Barron's Cover

What Recession? GDP Set to Grow 3%

The gloomy stock market notwithstanding, economic growth in the U.S. could be the best in years.

By Gene Epstein          

Blend Images/Getty Images            

 

Is the U.S. economy going through a growth pause, or is this the pause before the onset of recession?

The answer to that question highlights two quite divergent outcomes for 2016—one good, one terrible.

We subscribe to the former view. But before we make our case, let’s consider the bear argument.

If recession is imminent, then economic output will contract for an extended period, the stock market will continue to head south, and credit spreads will rapidly rise. The near-full-employment economy, signaled by January’s jobless rate of 4.9%, will quickly unravel and vault toward 6% within months.

But what if, as often happens, the indicators signaling recession are false alarms? Then, the generally quite favorable fundamentals at this stage in the expansion should dominate. Indeed, we expect economic growth to run at an annual rate of 2.8% through the first half of this year, then accelerate to 3.2% by the second half.

Growth of real economic output in 2016 would therefore come in at 3%, by the conventional fourth-quarter-over-fourth-quarter measure. This would make 2016 the best-performing calendar year since the expansion began in mid-2009. Under this scenario, the job market will continue to tighten, as the unemployment rate falls toward 4%. Credit spreads will narrow, and the stock market could rebound, probably touching new highs by the end of this year. The wild card: the presidential election.

Our 3% outlook, while upbeat, isn’t off the charts. According to the Feb. 10 release from the monthly Blue Chip Economic Indicators, the consensus of 50 forecasters projects growth in 2016 at 2.4%. Blue Chip’s “optimistic” consensus of top 10 forecasts puts growth at 3% to 3.1%.

Skeptics might wonder if these two divergent routes to famine or feast are too extreme. Might there be a more plausible in-between scenario that splits the difference between recession and accelerating growth?

To begin with, while a 3% increase in gross domestic product might sound unduly ambitious, this reflects only the lowered ambitions of the current era. Every expansion since World War II has gone through intervals of slow growth. However, all have had years in which economic growth ran at 4% or better, including the 2002-07 expansion. If the economy rises by 3% this year, the current expansion will still retain the dubious honor of being the weakest on record (see chart above).

Growth of 4% seems unattainable due to the drag on exports from weak economies abroad, combined with a strong dollar that makes those exports more costly, plus below-par performance of the small-business sector and slowed expansion of the labor force, owing mainly to the retirement of baby boomers. But if the vicious cycle of recession is avoided, a virtuous cycle should ensue, as positive factors reinforce one another.

Employment gains and the tight labor market are already driving up wages and salaries. That is boosting consumer spending, which is encouraging capital investment, which is causing businesses to hire, which, in turn, is driving employment gains. The virtuous cycle has also begun to include the housing sector.

Employment gains make it possible for more people to form households, which spurs demand for apartment buildings and detached homes, which, in turn, leads to greater gains in employment.

With faster top-line growth, corporate profits can also rise. Profit increases typically slow long before an economic expansion runs out of steam. The pace of the bull market of the past few years has probably slowed, but stock prices can still reach new highs.

IF RECESSION IS AROUND the corner, it will turn history on its head. Take the impact of oil since the mid-1970s. As the chart below shows, each of the past six recessions has been preceded by a spike in crude prices, often called an “oil shock.” The logic is straightforward: Businesses and consumers suffer financial shock when this essential commodity suddenly becomes more costly.

The current collapse in petroleum prices has also been called an oil shock, even though plunging tabs for such items as gasoline, heating oil, diesel fuel, and jet fuel have enriched those same businesses and consumers.

Of course, cheaper crude does hurt energy producers. But since most publicly traded companies are consumers of energy, it makes no sense for the broad stock indexes to track oil.

The recent pattern in which the Standard & Poor’s 500 index moves up and down in concert
with crude seems to reflect equity traders’ belief that a low price for crude signals an economic slowdown.

Hopefully, the market will soon break out of this circular-reasoning trap. If Barron’s is right that oil will rise to $55 a barrel by December, this pattern will be broken by events. Our Feb. 6 cover story, “Here Comes $20 Oil,” referred to the likely final leg of the energy bear market, which should end by April, before a rebound to $55 by December.

Defaults by the energy sector on loans are hurting U.S. banks. But according to estimates by economist Carsten Valgreen of Applied Global Macro Research, such loans account for no more than 4% of the banks’ total loan book. So even if losses on these loans run as high as one-half, this should hardly trigger a banking crisis.

