America’s Risky Recovery?

Martin Feldstein, Professor of Economics at Harvard University, wrote a comment for Project Syndicate on America’s risky recovery:

The United States’ economy is approaching full employment and may already be there. But America’s favorable employment trend is accompanied by a substantial increase in financial-sector risks, owing to the excessively easy monetary policy that was used to achieve the current economic recovery.

The overall unemployment rate is down to just 5.5%, and the unemployment rate among college graduates is just 2.5%. The increase in inflation that usually occurs when the economy reaches such employment levels has been temporarily postponed by the decline in the price of oil and by the 20% rise in the value of the dollar. The stronger dollar not only lowers the cost of imports, but also puts downward pressure on the prices of domestic products that compete with imports. Inflation is likely to begin rising in the year ahead.

The return to full employment reflects the Federal Reserve’s strategy of “unconventional monetary policy” – the combination of massive purchases of long-term assets known as quantitative easing and its promise to keep short-term interest rates close to zero. The low level of all interest rates that resulted from this policy drove investors to buy equities and to increase the prices of owner-occupied homes. As a result, the net worth of American households rose by $10 trillion in 2013, leading to increases in consumer spending and business investment.

After a very slow initial recovery, real GDP began growing at annual rates of more than 4% in the second half of 2013. Consumer spending and business investment continued at that rate in 2014 (except for the first quarter, owing to the weather-related effects of an exceptionally harsh winter). That strong growth raised employment and brought the economy to full employment.

But the Fed’s unconventional monetary policies have also created dangerous risks to the financial sector and the economy as a whole. The very low interest rates that now prevail have driven investors to take excessive risks in order to achieve a higher current yield on their portfolios, often to meet return obligations set by pension and insurance contracts.

This reaching for yield has driven up the prices of all long-term bonds to unsustainable levels, narrowed credit spreads on corporate bonds and emerging-market debt, raised the relative prices of commercial real estate, and pushed up the stock market’s price-earnings ratio to more than 25% higher than its historic average.

The low-interest-rate environment has also caused lenders to take extra risks in order to sustain profits. Banks and other lenders are extending credit to lower-quality borrowers, to borrowers with large quantities of existing debt, and as loans with fewer conditions on borrowers (so-called “covenant-lite loans”).

Moreover, low interest rates have created a new problem: liquidity mismatch. Favorable borrowing costs have fueled an enormous increase in the issuance of corporate bonds, many of which are held in bond mutual funds or exchange-traded funds (ETFs). These funds’ investors believe – correctly – that they have complete liquidity. They can demand cash on a day’s notice. But, in that case, the mutual funds and ETFs have to sell those corporate bonds. It is not clear who the buyers will be, especially since the 2010 Dodd-Frank financial-reform legislation restricted what banks can do and increased their capital requirements, which has raised the cost of holding bonds.

Although there is talk about offsetting these risks with macroprudential policies, no such policies exist in the US, except for the increased capital requirements that have been imposed on commercial banks. There are no policies to reduce risks in shadow banks, insurance companies, or mutual funds.

So that is the situation that the Fed now faces as it considers “normalizing” monetary policy. Some members of the Federal Open Market Committee (FOMC, the Fed’s policymaking body) therefore fear that raising the short-term federal funds rate will trigger a substantial rise in longer-term rates, creating losses for investors and lenders, with adverse effects on the economy. Others fear that, even without such financial shocks, the economy’s current strong performance will not continue when interest rates are raised. And still other FOMC members want to hold down interest rates in order to drive the unemployment rate even lower, despite the prospects of accelerating inflation and further financial-sector risks.

But, in the end, the FOMC members must recognize that they cannot postpone the increase in interest rates indefinitely, and that once they begin to raise the rates, they must get the real (inflation-adjusted) federal funds rate to 2% relatively quickly. My own best guess is that they will start to raise rates in September, and that the federal funds rate will reach 3% by some point in 2017.

Martin Feldstein is an excellent economist and someone I take seriously but I humbly disagree with so many of the points he raises above and need to go over them in detail below.

First and foremost, I agree with Feldstein, the Fed is about to change course, and it will wreak havoc in markets. But unlike him, I'm in the Larry Summers/ Ray Dalio/ Jeffrey Gundlach camp and truly believe if the Fed starts raising rates anytime soon, it will be making a monumental policy mistake.

Importantly, Gundlach is right, this time is really different, and if the Fed starts raising rates, it will all but ensure another financial crisis and global deflation which will spread to America.

That brings me to my second point. Feldstein seems to think that bond yields are "artificially low" because of the Fed's "unconventional monetary policy." I happen to think that bond yields are at historic lows all around the world not because central banks are engaging in massive quantitative easing but because in the global titanic battle of inflation vs deflation, the latter is clearly winning.

