shsawant379@gmail.com

It might have flown quietly under the radar, but this was an eventful week in Treasury Markets – marked by the auction results turning out to be a fairly non-event. That’s an Oxymoron for you!

But more than the week, it has been the past 3-month correlation between movements in treasury yields and equity market performance which, for me, has been the star event of the year.  

Lets do a recap. Risk assets or S&P500 (or mostly the Magnificent 7) were doing quite well up until 31^st July. That when the US Treasury announced its refunding plans for Q3 and Q4 of 2023. In simple terms, the Refunding Plans are the mechanism through which the US Treasury tells the market how much it intends to borrow and what format it intends to borrow in (bills vs bonds).

I had written about this in early August highlighting the substantial increase in marketable borrowing plans of the US Treasury as well as the increase in coupon auction sizes. Link here (or go to the Posts section on my Linked in Profile): https://www.linkedin.com/posts/shashank-sawant-459a06_home-activity-7092916022877306880-uzwH?utm_source=share&utm_medium=member_desktop

In immediate response to the treasury refunding announcement, long bond yields rose higher and the S&P500 experienced an equally swift fall.

The US Treasury announced its latest borrowing plans on October 30^th and November 1^st.

It surprised markets by announcing a lesser than expected borrowing quantum for Q4 2023 and also increased coupon auction sizes by lesser than expected. The marketable treasuries borrowing estimate for the 4^th quarter of 2023 was revised down from US$852bn to US$776bn. And coupon auction sizes for auctions in the months of November 2023 through January 2024 were also lower than expected. Specifically, auction sizes for the 3 year, 10 year and 30 year bonds to be auctioned in the month of November were lower than expected by US$2bn.

Once again in immediate response long bond yields fell sharply and the S&P500 experienced an equally swift rise back up again.

Given this backdrop, the key event to watch out for in the week of 6^th November was the performance of the 3 year, 10 year and 30 year treasury auctions. And thankfully, it turned out to be relatively non-eventful. Auction performance across the 3 year and the 10 year was relatively benign, while the 30 year auctions results were quite disappointing last night. The weak auction, coupled with a hawkish speech from Jerome Powell which suggested that the Fed may not be done hiking, sent bond yields higher again and risk assets lower.

The table below summarizes the auctions results this week.

*The comparison and colour grading is against an average figure of the last 6 auctions in that tenor.

In general, demand at the longer end is likely to continue to be tepid. That will cause a lot of volatility especially in the 20 and 30 year tenors (Opportunity or Risk for the TLT ETF enthusiasts!!).

What should I watch out for next?

The next event to watch out for is the October US CPI release on Nov 14, 2023. The first point to note is that the base effect is favourable in October 2023. M-o-M CPI had increased 0.5% in October 2022.

Secondly, given this base effect and the recent drop in energy prices, it is likely that we will see a fall in headline y-o-y inflation. A drop in core inflation will probably cause long bond yields to dip further slightly and will be positive for risk assets. Yet, it is equally important to consider other factors that will have a large bearing on the markets into the year end viz. government shutdown risks, seasonal trends, tax loss harvesting and larger coupon auctions into the next 2 months. In summary, both bond and stock markets seem poised for range bound activity – which makes certain option strategies like selling strangles or covered calls the ideal trades to perform. That is if you still want to generate some income instead of heading out to the mountains, beach or the bar in the holiday season!

Happy Diwali.

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

Information overload is a pitfall of the digital era we live in. A ton of apparent topics get covered in mainstream financial media. The interesting bit is to explore and educate on lesser discussed issues.

Alan Greenspan, the 13^th Chair of the Federal Reserve, served five terms from 1987 to 2006. He is best known for having presided over the “Great Moderation”, a period from the mid 1980s to the GFC of 2007, characterized by relatively stable inflation and solid economic growth. The term “Greenspan Put” a cornerstone at the intersection of monetary policy and financial markets is another of his legacies. Also, one of his key achievements, is said to be the “Soft Landing” navigated in the US economy in the mid 1990s.

Have a look at the charts below.

The first chart show US labour productivity through the 1990s. The second shows US labour productivity from right before the pandemic till date. The question to ask ourselves is will the productivity boom experienced by the US economy from mid 1995 till the end of that decade (marked in red) repeat itself in the next few years to come?

Why does that matter? Read on..

US Labour Productivity 1991 to 2000

US Labour Productivity 2019 to Q3 2023

The monetary policy tightening cycle of 1994-95 is remembered as probably the only instance in recent history when the Fed achieved a soft landing. After a brief recession (caused by the Gulf war), the US economy witnessed 2-3 years of stellar GDP growth in the early nineties.

GDP Growth up until the monetary tightening cycle of 1994

Inflation concerns from a booming economy led to Greenspan initiating 7 back-to-back rate hikes starting from February 1994.

Rate Hikes starting 1994

The last of these rate hikes took place in February 1995. By the first quarter of 1995 there was some slowdown in economic growth, but far from unequivocal clear signals of a significantly slowing economy or rapid disinflationary indicators. Yet, Greenspan initiated a series of rate cuts. Starting from July 1995, the Fed cut rates 3 times by a cumulative 75 basis points into the start of 1996.

Rate cuts starting mid 1995

Up until May 1995 inflation was still running at a solid 3.0%. The US economy continued to record robust growth. Yet Greenspan saw what no one else did. The upcoming productivity expansion.

Relationship between Productivity, Inflation and Wages:

Now, let me shift gears a bit and explain the relationship between Productivity, Inflation and Nominal wage gains. Wage growth can be said to equal productivity growth plus inflation. All other things being equal, if productivity grows at 1.5% and nominal wages grow at 4.5%, that can likely mean an average realized inflation of around 3%. Explained in another way, productivity improvements lead to a higher output for the same hours of labour worked. Higher output per hour of labour gives companies and businesses the ability to raise wages without crimping profit margins or eroding competitiveness. This fuels a virtuous cycle of economic growth and wage gains. But the low unit labour costs on the back of continuous productivity gain keep inflationary pressures low. This is precisely what occurred in the late nineties.

