U.S. Consumer Spending Yet to Overheat: Fed to Pause

According to the CME Fed Watch, the chance of a Fed rate hike this Wednesday is virtually zero. The reasons for the Fed to “stand pat” have been well recited but here they are again: 1) ongoing, elevated global systemic/slowdown risks due to the recent decline in global financial stocks, a Chinese economic slowdown, and chronically low oil prices resulting in fears of higher corporate defaults, 2) despite a recent pick-up in the U.S. core inflation rate (the 12-month change in the January core CPI is at 2.2%), the Fed’s preferred measure of core inflation, i.e. the 12-month change in the core PCE, remains tolerable at 1.7%, and 3) Since the late 1990s, the world’s developed economies have mostly grappled (unsuccessfully) with the specter of deflation; e.g. over the last 3 years, the Bank of Japan expanded its monetary base by 173%, and yet, the country is still struggling to achieve its target inflation rate of 2% (Japan’s January core CPI was flat year-over-year). As such, the Fed should err on the side of caution and back off from its recent rate hike campaign.

As of today, the CME Fed Watch is suggesting 50/50 odds of a 25 basis point rate hike at the Fed’s June 15 meeting. Historically, the Fed has only hiked when the odds rise to more than 60/40, and I believe this is the case here. Many things could change from now to June 15; however, given: 1) lingering fears over a Chinese slowdown and the loss of Chinese FOREX reserves, and 2) the fact that core PCE readings have not yet registered a +2.0% reading (I need the year-over-year change in the core PCE to sustain a level of over +2.0% for many months before I am convinced that inflation is a problem), I remain of the opinion that the next rate hike will mostly likely occur at the FOMC’s September 21 meeting.

Finally–despite an ongoing rise in U.S. employment levels (see Figure 1 below)–both U.S. wage growth (see Figure 2 below) and consumer spending growth (See Figure 3 below) remain anemic. Note that both U.S. wage growth and consumer spending growth do not “turn on a dime”; this means that–until or unless we witness a sustained rise in both U.S. wage and consumer spending growth–the Fed should err on the side of caution and back off on its rate hike campaign. At the earliest, this will mean a 25 basis point hike at the FOMC’s September 21 meeting.


Figure 2: Nominal Wage Growth Remains Below Target Despite Year-end 2015 Push




The Bank of Japan Surprises: Profound Implications for Global Risk Assets

Since the Japanese stock market and real estate bubbles popped in 1990, one of the surest ways for a portfolio manager to get fired is to go long Japanese stocks or real estate. ROEs on Japanese companies are among the lowest in the world; while Japanese real estate prices had been mired by a 23-year secular decline. There were massive policy failures–including building “bridges to nowhere” and the infamous consumption tax hike from 3% to 5% in 1997–just as SE Asia sank into a depression. While Japan’s policy rate was eventually brought down to zero, it came too little, too late. High-ranking BOJ officials eventually stopped attending the annual Jackson Hole Economic Policy Symposiums simply because they did not want to be ridiculed by other central bankers.

All this changed tonight. The Bank of Japan just announced it will double its monetary base over the next two years, as well as embark on a massive quantitative easing policy with an annual goal of 50 trillion Yen (US$538 billion) in JGB purchases. Consensus going into the meeting was in the order of an annual 15 to 20 trillion Yen in JGB purchases. A US$538 billion QE policy is massive, as Japan’s economy is less than 40% the size of the U.S. economy. Essentially, the BOJ will be purchasing JGBs at the rate of over 9% of its GDP every year. An equivalent QE policy in the U.S. would be in the realm of nearly US$1.4 trillion in Treasury purchases on an annual basis.

The policy implications are massive. For one, no living portfolio manager had ever been surprised by the BOJ in such a manner. Surprises have been many, but those have all been disappointing. The Yen is down by 1.1% as I am writing this article. We expect more competitive currency devaluations and supressions by other Asian central banks in 2013 and 2014. Such a move will no doubt generate a massive rise in global liquidity–which will drive up the prices of risky assets around the world.

For two, we know that Japanese households have continued to hold massive amounts of cash and deposits due to ongoing deflationary fears and general aversion to risk-taking. According to the BOJ’s Flow of Funds, Japanese households held nearly 800 trillion Yen in cash and deposits as of June 2012, or nearly US$8.6 trillion (see below chart). With a yield of 0%–and with the BOJ now hell-bent on a 2% inflation target–many Japanese households will no doubt start deploying their capital back into higher-yielding or riskier assets. A mere 10% shift out of cash into riskier assets would mean a wall of liquidity totaling nearly $900 billion. Keep in mind that this amount is equivalent to the sum total of ALL U.S. equity/hybrid/bond mutual fund inflows (totaling $913 billion according to ICI) during the peak tech bubble years from 1997 to 2000! We thus expect global risk assets–especially U.S. stocks and U.S. commercial real estate–to be driven significantly higher by Japanese inflows over the next few years (to be compounded by Chinese inflows as the Chinese capital account is liberalized). All corrections from hereon should be bought.