As Valgreen also points out, in all three categories of bank lending—commercial and industrial, consumer, and residential real estate—conventionally calculated loss ratios are near historic lows.

“Bank lending has been gathering steam,” observes Rennaissance Macro Research economics head Neil Dutta, noting that over the 13 weeks through Feb. 3, commercial bank lending accelerated across all categories. Valgreen, who helps run a hedge fund that trades on such insights, believes that the recent selloff in U.S. banking stocks offers a unique buying opportunity.

Another channel through which low energy prices supposedly threaten recession: weakness in developing lands that export oil. Making matters worse is slower economic expansion in China, Japan, and the euro zone.

But while U.S. growth will certainly take a hit from lower exports to the global market, Michael Lewis, economics chief at Free Market, observes, “In the modern era, there is not a single recession that can be traced to foreign economic woes.”

For example, the 1998 meltdown in the Asian economies that caused a brief selloff in the U.S. stock market didn’t trigger the recession that many expected at the time. Adds Lewis: “While a U.S. sneeze can give the rest of the world the proverbial flu, the reverse still does not happen.”

To be sure, the ultralow interest rates maintained by the Federal Reserve have created a breeding ground for financial excesses that, when painfully corrected, often bring recession.

But so far, it appears that the Fed and the economy have been lucky. Major excesses are hard to find.

Even if stocks make new highs by the end of the year, standard price/earnings ratios will be noticeably below their peak of 2000, especially if earnings make modest gains. And the home-price bubble that started to burst in 2007 is a long way from forming again. The classic excess cited in the textbooks—the excessive buildup of inventories—is hardly present today, especially in light of the cuts to inventory investment in the second half of last year.

ONE INDICATION that the economy has found renewed strength: the labor force turnaround of prime-age workers 25 to 54. Much of the reason for slowed growth in the labor force has been demographic. The baby boomers are reaching retirement age, and they are merely following a predictable life cycle by leaving the workplace. But as Barron’s has pointed out (“Work’s for Squares,” Aug. 30, 2014), another, far more disconcerting trend was also evident: lower participation by prime-age workers.

This unanticipated trend is a key reason that forecasters have been surprised by how far the unemployment rate has fallen, despite modest growth. Skeptics have therefore dismissed the decline as bogus. Why place any value on a statistic that becomes more favorable as job seekers stop seeking jobs? But that is no longer true of prime-age workers, and the turnaround is due to the full-employment economy signaled by the jobless rate’s decline to 4.9%.

The prime-age labor force fell to a low of 100.6 million in second-quarter 2014 from its fourth-quarter 2007 peak of 104.4 million. Over the past six calendar quarters, however, it has rebounded by 1.3 million, to 101.9 million in January. The unemployment rate’s decline over this period, to 4.9% from 6.2%, has therefore been accompanied by more prime-age job-seekers rejoining the workforce.

THE RECENT TREND in the unemployment rate also tells us something about the diminished chances of recession. Evidence shows that increases in joblessness consistently lead economic turndowns. In the 12 months before all 11 recessions since World War II, the jobless rate rose on a three-month basis at least once, and usually several times, no doubt because it started to feel the tremors from reduced economic activity before the recession hit.

In the 12 months prior to the 2008-09 recession, the unemployment rate rose on a three-month basis no fewer than seven times. Before the previous recession, of 2001, it climbed five times, and before the 1990-91 recession, six times.

But over the past 12 months—in fact, over the past three years—the three-month change in the unemployment rate has generally been negative and occasionally flat; it hasn’t risen even once.

The last three-month increase in joblessness occurred as of January 2013, when it hit 8%.

Further confirming the positive trend in the labor markets: the persistent decline in new claims for unemployment insurance. As Free Market’s Lewis points out, initial claims are “one of the most reliable leading indicators, typically giving ample warning of recessions.” But, he adds, there is “not even an inkling [of a rise] yet.” In the four weeks through Feb. 13, weekly claims averaged 273,000, one of the lowest figures in decades.

For real GDP to grow by 3% this year, real consumer spending must do its part, rising at an annualized 3% or more in each calendar quarter. So far, at least, consumption seems to be off to a good start. Based on the solid retail sales report for January, economist Neil Dutta is tracking 3.2% growth in the current quarter. If that persists, it will be noticeably higher than the lackluster performance of 2015, when real consumption for the full year rose by just 2.6%.