Labour productivity improved substantially as foreseen by Greenspan..

Wages gained through the period…

And yet inflation remained fairly benign through most of the late nineties…

The productivity change of approximately 2.1% was significantly greater than the 1.4% and 1.6% seen in the previous two cycles of the seventies and the eighties.

The productivity boom and economic growth also translated commensurately into company earnings and consequently equity market performance. (Needless to say there were a ton of other factors which influenced that period’s equity performance including the famous “irrational exuberance” of the late nineties)

Does History Rhyme?

There has been ample amount of literature that attempts to explain the post 1995 productivity acceleration. Some of the key points to note are –

• Investments in Information Technology caused an increase in labour productivity throughout the economy. The semi-conductor industry experienced rapid innovation with better performing chips and shorter gestation periods for node innovation. The emergence of the internet further contributed to a demand boom for personal computers

• High or increasing competitive intensity resulted in the spread of innovation. For instance, in general merchandise retailing, Walmart’s success forced competitors to improve operations. Pharmaceutical wholesalers responded to competition from large retailers by automating distribution centers.

• Another key aspect of the post 1995 productivity boom was that the US experienced a much larger increase in productivity compared to the rest of the world.

• Low inflation itself created competitive pressures which forced businesses to spur productivity growth (although there is a circularity in this argument)

While the intent of the note is not to dive into the absolute specifics of the post 1995 productivity spike, it would be remiss to not draw some parallels to the current trends in the world. While AI might be an over-hyped and often abused term, it hard to miss daily narratives of simple improvements to personal and corporate lives – ranging from work from home to virtual meetings to digital assistants to electric vehicles to driverless cars to lightning speed 5G connections to gene editing to tele-medicine to 3D printing. The list is almost endless.

Summary:

So what’s the summary? The BLS released US labour productivity data on 2^nd Nov 2023. The report showed non-farm business sector labour productivity increased a substantial 4.7% in the 3^rd quarter of 2023. Productivity has been improving since Q3 2022. If we continue to see an above trend improvement in productivity, wage increases at 4.0 – 4.5% can be sustained without causing a wage price spiral. The almost elusive “Soft Landing” will have actually materialized then! There are a ton of other factors to consider including the role of relative leverage in the economy, which is significantly higher now compared to the late nineties and can potentially have devastating effects on the economy and risk assets. Similarly, it is also key to consider fiscal dominance given budget deficits of 6-8%. Nonetheless, it is equally key to keep an eye on productivity trends. Like the cliché says, history does not repeat itself but it often rhymes.

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

Two banking behemoths. Two different years. Two divergent equity returns. One common underlying reason.

There is no denying the fact that JP Morgan and Bank of America are in a league of their own. By their sheer size, scale and market dominance, they have a systemically important place in the financial system that is probably unparalleled in history.

Today we examine how their paths have differed over the past 3 years post the pandemic – all mostly attributable to one underlying reason.

First, here is a look at their comparative share price performance over 3 periods:

Full year 2021 – BAC : 48% , JPM : 26%

January through November 2022 – BAC : -18% , JPM : -16%

December 2022 till Oct 6 2023 – BAC : -29% , JPM : +5%

Borrow from Peter and Lend to Paul:

The business of banking, even though some folks might make it seem like fancy financial engineering, is a surprisingly simple one – Maturity Transformation. Borrow short and Lend long. And the summary in this case is that Bank of America decided to allocate a larger portion of their asset base to the “lend long” bucket than JP Morgan did. The result – JPM now has more flexibility to take advantage of increasing rates than it closest competitor BAC.

Lets dig a bit deeper.

BAC – Make hay while the sun shines

The first chart shows the trajectory of the two competitors’ asset deployment strategy over the past 5 years. BAC undertook a clear strategy to allocate a large percentage to investment securities compared to reserves (funds held at the Federal Reserve) and deposits at other banks. More specifically a larger chunk was allocated to Agency Mortgage backed Securities for the incremental spread over comparable maturity treasuries. It was good till it lasted in 2021 and BAC stock returns out-performed JPM by a mile. That was until the Fed embarked on the fastest rate hike in recent history. In simple terms, that means a larger portion of BAC balance sheet is locked up in these low yielding assets. Given the massive duration on these securities, any sales to free up balance sheet capacity entails crystallizing a significant loss.

JPM – Deposit taker of the last resort?

Second, and a bit surprisingly, BAC recent deposit trends look weaker than JPM. To comprehend the full landscape, one must understand that it is non-interest bearing deposits which matter most to a bank’s economic performance. A bank can mop up money with a high paying CD. But that’s hardly of any economic use in today’s rate and economic environment. While BAC is “home’ bank to many US blue chip corporations (OPAC liabilities) and a dominant retail franchise, the stark contrast to JPM in the loss of non-interest bearing deposits is unmistakable. Most of the drop in deposits for BAC seems to be attributable to its Consumer Banking and Wealth Management franchise. Conversely, deposits for JPM Consumer Banking and Wealth Management seem to be holding much better.

NIM-ble footed JPM

In summary, balance sheet flexibility due to a lower share of long duration fixed rate investments and the stronger deposit performance is enabling JPM to have a clear differentiation in Net Interest Margin and consequently Net Interest Income – a key driver of bank profitability.

Quarterly focus vs Long term strategy

The capitalist world can be unforgiving. For a period of time rates were very low in the immediate aftermath of a severe pandemic. Even the most distinguished of finance leaders were suggesting transitory inflation. After all we had lived through more than a decade of sub 2% inflation. It was in this environment that JPM still chose to take a different path than its closest competitor and hold more reserves at the Fed compared to investment securities. At every earnings release during 2021, JPM was asked the same question – why not sweat the asset book more by investing more in government treasuries and agency securities.  Here’s an example below from the 3Q 2021 investor call. The pressure must have been intense all through 2021 and into 2022. But patience has its rewards – which are now manifesting in JPM stock returns in 2023.

