on in most areas of the world economy.


All of this likely suggests that the Fed will not end up raising rates in June, or if they do, they will find that the market starts to price in a policy mistake due to the realization of a slowing economy and increasing pressure on trade from the rising dollar.




Before I close, let’s highlight a few of the growing bizarre developments in the world of finance around the globe. 


-          German 10-year bund yields have now dropped below 10-year Japanese Government bond yields – wasn’t the worst of deflationary pressures in Japan?


-          Following 3 consecutive rate cuts by the Danish Central bank, BBC News reported that a local bank offered a mortgage with a negative interest rate!  In effect, with negative interest rates, you could have savers pay the bank to hold their money and the bank pays the debtor to take out a loan!


-          Noted by CNN Money, chocolate is the new gold…the yield on Nestlé’s corporate debt went negative this week.  That means that investors are willing to pay Nestle for the right to park their money in the safety of the Swiss chocolate company!  The Euro denominated bonds of Bank of America, GE and McDonald’s are all near zero.


-          In the same article by CNN Money, it highlights that the central bank moves have knocked the yields on various government bonds into negative territory including Belgium,  Denmark, France, Germany, Japan and the Netherlands.  Investors are guaranteed to lose money on the bonds if they hold them to maturity.  And, these bonds have been the fastest growing asset class in Europe with the total amount of euro government debt and bills yielding below zero has surged to 1.2 trillion euros from 500 billion in October and zero in June!


-          Here is the mentality of an institutional bond trader in Europe – “You've got over 1 trillion of euros that will be created.  All of that new money needs to find a home," said Thomas Urano, a managing director at fixed-income manager Sage Advisory. "I could park it in the bank and lose money for certain or I could put it into a corporate bond and maybe only lose one basis point."  Amazing!


Even though global central banks have printed over $11 trillion dollars in the past 5 years we are sliding, in a number of areas around the world, to where savers have to pay banks to hold their money and in some cases, the bank pays the borrower to take out a loan.




To highlight the backdrop of this emerging world of bizarre finance, we can look at the following three charts.



The chart above shows our Central Bank’s monetary base.



The chart above shows market based inflation expectations even with all the free money.


Now, let’s put this into further historical context with the following chart.




The chart above shows the interest rate policy set by the Bank of England going back to 1705, covering over 300 years.  As the chart illustrates, they have never been as low as they are now...how’s that for perspective!




We are likely to see an increasing number of oddities in the financial world as the global economic and central bank environment evolves.  It would be interesting to see what kinds of behavior would occur if rates were to go negative here in the U.S. like they are in parts of Europe now.  Here is a long-term chart of short-term Treasury-bill yields from an article by Kenneth Garbade and Jamie McAndrews of the NY Fed back in August of 2012.




Rates are at the floor so the next step is into negative territory if the deflation in Europe and Japan continues to come onto our shores.  As an additional read, I have posted the article at the end of this commentary by those two at the NY Fed contemplating the strange and possible behaviors that they believe may occur in a negative rate environment. 


While the volatility has increased in the stock market over the past two months, there seems to be little concern among investors.  In fact, the latest Bloomberg poll finds investors to be the most bullish they have been in five years.  However, it would be unusual to see the type of volatile movements in the currency, commodity and interest rate markets like we have seen over the past number of months without it spilling over into the broader equity markets.  We continue to live in historical times relating to the financial markets and I think the types of oddities that are beginning to surface, which I highlighted above, are just getting started.  Take a look at the commentary below from the two at the NY Fed to get your imagination going.  Some of it may seem far-fetched but a number of countries are already going to negative rates and that seemed far-fetched not too long ago.



Joseph R. Gregory, Jr.



If Interest Rates Go Negative . . . Or, Be Careful What You Wish For


By Kenneth Garbade and Jamie McAndrews.  August, 2012.


The United States has slid into eight recessions in the last fifty years.  Each time, the Federal Reserve sought to revive economic activity by reducing interest rates.  However, since the end of the last recession in June 2009, the economy has continued to sputter even though short-term rates have remained near zero.  The weak recovery has led some commentators to suggest that the Fed should push short-term rates even lower—below zero—so that borrowers receive, and creditors pay, interest.


One way to push short-term rates negative would be to charge interest on excess bank reserves.  The interest rate paid by the Fed on excess reserves, the so-called IOER, is a benchmark for a wide variety of short-term rates, including rates on Treasury bills, commercial paper, and interbank loans.  If the Fed pushes the IOER below zero, other rates are likely to follow.


Without taking a position on either the merits of negative interest rates or the Fed's statutory authority to fix the IOER below zero, this post examines some of the possible consequences.  We suggest that significantly negative rates—that is, rates below -50 basis points—may spawn a variety of financial innovations, such as special-purpose banks and the use of certified bank checks in large-value transactions, and novel preferences, such as a preference for making early and/or excess payments to creditworthy counterparties and a preference for receiving payments in forms that facilitate deferred collection.  Such responses should be expected in a market-based economy but may nevertheless present new problems for financial service providers (when their products and services are used in ways not previously anticipated) and for regulators (if novel private sector behavior leads to new types of systemic risk).  


Cash and Cash-like Products:

The usual rejoinder to a proposal for negative interest rates is that negative rates are impossible; market participants will simply choose to hold cash.  But cash is not a realistic alternative for corporations and state and local governments, or for wealthy individuals.  The largest denomination bill available today is the $100 bill.  It would take ten thousand such bills to make $1 million.  Ten thousand bills take up a lot of space, are costly to transport, and present significant security problems.  Nevertheless, if rates go negative, the U.S. Treasury Department’s Bureau of Engraving and Printing will likely be called upon to print a lot more currency as individuals and small businesses substitute cash for at least some of their bank balances.


If rates go negative, we should also expect to see financial innovations that emulate cash in more convenient forms.  One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault).  Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash.  Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower.


Early Payments, Excess Payments, and Deferred Collections:

Beyond cash and special-purpose banks, a variety of interest-avoidance strategies might emerge in connection with payments and collections.  For example, a taxpayer might choose to make large excess payments on her quarterly estimated federal income tax filings, with the idea of recovering the excess payments the following April.  Similarly, a credit card holder might choose to make a large advance payment and then run down his balance with subsequent expenditures, reversing the usual practice of making purchases first and payments later.


We might also see some relatively simple avoidance strategies in connection with conventional payments.  If I receive a check from the federal government, or some other creditworthy enterprise, I might choose to put the check in a drawer for a few months rather than deposit it in a bank (which charges interest).  In fact, I might even go to my bank and withdraw funds in the form of a certified check made payable to myself, and then put that check in a drawer.


Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees.  Commercial banks might find their liabilities shifting from deposits (on which they charge interest) to certified checks outstanding (where assessing interest charges could be more challenging).  If bank liabilities shifted from deposits to certified checks to a significant degree, banks might be less willing to extend loans, because certified checks are likely to be less stable than deposits as a source of funding.


As interest rates go more negative, market participants will have increasing incentives to make payments quickly and to receive payments in forms that can be collected slowly.  This is exactly the opposite of what happened when short-term interest rates skyrocketed in the late 1970s: people then wanted to delay making payments as long as possible and to collect payments as quickly as possible.  Some corporations chose to write checks on remote banks (to delay collection as long as possible), and consumers learned to cash checks quickly, even if that meant more trips to the bank, and to demand direct deposits.  However, if interest rates go negative, the incentives reverse: people receiving payments will prefer checks (which can be held back from collection) to electronic transfers.  Such a reversal could impose novel burdens on payment systems that have evolved in an environment of positive interest rates.



The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation.  Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.