Last year, the money generated by the boost to disposable personal income was mainly saved, rather than spent.

Applied Global Macro Research economist Jason Benderly predicts that consumption will rise by 3.4% this year. His forecast seems plausible if, as he expects, three factors that figured in 2015’s weak performance recede this year.

The first factor, which weighed on consumer spending, was a fall in confidence. Benderly has found the best indicator of consumer confidence isn’t the standard surveys of confidence, but rather credit spreads. The spread between yields on Baa corporate bonds and 10-year Treasuries widened steadily over the course of last year and is now even wider. But as recession fears recede, this spread should start narrowing. That should signal a rise in confidence, he argues, accompanied by a rise in spending.

The second factor is, ironically, faster growth of wages and salaries. Benderly has found that consumer spending responds with a lag when wage-and-salary growth accelerates. That happened last year, with the extra income going into extra saving. This year, however, consumer spending should start to catch up with the increase in income.

THE FINAL FACTOR is also a lagged response, in this case, to lower energy prices. Benderly has found that when prices of necessities decline, consumers initially save much of the windfall, only to spend it later.

So last year’s plunging energy costs went into savings, but much of it will be spent on consumption this year.

Another key component of economic output—investment in plant and equipment— was hurt by the severe cutbacks by the energy sector. But if the oil price rebounds to $55, as Barron’s expects, then key parts of energy investment will make a comeback before the year is out, says Citigroup senior energy analyst Anthony Yuen. And in general, Benderly anticipates a gradual rebound in U.S. manufacturing, as it responds with a normal lag to the pickup in retail sales.

The government portion of output, which began to make small contributions to growth in 2015, should pick up a bit this year, too, given the turnaround in state and local employment. Residential investment, which has been making steady contributions to GDP growth, should also climb a bit faster, as rising incomes spur greater household formation, in turn causing greater production and spurring greater employment and formation of households.

In short, the virtuous cycle should dominate. 

Marc Faber on Cashless Society Insanity and Why Wall Street Hates Gold

by: Mike Gleason

Review & Outlook

The Political War on Cash

So long, Ben Franklin. Politicians want to coerce you to spend.

   

Closing Developing Countries’ Capital Drain

Joseph E. Stiglitz, Hamid Rashid
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When Will Gold and Gold Stocks Correct?

By: Jordan Roy-Byrne

Wednesday evening we raised a question in a subscriber update. We wrote: The current question for Gold and gold stocks is if they will push to higher targets before or a correction or if a correction has already started. We should know the answer in the next day or two. The gold stocks exploded higher on Thursday. GDX gained 6% while GDXJ surged 7.4%. Meanwhile, Gold solidified its support at $1200/oz. Markets that become overbought within strong trends can become extremely overbought before they correct. Recent price action in the precious metals complex argues that the path of least resistance in the short term continues to be higher.

The chart below plots the weekly candle charts of GDXJ and GDX. The first observation is although the miners are very overbought on the daily charts, they aren't that overbought on the weekly charts. They will close this week flat after three strong weeks of gains. Also, the miners figure to face stronger resistance at higher levels. GDXJ is trading pennies below $25.00. If it surpasses its 80-week moving average then its next target is $27-$28. (Note that a measured move from the July 2015 to January 2016 consolidation projects to $28). Meanwhile, GDX is holding above previous resistance at $18. Its next strong resistance targets are $21 and $22. (The measured move from the July 2015 to January 2016 consolidation projects to $21).





The monthly chart of Gold continues to give the most clarity on its prognosis. We have written about the importance of Gold holding support at $1180-$1200/oz, which it did this week. A monthly close above that support adds greater confirmation to a change in the primary trend.

Gold has near-term upside potential to $1285/oz which marks monthly resistance and contains the 40-month moving average. Note that weekly resistance is at $1294. In addition, there should be very strong monthly resistance at $1330.




The odds favor Gold and gold stocks continuing to move higher before a correction begins. Both GDX and GDXJ could gain more than 10% before reaching stronger resistance while Gold has upside potential to $1285-$1294/oz. The counter-trend moves within very strong trends occur quickly. Gold declined from $1264/oz to $1192/oz in less than three days while the miners (GDX and GDXJ) have corrected 9-10% twice in the past ten days. Unless Gold and gold stocks fall below Thursday's lows then we should anticipate higher prices in the short-term. A bigger correction will come but not yet.