Question

Quote

Hey, guys. Was hoping to follow up on the capacity to deploy liquidity. And I guess just to kind of lean in a little bit, if we look at the growth in deposits, I know some of them are kind of considered noncore, but take out the loan growth and the growth in securities book since COVID, you’ve got about an extra $500 billion of deposits. And how much of that do you think can be deployed into securities, and understanding that you expect loan growth to pick up so that will go to some, but is there a way to size that $500 billion capacity in terms of buying securities?

Unquote

Answer

Quote

Yeah, so I think there’s a lot of factors that play into what the deployment decision is in any given moment. Obviously, as you said, loan growth, but also, we always make these decisions on the long-term economic basis, not for the purpose of generating short-term NII. And so when you do that, you have to think about capital volatility, drawdowns, and frankly, whether or not you see value. And that, if anything, is probably the biggest single factor right now.…So we’re always – we always try to be long-term economically motivated there considering all the scenarios, considering risk management, considering the convexity of the balance sheet, and looking at value and being tactical there. So that’s really how I would think about that.

Unquote

Who says Accountants are not Creative

Lastly, a short note on accounting jugglery as well. Investment securities generally are classified as Held to Maturity or Available for Sale. In the case of the former, the bank does not mark-to-market investment losses on the securities i.e. they are carried at amortized cost on the bank’s books. On the other hand, investment securities held in the Available for Sale book, need to be measured at fair value with any losses accounted for in the Bank’s Equity (via Other Comprehensive Income). It does not take a genius to figure that in an environment of steeply rising rates, it makes sense to transfer securities from Available for Sale to Held to Maturity, so that any further reductions in fair market value do not result in more hits to bank equity. The below paper at the University of Chicago suggests that cumulatively Banks in the US reclassified more than $900bn securities from AFS to HTM during 2022 (https://bfi.uchicago.edu/insight/research-summary/bank-fragility-and-reclassification-of-securities-into-htm/). It is difficult to pin point precise numbers since many Banks do not specifically disclose reclassification in quarterly results (I could find JPM disclosures on quantum of reclassified securities from AFS to HTM. But not for BAC). But the below graph does provide a representative (even though not comprehensive) idea of the difference in reclassification strategies adopted by BAC and JPM.

Earnings Yearnings

Bank earnings kick off next week. As of June 2023, BAC had gross unrealized losses of $105.7 billion on its Held to Maturity debt securities. Moreover, given the relatively benign or even favourable rates movement in the previous 3 quarters (4Q 2022, 1Q 2023 and 2Q 2023), the impact of mark-to-market losses on the AFS investment portfolio was benign (and mostly positive). The monster rates rally in Q3 2023 will have a negative impact on OCI and consequently Equity (that assumes no offset from derivatives).

Just to clarify, the above analysis does not infer that BAC is in any form of solvency risk. In fact, far from it. There would be hundreds of other banks which would face trouble before things get so bad as to merit a question over BAC. But it does explain a substantial portion of the divergence in stock returns over the past years!

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

Non-Farm Payroll ? Non-Fathomable Payroll? Non-Faltering Payroll?

What does this article intend to achieve? One of two objectives: Either put you to sleep OR help you understand:

• Monthly Non-Farm Payroll
• Monthly Revisions to Non-Farm Payroll
• The BLS’ Annual Benchmarking Exercise
• Quarterly Census of Employment and Wages
• The Philadelphia Fed’s effort to forecast the BLS’Annual Benchmarking number

Non-Farm Payroll is arguably the most important economic data point in the US, or probably the next most important data point to the CPI.

We often tune in to just the first estimate of the NFP release for the month and then conveniently ignore any revisions to that number.

Needless to say, often it is the first estimate which is most important from an immediate market impact perspective given the reliance placed on it by trigger happy market participants and automated algorithms. Nonetheless, it is important to understand all subsequent revisions if an investor wants to get a good view of the employment situation in the US to make their own informed investing decisions.

Lets start from the beginning….

Monthly Non-Farm Payroll

The Non-Farm Payroll report is published by the Bureau of Labour Statistics on the first Friday of the following month. This news release presents statistics from two major surveys, the Current Population Survey (CPS or Household Survey) and the Current Employment Statistics survey (CES or Establishment Survey). The Household Survey provides information on the labor force, employment, and unemployment that appears in the “A” tables, marked “Household Data”. It is a sample survey of about 60,000 eligible households. The Establishment Survey provides information on employment, hours, and earnings of employees on nonfarm payrolls; the data appear in the “B” tables, marked “Establishment Data”. Each month the CES program surveys about 122,000 businesses and government agencies, representing approximately 666,000 individual worksites.

The below is the picture that the Establishment Survey’s first estimates showed us for 2023. Trending down for sure, but still a healthy pace of job creation compared to recent labour market history. Average monthly jobs created of 310K.

Monthly Revisions to Non-Farm Payroll

The Establishment Survey revises these published estimates to improve its data series by incorporating additional information that was not available at the time of the initial publication of the estimates. The establishment survey revises its initial monthly estimates twice, in the immediately succeeding 2 months, to incorporate additional sample receipts from respondents in the survey and recalculated seasonal adjustment factors. The below is the picture that the recent revisions of the Establishment Survey shows us. Average monthly jobs created in the first 5 months of 2023 of 255K – lower by 55K on average or 325K in total. That sounds like a sizeable over-estimation of overall job creation in the economy!

The BLS’ Annual Benchmarking Exercise

Ok. So what happens next? The sample-based estimates from this Establishment Survey are adjusted once a year (on a lagged basis) to universe counts of payroll employment obtained from administrative records of the unemployment insurance program. The difference between the March sample-based employment estimates and the March universe counts is known as a benchmark revision, and serves as a rough proxy for total survey error. Over the past decade, absolute benchmark revisions for total nonfarm employment have averaged 0.1 percent, with a range from -0.3 percent to 0.3 percent. In summary, not only are the initial estimates revised twice in subsequent months, they are also revised retrospectively once a year, typically in February of the next year. Too confusing ? Lets understand this with an example.