When I read articles on how the euro area’s brush with deflation might be over before it even started, I can't help but cry. Who are we kidding here? Any macro 101 student will tell you this temporary blip in the eurozone's inflation is all about the sinking euro, it has nothing to do with the underlying structural economies of the eurozone which remain very weak.

In fact, surveys from the region's services and manufacturing sectors recently indicated the eurozone's economic recovery could be at risk of losing momentum:

Markit's composite flash April Purchasing Managers Index fell to 53.5 in April from 54.0 in March, below analyst expectations in a Reuters' poll for a reading of 54.4.

The headline index, which remained above the 50-mark that is consistent with expansion, is based on surveys of thousands of companies and viewed by analysts as a good gauge of growth.

"Disappointing overall but not disastrous," said Howard Archer, chief European economist at IHS Global Insight, in a note. "Euro zone manufacturing and services expansion unexpectedly moderated in April according to the purchasing managers, perhaps providing a reality check on the strength of the region's upturn."

Archer added that it remains to be seen whether the slowdown in business growth was mostly a correction after four months of improvement, or a sign that a pick-up in euro zone economic activity was levelling off.

Earlier on Thursday, Markit's German flash composite PMI fell to 54.2 in April from an eight-month peak of 55.4 in March. France's composite PMI, meanwhile, fell to 50.2 from 51.5 in March.

"We also had the reading from France and the French manufacturing and services PMI data has done what it does the best - disappoint investors to their core," said Naseem Aslam, chief market analyst at AvaTrade, in a note.

Again, all this talk of a eurozone recovery has more to do with the mighty greenback surging higher relative to all currencies, especially the euro, and less to do with the underlying structural economies.

But the U.S. dollar dropped to an eight-week low on Tuesday after an unexpectedly weak U.S. consumer confidence report for April, with investors growing cautious about a Federal Reserve meeting which could prove to be a major shift in policy:

That meeting could reinforce the view that the pace of U.S. interest rate increases would be slower than initially thought. The Fed is expected to keep interest rates on hold, but the main focus will be on the statement at the end of its policy meeting on Wednesday.

Worries that the U.S. economy is stalling, following a run of soft data, have seen the dollar lose 4 percent in the past six weeks as expectations of a rate rise in June have faded. But many still expect the Fed to lift rates in September.

I fully expect the Fed to hint that it's ready to start raising rates when it delivers its monetary policy comment later today. Risk assets will tank and there will be an uneasy period that will follow, making this a very hot and uncomfortable summer from a monetary policy perspective.

This is one reason why I don't agree with hedge funds that think now is the time to short the U.S. dollar. When there is heightened uncertainty in global financial markets, investors flock to good old U.S. bonds.

Another problem with Feldstein's comment above is that just like many others top American economists (and the Fed), he seems to think the U.S. economy operates in a vacuum and is totally insulated from global events.

Nothing can be further from the truth. The focus is once again on Greece where things are quickly reaching a boiling point. The only hope there is that 'Varoufexit' will mean no Grexit but with Tsipras in Dreamland, it is far from clear how things will play out there, especially since Syriza's failure could bring about political chaos in Greece.

But above and beyond Greece, which is nothing more than an endless distraction, the real worry is China. Another great economist, Nobel-laureate Michael Spence, wrote an excellent comment for Project Syndicate on China's slowing new normal:

The world’s two largest economies, the United States and China, seem to be enduring secular slowdowns. But there remains considerable uncertainty about their growth trajectory, with significant implications for asset prices, risk, and economic policy.

The US seems to be settling into annual real (inflation-adjusted) growth rates of around 2%, though whether this is at or below the economy’s potential remains a source of heated debate. Meanwhile, China seems to be headed for the 6-7% growth rate that the government pinpointed last year as the economy’s “new normal.” Some observers agree that such a rate can be sustained for the next decade or so, provided that the government implements a comprehensive set of reforms in the coming few years. Others, however, expect China’s GDP growth to continue to trend downward, with the possibility of a hard landing.

There is certainly cause for concern. Slow and uncertain growth in Europe – a major trading partner for both the US and China – is creating headwinds for the US and China.

Moreover, the US and China – indeed, the entire global economy – are suffering from weak aggregate demand, which is creating deflationary pressures. As central banks attempt to combat these pressures by lowering interest rates, they are inadvertently causing releveraging (an unsustainable growth pattern), elevated asset prices (with some risk of a downward correction, given slow growth), and devaluations (which merely move demand around the global economy, without increasing it).

For China, which to some extent still depends on external markets to drive economic growth, this environment is particularly challenging – especially as currency depreciation in Europe and Japan erode export demand further. Even without the crisis in major external markets, however, a large and complex middle-income economy like China’s could not realistically expect growth rates above 6-7%.