How the Kurds Became Syria’s New Power Brokers

And why Erdogan's war against them threatens to undermine his relationship with the United States and spark a civil war in Turkey.

By Amberin ZamanAmberin Zaman is a Public Policy Scholar at the Wilson Center.

 

Tal Rifaat, Menagh air base, Kefir Naya, Kefir Neris — town after town, village after village is falling to Kurdish-led forces as they blaze their way across northern Syria. The latest push by the U.S.-backed group known as the Syrian Democratic Forces (SDF) marks an explosive new phase in Syria’s five-year war. Turkey, a key, and increasingly unpredictable, NATO ally, is now on the verge of being sucked into the battle, against the group the U.S. favors.

Turkey has long insisted that Syria’s Kurds pose a greater threat to its security than the Islamic State jihadis do, and is furious that the United States is helping them. On Feb. 18, the Turkish government identified a Syrian Kurd, Salih Necar, as the perpetrator of a car bomb attack in the heart of Ankara.

Nacar allegedly drove a car laden with explosives into the midst of shuttle buses carrying military personnel and civilians outside the air force headquarters in the Turkish capital, killing himself and at least 27 other people.

Less than a day later, at least six Turkish soldiers died in the country’s mainly Kurdish province of Diyarbakir following a bomb attack also thought to have been carried out by Kurdish insurgents.

The main Syrian Kurdish militia, the People’s Protection Units (YPG), was set up as a franchise of the Kurdistan Workers’ Party (PKK), which has been fighting the Turkish state on and off since 1984, first for independence and now for Kurdish self-rule inside Turkey. Salih Muslim, the co-chair of the Democratic Union Party, which serves as the political wing of the YPG, swiftly denied any connection to the Ankara blast. The YPG has never attacked Turkey before and would surely desist from any actions that put its alliance with the United States at risk.

However, the Turkish prime minister, Ahmet Davutoglu, an Islamist, insisted that the bomber was “definitely” a member of the YPG who had “infiltrated” Turkey.

Turkey is adamant that the PKK and the YPG are “terrorists.” Washington half agrees. The PKK is on the State Department’s list of terrorist organizations. But the YPG is not, a fact that has paved the way for its deepening partnership in Syria, as Washington has provided the group with air support and weapons.

It remains unclear what sort of retaliatory action Turkey will take. What is certain is that Washington’s delicate balancing act between its Turkish and Kurdish allies is looking more precarious than ever.

Since Feb. 13, Turkish tanks have been shelling SDF positions near the Syrian town of Azaz, which is a vital resupply line for rebel forces in Aleppo who are allied with Ankara and doubles as a rear base against the Kurds. Turkey has vowed to prevent it from falling into their hands. Deputy Prime Minister Yalcin Akdogan made Turkey’s intentions clear, saying that it wants to create a “secure” strip of territory roughly 6 miles deep on the Syrian side of the border, including Azaz. Thousands of Turkish troops have been massing in the area for weeks, prompting Russia to warn that Turkey was planning an invasion of Syria.

These steps have placed Turkey on the brink of a conflict with its regional antagonists. The Kurds say they will fight back against any Turkish aggression. Syrian President Bashar al-Assad, whose own forces are inching their way toward Turkey’s border, says he will do the same. And few doubt that Russia, which is itching to avenge last year’s downing by Turkish pilots of its Sukhoi SU-24 jet, would deliver the biggest whacking of all.

Meanwhile, the SDF is skirting Azaz, punching a corridor further south — well out of Turkey’s range — and recruiting rebel groups along the way. Turkey’s demands that Washington stop aiding Kurdish “terrorists” has so far fallen on deaf ears. Rather, Washington has been calling on Turkey to stop attacking the Syrian Kurds.

Ankara may seem powerless in Syria, but it still has cards to play. It can, and already has begun to, reinforce its rebel proxies against the Kurds. More ominously, it could yet again ease restrictions on the flow of foreign jihadis into Syria.

Turkey’s troubles with its own Kurds explain why it is prepared to go to such extremes. The latest and most promising round of peace talks between the Turkish government and the PKK collapsed last summer when Turkey resumed its battle against the insurgents and began pummeling their strongholds in Kurdish-controlled northern Iraq. The PKK responded by shifting its fight to urban centers in the largely Kurdish southeast of Turkey, where its youth wing is mired in a bloody standoff with Turkish security forces. PKK fighters frequently target army convoys, which is why they cannot be ruled out as a suspect in the Ankara bombing.