The first chart below shows 2022 monthly job creation based on initial estimates and then the 2nd monthly revision. The second chart below shows 2022 monthly job creation based on the 2^nd monthly revision and the final benchmark revision conducted in February 2023.

Both the charts collectively have the following takeaways:

1. Total jobs created in 2022 per the initial estimates of the Establishment Survey were 4.62mn
2. Total jobs created in 2022 post the 2^nd monthly revision was more or less the same (you can see not a lot of white bars in the first chart)
3. However, total jobs created in 2022, after the benchmarking exercise was completed in early 2023, were 240K lower at 4.79mn (more orange bars in chart 2 compared to the white bars in chart 1)

So, how are we doing in 2023? Well, we have to wait till Feb 2024 to really find out. However, the BLS also provides some preliminary idea earlier in the year about the likely revision that will come up next year.

On August 23^rd, 2023, the BLS’ published a preliminary estimate suggesting that US job growth through 2023 March was less robust than previously estimated. The preliminary estimate of the benchmark revision indicated a downward adjustment to March 2023 total nonfarm employment of  minus 306,000 (−0.2 percent).

Quarterly Census of Employment and Wages

The monthly Establishment Survey data is timely, but inaccurate. The final data post the completion of the benchmarking exercise in February is the most accurate, but not timely (i.e. with a year’s lag). So what’s the solution? Enter Quarterly Census of Employment and Wages. The QCEW program publishes a quarterly count of employment and wages reported by employers covering more than 95 percent of U.S. jobs available at the county, Metropolitan Statistical Area (MSA), state and national levels by detailed industry. Unlike the monthly Establishment Survey data, the QCEW data are based on state unemployment insurance tax records and cover nearly all of US jobs. BLS publishes data from the QCEW program every quarter in the County Employment and Wages press release, within 5 months after the end of each referenced quarter. So in summary, instead of waiting for 12 months to get the full revised job picture, you can look at the QCEW data which comes with a lag of only 5 months !

For instance, the latest QCEW (released in August 2023) showed that in March 2023, national employment increased to 151.4 million, a 2.5% increase over the year. In contrast, the existing data from the BLS survey shows jobs increased 2.7% y-o-y in March 2023. (Side Note : Even the annual benchmarking exercise on the Establishment Survey data is based on the QCEW data)

The Philadelphia Fed’s effort to forecast the BLS’Annual Benchmarking number

Lastly, for those like me with a sadistic desire to inflict unending pain on yourself, you can read the Federal Bank of Philadelphia’s release which solves the lagged data problem even further. It produces quarterly early benchmark estimates of monthly state employment for all 50 states and the District of Columbia. In other words, since the QCEW data are available quarterly, the Philly Fed researchers are able to create their own early benchmark estimates on a more timely basis.

The latest report for Q4 2022 issued by the Philly Fed shows US job creation in the year through December 2022 was estimated to be 2.7% and in the year through March 2023 is estimated to be 2.3%. Calculated differently, the Philly Fed report shows they annual benchmark revision for March 2023 (that the BLS will release in Feb 2024) is likely to be around minus 550K.

Summary: One of the most prominent and sometimes unfortunate aspects of the investing world is “Information Asymmetry”! And the Retail and Small Institutional Investor is always on the disadvantaged side. So the next time you see a Bloomberg news run like the below….

…. check the data for yourself. Make sure you understand the meaning of every key economic statistic. Be an Informed Investor!

Shashank Sawant

www.thecreditbalance.com

Economic history is replete with incidents of hubris followed by lessons in humility. The latest CPI data showed y-o-y CPI is down to 3.0% in June 2023. The last time headline CPI had a three handle was 2 years and 3 months back in March of 2021. So a lot of folks have been asking “Why isn’t the Fed doing a victory parade flaunting the vanquished adversary of inflation on its monetary policy spears” ?

And the simple answer is : There is a good chance that inflation has bottomed and the Fed is far from done. Now, notice that I used the word chance and did not put a 100% probability to this event. Putting a 100% probability to any event in economics is foolhardy business. But there is a good chance we have not seen the end of inflation and the last of the Fed rate hikes.

The Base Effect

The chart below illustrates the underlying message better than any amount of words can.

Average monthly inflation in the 12 months to June 2022 was 0.7%. Hence it was an easier bar to cross on the way down for y-o-y CPI over the past 12 months. However, average monthly inflation during the 12 months to June 2023 has been 0.2%. That is a much tougher threshold to beat!

For headline CPI to come down below 3%, a number of factors need to come together. For instance, declining food prices, energy prices falling further from current levels, goods disinflation which includes new and used car prices and finally shelter coming down rapidly over the next 12 months. The next 2 months are especially hard to beat, given that m-o-m CPI had registered 0% and 0.2% in July and August 2022. Lets take a deeper look at shelter and used car prices.

Shelter Component in Inflation

The Fed is banking a lot on a rapid decline in shelter inflation. Owners equivalent rent of residence, which has a 25% weight in CPI, declined from a 0.5% to 0.4% in June 2023. That is still 4.8% on an annualized basis – which is not sufficient to bring headline inflation below 2%. The lagged effects between private measures of rent and the shelter component of CPI have been well documented by economists. See below chart. Past statistical analysis show a 12 month lag before current rent inflation starts reflecting in official CPI data. In other words, the shelter component of CPI will substantially trend down in 2H 2023. The issue though is that even now private rents are as high as 4% annualized.

Source: Zillow, BLS.

The latest ZORI read was +4.1% y-o-y rent inflation, which is not sufficient to bring headline CPI inflation below 2%.

Used Cars Price Inflation

On the other hand, used car prices are helping the case for disinflation.

