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Interesting Times for Fed Watchers and Bond Market Junkies

John Rowland

Posted on March 26, 2018 09:14

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As the new Federal Reserve Chairman Jerome Powell takes over, we all surely wish him the best of luck – he may very well need it.

As the new Federal Reserve Chairman Powell recently appeared before Congress, one can’t help but wonder about a couple of near-term considerations facing the Fed.

For starters, Powell takes the helm at a time when the current so-called economic recovery is very long in the tooth: Around 105 consecutive months – the second longest in history (Contra Corner).

Moreover, the Fed and many others are trumpeting rhapsodic at how the U.S. is essentially at, or very near, full employment. This rejoicing is largely based on the BLS' U3 unemployment number -- the "official" number, currently at 4.1% (BLS). But hey, if the real rate happened to be, say 8%, perhaps that's close enough for government work.

But all of this basically amounts to economic/political theater anyway.

Factoring in metrics like labor hours per year (some would include the labor participate rate), along with the BLS' constant re-benchmarking scheme (part of the U3's formulating methodology), the entire U3 exercise ultimately amounts to gross understating; statistical sophistry.

Even President Trump (during the campaign) rightly questioned the validity of the U3 rate; of course, he now embraces it as his baby -- one of his economic accomplishments. Politicians will be politicians.

So this ongoing silliness of associating the U3 with full employment fundamentally amounts to kindergarten economics.

The CPI is also one problematic animal.

But back in the days (roughly 30 years ago) before massive monetary monetization, "crowding out" was a real consideration. The idea that an increasingly-large public sector presence, economically speaking, would crowd out and preclude private sector spending and investment. This could be revisited upon all of us soon because the monetization free-lunch picnic may be over.

For the upcoming fiscal year, there are at least two forces which will add greater market pressure for higher interest rates. Due principally to a serious lack of fiscal discipline, the Treasury is looking at having to flood the bond market with $1.2 trillion in debt paper, while the Fed will be unloading some $600 billion from its bloated $4.39 trillion balance sheet (CNBC; Contra Corner).

For interested bond market nerds, the occurrence and scope of these two simultaneous dynamics is largely unprecedented -- sui generis.

So when the buyer of last resort (the Fed) becomes a seller, who then are the buyers? Unless the laws of supply and demand have been repealed, yields must rise -- significantly.

Throw in the recent $1.5 trillion stimulative tax package for good measure, serving as yet another force (inflationary) for higher interest rates (Bloomberg).

So what’s the reaction in equity markets? The bond pits? How will they discount and price in higher interest rates? Or the masses of interest rate derivative contracts? Don’t even go there.

All of this notwithstanding, best of luck to Chairman Powell and the FOMC.

John Rowland

Posted on March 26, 2018 09:14

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