Yet, in the aftermath of the global economic crisis, China insisted on maintaining extremely high growth rates of 9% for two years, by relying on fiscal stimulus, huge liquidity injections, and a temporary halt in the renminbi’s appreciation. Had the government signaled the “new normal” earlier, expectations would have been conditioned differently. This would have discouraged undue investment in some sectors, reduced non-performing loans, and contained excessive leverage in the corporate sector, while avoiding the mispricing of commodities. Growth would still have slowed, but with far less risk.

In the current situation, however, China faces serious challenges. Given weak growth in external demand and an already-large market share for many goods, China cannot count on export growth to sustain economic performance in the short run. And, though support for infrastructure investment by China’s trading partners – especially through the “one belt, one road” policy – may help to strengthen external markets in the longer term, this is no substitute for domestic aggregate demand.

Investment can sustainably drive growth only up to the point when returns decline dramatically. In the case of public-sector investment, that means that the present value of the increment to the future GDP path (using a social discount rate) is greater than the investment itself.

The good news is that growing discipline seems to be pushing out low-return investment. And there is every reason to believe that investment will remain high as the economy’s capital base expands.

But, in order to boost demand, China will also need increased household consumption and improved delivery of higher-value services. Recent data suggest that, notwithstanding recent wage increases, consumption amounts to only about 35% of GDP. With a high household savings rate of around 30% of disposable income, per capita disposable income amounts to roughly half of per capita GDP. Expanded social-security programs and a richer menu of saving and investment options could go a long way toward reducing precautionary saving and boosting consumption. But what is really needed is a shift in the distribution of income toward households.

Without a concerted effort to increase households’ share of total income and raise consumption’s share of aggregate demand, growth of consumer products and services on the supply side will remain inadequate. Given that services are a significant source of incremental employment, their expansion, in particular, would help to sustain inclusive growth.

Another key challenge concerns China’s slumping property sector, in which construction and prices dropped rapidly last year. If highly leveraged developers are under stress, they could produce non-performing loans – and thus considerable risk – in both the traditional and shadow banking sectors.

Fortunately, Chinese households’ relatively low leverage means that the kind of balance-sheet damage that occurred in some advanced countries during the crisis, leading to a huge drop in demand, is unlikely, even if real-estate prices continue to decline. It also means that there remains some space for expanding consumer credit to boost demand.

That is not the only source of hope. Wages are rising, deposit insurance will be introduced, and deposit rates are being liberalized. Internet investment vehicles are growing. New businesses in the services sector – 3.6 million of which were started just last year – are generating incremental employment, thanks partly to a new streamlined licensing framework. And online platforms are facilitating increased consumption, while expanding market access and financing for smaller businesses.

China’s leaders should aim to accelerate and build upon these trends, rather than pursuing additional fiscal and monetary stimulus. Public investment is high enough; expanding it now would shift the composition of aggregate demand in the wrong direction. And, with the corporate sector already overleveraged, a broad-based expansion of credit is not safe.

Any fiscal stimulus now should focus on improving public services, encouraging consumption, and increasing household income. Accelerating the expansion of state-funded social security could bring down household savings over time. More generally, China must deploy its large balance sheet to deliver income or benefits that expand what households view as safely consumable income. Given that private investment responds mainly to demand, such measures would likely reverse its current downward path.

A further slowdown in China is a distinct possibility. China’s leaders must do what it takes to ensure that such a slowdown is not viewed as secular trend – a perception that could undermine the consumption and investment that the economy so badly needs.

I'm afraid that China's economy will experience a long deflationary spiral, and its citizens have moved from real estate speculation to speculating on stocks. The real concern is what happens when the China bubble bursts and spreads even more deflation throughout the world at a time when central banks are "normalizing" their respective policies.

One final thing on Feldstein's comment above. He raises a good point on low liquidity in the markets, one that Bryan Wisk at Asymmetric Return Capital discussed with me following my comment on the shift toward smaller hedge funds.

According to Bryan, investors are underestimating liquidity risk in this environment: "A lot of the big macro and quant funds you discuss on your blog are forced to trade in deep liquid markets or else they will get killed exiting anything remotely illiquid. This constrains their investment opportunities and is an example of why being too big can come back to really haunt you when markets seize and there are no bids for your offers."

In a nutshell folks, what Bryan is saying is that America's risky recovery is a lot riskier than most can possibly fathom. Our modern economies are inexorably tied to well functioning financial markets which provide credit to millions of small and large businesses. If this recovery falters or worse still, if the Fed begins raising rates too fast and another crisis hits, there will be huge economic and financial dislocations. At that point, America's Minsky Moment will come and it will be game over for decades, not a year like 2008.

Below, George Goncalves of Nomura predicts what the Fed will say and how it will impact the bond market, with CNBC's Jackie DeAngelis and the Futures Now Traders.

And CNBC's Rick Santelli discusses the latest action in the bond market, and the U.S. dollar, after soft GDP data.