The Manheim Used Vehicle Value Index has been, in my humble opinion, a good predictor of used car inflation in the CPI with a few months lag. See chart below. From this perspective, it is a blessing that wholesale used vehicle prices have been rapidly falling over the past 3 months of April, May and June. The latest data also shows wholesale used vehicle prices declined a further 1% in the first 2 weeks of July. We can expect the decline to reflect in the official CPI data over 2H 2023.

Source: Manheim, BLS

The Unprecedented Strength of the American Economy

Consensus Expectations for 1Q GDP growth were 1.8%. Instead the advance estimate from the Bureau of Economic Analysis showed US GDP grew at 2.4% in the first quarter. Does anything need to be said further?

Source: BEA

Here is an “as-concise-as-it-gets” summary of the US economy.

• The US consumer is still resilient.
• Bank lending, while undoubtedly slower, can hardly be described as collapsed.
• The downturn in the US residential real estate sector has proved to be the shortest ever.
• Core capital goods, which are a good indicator of business spending, are growing and far from recessionary levels.
• New home sales have bottomed at the end of 2022 and are about 24% above the lows of 2022. New Home Builder confidence is in expansionary territory and builder stocks are at all-time highs.
• Services PMIs are still in expansionary territory
• M2, which was falling since mid 2022, has increased since Apr 2023
• The consumer confidence index is on an upswing and future expectations index above levels that indicate a recession.
• Initial jobless claims have moved back down over the past 6 months.
• And finally, jobs are still being created at a 200K+ clip.

The FOMC which turned out to be a Non Event

Given the uncertainty around the inflation path forward and the surprisingly resilient US economy, it was little surprise that Chairman Powell wanted to keep his cards as close to his chest as possible at the latest FOMC press conference. It was probably the most uneventful FOMC meeting in recent monetary policy history. In fact, at one point during the Q&A, Chairman Powell actually said –

This is not an environment where we want to provide a lot of forward guidance.

Chairman Powell. July FOMC Press Conference

The S&P500 and the 2 year Treasury were mostly flat during Fed Day, except for a brief few minutes during the press conference Q&A. It seemed like that brief reaction was in response to Chair Powell stating that he expects inflation to come down to 2% only in 2025 – which we already know is the Fed view based on the June Summary of Economic Projections.

Summary

So, the above economic data is the reason why the Fed isn’t doing a victory lap yet.

A ton of experts say that Chairman Powell’s pre-dominant fear is that he doesn’t want to go down in history as the second Arthur Burns. I believe that to be true. However, paradoxically, I believe, deep down he wants to prove to the world that even though he was wrong on “transitory inflation”, he is right on “achieving a soft landing”. That sets the world up to the possibility of a greater mistake!

Happy investing!

Shashank Sawant

www.thecreditbalance.com

There was supposedly a liquidity cliff looming. The theory was – once the debt ceiling is resolved, treasury bill issuance will re-commence. The barrage of issuances would drain liquidity from markets. And that will result in a big drawdown in risk assets…

The US debt ceiling was resolved on 3^rd Jun 2023. The Treasury General Account Balance around that date was US$44bn. It stands at US$514bn today!

Here is what risk assets have done in the interim:

S&P500 : +7.7%

Nasdaq Composite : +9.3%

So what really happened here in the context of liquidity. 2 things. First, just like the Fed planned, the Reverse Repo Facility came to the fore resulting in a lower drain of bank reserves. Second, the US government continued its spending binge. Lets look at both these factors in a bit more detail.

And then finally at the end, we will look at whether there was any statistical significance, in the first instance, to the theory of correlation between liquidity (aka bank reserves) and the broader market returns (i.e. S&P)

The Reverse Repo Facility

For the uninitiated, a Reverse Repo is a transaction where the Markets Operations Desk of the NY Fed sells securities to a counterparty subject to an agreement to repurchase the securities at a later date. You can think of this as a loan provided by market participants (primarily money market funds) to the Fed. It temporarily reduces the supply of reserve balances in the banking system. Theoretically, the US$2.5 trillion or so accumulated in the RRP at its peak in 2022 was surplus liquidity that the market did not need.

The build-up in the RRP facility in 2021 and 2022 to its highest level of approx. US$2.5Tn

When the Fed embarked on its Quantitative Tightening program in 2022, the key question on everyone’s mind was whether the draining of liquidity will come from these surplus balances in the RRP or will it come at the expense of bank reserves. The overarching concern about draining bank reserves beyond a certain level (in Fed lingo this is called “LCLOR” or “Lowest Comfortable Level of Reserves”) in Chairman Powell’s mind was influenced by the events of Sep 2019, infamously called the Repo Tantrum of 2019. In mid-September 2019 overnight money market rates spiked and exhibited significant volatility amid a large drop in bank reserves due to corporate tax payments and increases in treasury issuances. Those events had effectively led to the Fed shutting down its QT operations and re-starting QE. The question this time around was – Will history repeat itself?

Repo Meltdown in Sep 2021 attributable to reserves falling below acceptable levels

Chairman Powel must have breathed a sigh of relief given that this is the one thing that the Fed was been proved right on….. so far. As the US Treasury ramped up its bill issuance after the resolution of the debt ceiling, the RRP balance has come down by approx. US$440 billion from US$2.16 trillion to US$1.72 trillion. On the other hand, bank reserves have fallen only approx. US$70bn to a latest level of US$3.23 trillion, still significantly higher than the roughly US$2.2 to US$2.5 trillion or so that the Fed estimates to be LCLOR.

“We have the standing reverse repo facility and everyday firms are handing us over $2 trillion in liquidity they don’t need. They give us reserves, we give them securities. They don’t need the cash,” Waller said. “It sounds like you should be able to take $2 trillion out and nobody will miss it because they are already trying to give it back and get rid of it”

Chris Waller at an event hosted by the Council on Foreign Relations in Jan 2023

RRP balances substantially lower in the last 45 days….

…but Bank Reserves have held up well.

Deficit Spending

There are only 2 ways of real money printing in our modern economic world. The first is through commercial bank lending. The second is through deficit spending. And unarguably the US is on a mission to outdo every other country and its own historical record on this account! Here are some bullet points to illustrate the message.

This is money squarely into the hands of the public…. the final consumer… in an economy which is 67% driven by domestic consumption. The deficit in the last 4 months alone has been US$670 bn compared to US$39 bn in same period last year. Medicare payments are on track to cross US$1 trillion for the first time. All this money gradually finds its way back into the banking system a.k.a Reserves!

Source: US Treasury

Summary

So while US monetary policy continues on a tightening path by raising interest rates and crimping bank credit, the overall liquidity scenario in markets has not deteriorated further from 2022.

Going back to the hypothesis

But does this explain the rally in risk assets in 2023. Like I mentioned at the start, a number of strategists were predicting a precipitous drop in equities with the draining of liquidity post resolution of the US debt ceiling. However, this correlation between US liquidity, as measured by bank reserves and the broader equity market i.e. S&P500 is extremely weak. I ran a regression on Change in Monthly Average Reserves and S&P 500 Monthly Returns. Below is the regression output. In simple words, the correlation coefficient between the 2 data sets was 22%. R Square, the Coefficient of Determination, which explains the relationship between the “y” variable (S&P returns) and “x” variable (change in reserves) was a mere 5%.

I also tried lagging the S&P returns by 1, 2 and 3 months to see if there was still a statistically significant relationship, albeit with a lag. No such luck!

Just to caveat, I am not making a case here to suggest that the S&P500 is going to scale new heights this year. Neither am I suggesting that liquidity does not matter for risk assets. In fact, I hold the view that risk assets are overbought right now and ripe for a correction. The bottom line though is that risk markets are driven by a multitude of fundamental factors and sometimes just pure sentiment and herd mentality. To overly rely on a single factor for determining market direction is a sub-optimal investment strategy.  

Happy investing!

Shashank Sawant

www.thecreditbalance.com

Everyone knows that the Fed is intensely focused on core services ex-housing inflation to determine future course of monetary policy. This chosen path makes two assumptions – core goods disinflation continues unabated and the lagged effects of reducing shelter inflation start to factor into the CPI calculation by mid-2023.

The central thesis is that core inflation, which currently is still elevated at 5.6%, is on track to moderate to around 3.5% – 3.7% by end 2023. A nominal Fed Funds rate of approx. 5.1% (assuming they hike in May) leaves the real interest rate in the region of 1.4% – 1.6% – which is deemed to be sufficiently restrictive monetary policy to help achieve inflation goals. 

Firstly, goods disinflation is not a slam dunk. But that story is for another day. Today we talk about shelter inflation.

Shelter, and within Shelter – Owner’s equivalent rent of residence – a has large weightage in the overall CPI calculation.

I will explain this concept a bit further. The shelter service that a housing unit provides to its occupants is the relevant consumption item for the CPI. The house itself is an asset and house price changes don’t factor into the CPI. In other words, the purchase price of a home, renovation costs, etc are treated as investments and not consumption items. Most of the cost of shelter for renter-occupied housing is rent. For an owner-occupied unit, most of the cost of shelter is the implicit rent that owner occupants would have to pay if they were renting their homes, without furnishings or utilities.

Latest Core CPI recorded for Mar 2023 was 5.6% and headline CPI was 5.0%. Shelter inflation came in at 0.6% m-o-m and 8.2% y-o-y. The one-month annualized rate of shelter inflation is 7.2% and the 3-month annualized number was 8.4%. Historical CPI shelter inflation average has been 3.7% and the Fed is assuming we will start seeing a taper down to this rate by mid-2023.

This belief that shelter inflation will start tapering by mid 2023 is based on more timely private measures of rent. For eg. the Zillow Observed Rent Index (“ZORI”).

Current Rentals vs Shelter CPI

Previous studies of correlations between private measures of rent and CPI rent inflation have shown a lag of 18-24 months. An FRBSF paper released in Jan 2022 had accurately predicted the rise in CPI shelter inflation based on a model that takes into account increases in current asking rents and the CPI rent index. The model predicted that CPI rent inflation will increase by an additional 3.4% for both 2022 and 2023. While asking prices of current rents have reduced, they are still close to 6.0% on a y-o-y basis. See graph below. The lag of 18-24 months works both on the way up and down. For instance – In the early days of the pandemic, market observed rents fell sharply, but the shelter component of CPI was slow to react.

Source: Zillow, BLS, TCB calculations

House Price Growth vs Shelter CPI

Another point of consideration is the correlation between changes in house prices and the OER component in CPI shelter inflation. A study conducted by the Dallas Fed in Aug 2021 showed that house price growth has led inflation by somewhat less than 2 years. The study confirmed the relationship by computing the correlation between current rent inflation and past and future house price growth which was the strongest at an 18 month lag. Given that house prices really peaked only in Mar / Apr 2022, it is likely that the effect will make its way into OER inflation only by early 2024. In other words, an annualized rate of 3.0-3.5% shelter inflation seems more a 2024 scenario instead of a 2023 one.

Source: Case Shiller, BLS, TCB calculations

What matters most though:

However, while the lag with which the shelter component in CPI will come down is key, what is even more important is to note current developments in the US residential market. Here is a summary –

• The sharp rise in mortgage rates has perversely resulted in a lower inventory of existing homes for sale.
• While affordability has taken a hit because of higher mortgage rates, buyer demand (from the extreme wealth creation of the past 3 years) remains resilient.
• This has caused a shift to more buyer activity in the new homes market. New home sales have posted a m-o-m gain for the past 5 months in a row!
• Home price growth, on a m-o-m basis, has accelerated in the past few months – indicated by almost all private measures of the US residential market. While this is seasonal in nature, it is an increase nonetheless.
• The NAHB Index – a gauge of home builders demand – has increased for 4 consecutive months.
• ITB, the iShares Home Construction ETF, is 16% up year-to-date and is only about 10% off its all-time high recorded in Dec 2021!
• The Zillow Observed Rent Index showed asking rents climbed 0.5% m-o-m in March. While this increase is seasonal in nature, it is an increase nonetheless and only slightly lesser than normal for this time of the year.

The longer Shelter inflation stays elevated the more concerned the Fed will grow about its ability to reach its desired inflation target. This story is not yet over…

Amongst the alphabet soup that we have been treated to these past few days – SI, SVB, SB, FRB, CS, UBS – there is one set of letters that we all need to pay attention to. It is the FHLB .aka The Federal Home Loan Bank System.

The FHLB raised a monumental $300bn last week. Why?

Here is an as-concise-as-it-gets primer on the FHLB and what you need to watch for.

• The FHLB is a depression era creation. It was created in 1932 as a govt sponsored enterprise to support mortgage lending and community investment. Eventually the FHLB gained the role of a lender of next-to-last resort. Even during the financial crisis, before the meltdown, it played a key role in maintaining market stability by providing funding to Banks collateralized by mortgages and mortgage related instruments. (See red oval in chart below).

• However, over the past 6-7 years, the FHLB became one of the primary sources of short term liquidity to the entire banking system – including the largest banks in the US. (see red arrow below).

• All FHLB advances to banks have “super priority in lien” – even in the event of an insolvency. i.e. FHLB loans are prioritized even over depositors money. As of Sep 2022, the total loans made to the banks, thrifts, insurance companies, etc amounted to approx. $660bn. Investment securities form the other major asset of the FHLB amounting to $195bn as of Sep 2022.

• FHLB, since it is a quasi-government entity, is rather thinly capitalized, with a capital level of about 5-6% of total assets. As of Sep 2022, the total capital of FHLB was $60bn and total assets were $1.09 trillion.

• The FHLB primarily raises funds by issuing discount notes and bonds – termed as Consolidated Obligations. Total FHLB borrowing as of Sep 2022 was $1.01 trillion. Post the 2008 financial crisis, the proportion of short term funding (maturity less than 1 year) on the FHLB books vis-à-vis its total obligations was down from peak GFC levels to ~50%. Over the years this number has steadily increased and as of Sep 2022 approximately 90%of the total $1.02 trillion of FHLB obligations mature within 1 year. In simple words, this means the extent of maturity transformation that FHLB takes on its books has progressively grown larger over the years.

• Given the thin capitalization and short term funding nature of the FHLB system, it cannot support large losses in the financial system, Of course, given its super lien characteristics, it will not face immediate losses even in the event of bank insolvency. i.e. even in an FDIC takeover scenario.

• The summary takeaways are dual. First – irrespective of the structural seniority of FHLB claims, keeping a close eye on the FHLB bond issuances and advances will provide a clearer picture of the liquidity requirements of and strains in the US banking system. Second – Should the FHLB system start experiencing some stress, the effects would likely be sudden, severe and contagious.  

• The dichotomy between the original purpose of creating the FHLB and the eventual key money market and banking system giant that it has morphed into is stark. Prior to money market fund reform and certain Basel regulatory requirements, prime funds fulfilled a key purpose of providing wholesale funding to Banks. With the growth of the FHLB, it is now effectively the key source of wholesale liquidity – with a major difference – the FHLB is quasi US government risk. In simple words, Banks still depend on wholesale funding as they did prior to 2008. Now that wholesale funding has a government backstop!   

• Which gets us to the final point of the thought process. Ultimately if the FHLB ranks super senior in an insolvency scenario, the buck stops with the FDIC. Now with the SVB and SB events, the US government has set a precedent for full coverage of unlimited deposits. Total deposits of all Commercial Banks in the US amounts to approximately $17.5 trillion. The FDIC insurance fund is approx. $130bn. You do the math. Is the US Government Debt to GDP really 120% or higher?

Its been a crazy start to the year! January and February have been riveting on both – economic data and market price action. Here is a short narrative to take you through the journey thus far this year. And then let that be food for thought as we try to think what the next few months will bring us on the economy and markets front. 

The Backdrop:

• The overarching theme in central banking in the 2^nd half of 2022 was “We do not want to repeat the policy mistakes of the seventies. a.k.a We do not want to do an Arthur Burns.

• Personal Consumption Expenditure had been incredibly resilient. While there were a few signs of falling consumption, they weren’t enough to declare victory on inflation.

• JOLTs data released on 4^th Jan 2023 still showed about 10.5mn Job Openings beating expectations of approx. 10.0mn – evidencing a still tight labour market (despite all the monetary tightening thus far)

My Assessment in early Jan:

Resilient consumption, a tight labour market, significant credit creation from banks, yet to be exhausted pandemic savings – all pointed to an expanding economy running still too hot to handle. Hence it did not make sense that the Fed Funds futures market was pricing a peak Fed Funds rate of 4.9% when the FOMC itself is guiding to a peak Fed Funds rate of 5.1%.

Likewise the 2 year Treasury at 4.3% seemed too low. And the S&P500 at 3900 and the Nasdaq Composite at 10,600 still seemed too rich and probably factoring an incorrect risk free rate input in valuation models!

And equity markets seemed to be on a different footing. Short covering, surplus liquidity despite QT, Powell’s dovish FOMC press conference, etc – whatever the reason. Equity markets seemed to be going in a different direction than I anticipated. (And still not down to the level that I thought they should be at) 

January data in Charts:

And then came January’s economic data starting with Non-Farm Payrolls on Feb 3^rd, 2023! The graphs below are so self-explanatory, I hardly need to write any further !

3^rd Feb 2023 – Non Farm Payrolls

3^rd Feb – ISM US Services PMI

14^th Feb – Consumer Price Index

15^th Feb – US Advance Retail Sales

15^th Feb – Industrial Production

15^th Feb – Industrial Production (Manufacturing)

16^th Feb – Producer Price Index

24^th Feb – PCE Price Index

27^th Feb – Non Defence Capital Goods Ex Aircraft

Conclusion:

With such a strong economic showing in January, the rates market has completely re-priced itself (with the 2 year touching 4.9% and the 10 year above 4%). But equity markets still seem to be distanced from reality.

As I write this, the February US Services PMI has just been released. And it recorded a healthy 55.1 again ! Which makes it harder for those who have been arguing about weather related factors playing a role in the unusually impressive economic showing in January. Also, it is worth noting that Initial jobless claims – week after week – are holding below a 200K threshold.

All eyes are now to the next February CPI print on 14^th March and February PCE print on 31^st March. And of course the FOMC in between. If inflation falls further, there would be a good chance that the equity markets will continue to rally (and we will start to hear soft landing chatter again). However, if inflation once again surprises to be upside, equity markets might not like the chatter of a 6% Fed Funds rate!

The First Advance estimate for 4Q released on 26^th Jan 2023 showed US GDP grew at a healthy rate of 2.9% annualized. Even Q3 GDP had been revised upwards to a final growth rate of 3.2% compared to the first advance estimate of 2.6%. Below are the key points to note about this report.

1. The US Consumer still remained incredibly resilient in Q4 but recent monthly data have evidenced a sharper reduction in consumption towards the end of 4Q 2022 and into 2023. The January Retail Sales report to be released on 15^th Feb becomes incredibly important in this backdrop.
2. A substantial acceleration in the change in private inventories had been a major contributor to the substantial GDP growth prints of 2.7% and 7.0% in Q3 2021 and Q4 2021. In similar fashion, change in private inventories contributed +1.46% to the 2.9% GDP growth rate in 4Q 2022. Resilient consumption in 1H 2022 meant those 2021 inventories were put to good use. If consumption slows significantly in 2023, any new build-up of inventories will put more downward pressure on prices and consequently corporate profits.
3. Non-Residential / Business Investment had been fairly resilient the past 2 years. However it was substantially soft in Q4 2022. When viewed together with falling industrial production and capacity utilization, it becomes a greater cause of concern from a recession perspective. However, similar to personal consumption expenditure, these levels are still far from the levels of the past recessionary episodes.

Let’s analyze each of the above 3 points in a little more detail…

1. The US Consumer still remains incredibly resilient.

Many had expected the US consumer to wilt by the end of 2022 in the face of constant elevated inflation. Yes, there has been an overall slowdown in consumption. But it, unexpectedly, remained resilient well into 2H 2022.

2022 real PCE compared to previous cyclical downturns of 2008 and 2018…

But recent Retail Sales data (November and December) presents a sharper downdrift which might be more indicative of things to come in 2023.

This is also evidenced in the monthly PCE data, especially readings for November and December.

Undoubtedly, consumption has been slowing on a month on month basis. Going back to the first graph in this Section though, while evidently slowing, it is still substantially higher than previous recessionary episodes.

2. A substantial acceleration in the change in private inventories had been a major contributor to the robust GDP growth prints of 2.7% and 7.0% in Q3 2021 and Q4 2021. In similar fashion, change in private inventories contributed +1.46% to the 2.9% GDP growth rate in 4Q 2022. Resilient consumption in 1H 2022 meant those inventories accumulated in 2021 were put to good use. If consumption slows significantly in 2021, any new build-up of inventories will put more downward pressure on prices and consequently corporate profits.

Headline GDP growth was stellar especially through the 2^nd half of 2021. A large part of that growth was attributable to rising inventories as companies over-ordered, over-produced and over-stocked driven by the late 2020 and early 2021 experience of booming sales and shortage of goods (and manpower) to satisfy consumer demand. Some of the inventories were taken down as consumption remained resilient in the first none months of 2022. However, a significant portion of the headline growth number for 4Q 2022 is also attributable to change in private inventories. The question is – will consumption remain resilient enough to take those inventory levels down? 

The below graph shows the contribution of change in private inventories to Gross Private Domestic Investment (and consequently to headline GDP growth rate) over the last 6 quarters. Just for clarity – Gross Private Domestic Investment in the GDP calculation includes Fixed Investment (i.e. Business investment, Software and IP investment, Residential Investment) and Change in Private Inventories. The yellow bars (CIPI) adjacent to the orange bars (GPDI) shows visually that a large part of the GDPI growth was attributable to increase in the pace of change of private inventories and less attributable to Fixed Investment. The grey bars represent Fixed Investment contribution to GDP growth which has been relatively soft – obscured by the robust headline numbers. Also, the drag in GDPI is mostly attributable to the significant slowdown in the US Residential Housing sector. 

Q4 2022 is even more stark in this context…

3. Non-Residential / Business Investment had been fairly resilient the past 2 years. However it was substantially soft in Q4 2022. When viewed together with falling industrial production and capacity utilization, it becomes a greater cause of concern from a recession perspective.

Before we dive deeper into this point, it is worthwhile to understand once again what do we mean by Gross Private Domestic Investment (“GPDI”) and Non-Residential Fixed Investment. GPDI is a key component of GDP. Non Residential Fixed Investment is a key component of GPDI and includes expenditures by private firms on tools, machinery, factories, etc. It is key to note that Commercial Real Estate spend also forms part of this Non Residential Investment category. Historically Private Non Residential Fixed Investment amounts to approximately 13-14% of US GDP.

The first point to note is that Non Residential Investment was fairly strong in late 2020 and 2021 as we came out of the pandemic. However, the pace of this growth in Business Investment has started slowing in recent quarters. Graph below.

Alongside this reduction in capital investments, the slowdown in the manufacturing sector can also be seen in recent releases of industrial production and capacity utilisation.

An interesting point to note is that industrial production and capacity utilization are coincident indicators at best or can even be categorized as lagging indicators – which can potentially mean that a recession has already begun. However, in reality, it is too early to state that a recession has already begun because other measures of recession (eg. jobs) are still robust.

And typically, business investment tend to fall a lot more during recession periods than the current levels.

Happy Investing!

www.thecreditbalance.com

Shashank Sawant