The Turkish government claims its fight against the PKK at home is directly connected to the war in Syria. It says it has discovered secret tunnels dug from the Syrian side of the border to the besieged Turkish town of Cizre, scene of some of the grossest rights abuses by the Turkish authorities in recent years. The tunnels are allegedly being used to funnel arms between the Syrian Kurdish insurgents and the PKK. A young Kurdish fighter quoted by Germany’s Der Spiegel confirmed that such tunnels exist.

It didn’t have to be this way — the Kurdish issue didn’t have to threaten to undermine both Turkey’s policy in Syria, and its alliance with the United States. In early 2013, the mood in Ankara was dramatically different: Recep Tayyip Erdogan, the then prime minister who was planning to campaign to become Turkey’s first popularly elected president the following year, was keen to strike a deal with the PKK’s imprisoned leader, Abdullah Ocalan. If the PKK disarmed and withdrew from Turkey, the Kurds would get something substantial — it remains unclear exactly what, but likely greater local autonomy, and some sort of amnesty for those not involved in violence — in return.

That wasn’t all. A deal could have helped Erdogan achieve two of his most cherished goals: The YPG would have had to join the rebel campaign to unseat Assad and refrain from any moves towards self-rule; and Turkey’s largest pro-Kurdish party, the People’s Democracy Party (HDP), would have needed to support Erdogan’s plans not only to become the president but also to expand his powers once in office.

But the PKK refused to play ball, claiming that Turkey’s latter-day “sultan” was stringing them along. Why else had the government not passed a single piece of pro-Kurdish legislation?

And why was it arming jihadis in Syria against the YPG? The government replied that it had provided hundreds of wounded YPG fighters with free medical care and opened its doors to more than a quarter of a million Syrian Kurdish refugees, but the PKK was not swayed.

Hopes of an agreement were rekindled a year ago when the PKK unveiled a 10-point roadmap for peace. But Erdogan swiftly disowned the document, and all communication between Ocalan and the HDP has since ceased.

Yet, Syria’s Kurds have continued to thrive. Today they enjoy the rare distinction of being the sole group that simultaneously enjoys U.S. and Russian support. The YPG’s links with Washington were initially forged when U.S. planes intervened to rescue the Kurdish town of Kobani from the Islamic State in 2014. Since last year, the Kurds have teamed up with a gaggle of opposition Arab, Turkmen, and non-Muslim brigades to form the SDF, mostly as a kind of fig leaf that allows Washington to justify its support for them.

The payoff for both sides has been huge. The SDF has driven the Islamic State out of a broad stretch of territory along the Turkish border, while helping to pressure the jihadis in their self-proclaimed capital of Raqqa. The Kurds boast they now control an area “three times the size of Lebanon.”

The Kurds are now looking to link their two self-administered “cantons” that lie to the east of the Euphrates, named Jazeera and Kobani, with the canton of Afrin, which lies to the west.

This means dislodging the Islamic State from the 60-mile area wedged between them, and also going through an area that rebel groups friendly to Ankara, including more moderate brigades that have received weapons from the CIA, dominate.

Until recently they had to hold back at Washington’s behest. Turkey, which opened the Incirlik air base to anti-Islamic State combat missions in July, claimed it had done so on the condition that the United States would not help the Kurds move west of the Euphrates.

Turkey wanted to organize a non-Kurdish rebel force to uproot the Islamic State from that area west of the Euphrates. But the force never materialized — and Russia’s intervention on behalf of Assad’s crumbling army has also bolstered the Kurds. Helping the SDF boot out anti-Assad rebels from the areas they covet has the added benefit, for Moscow, of poking Turkey in the eye.

But Syria’s Kurds want more. They are angling for diplomatic recognition. Russia has stepped up to the plate, hinting that it will back the Kurds’ plans for autonomy. It also insists that the Kurds must take part in the now-stalled Geneva talks. The United States also backed the Kurds’ participation in peace talks, but backed off when Ankara threatened to stay away from the talks if the Kurds were allowed to join.

The Kurds are skillfully playing the Russians and Americans off of each other to extract as much influence as possible. Kurdish threats to defect squarely to the Russian camp propelled Brett McGurk, President Barack Obama’s special envoy for the anti-Islamic State coalition, to speed up a long-mulled visit to Kobani. On Feb. 1, a beaming McGurk was photographed receiving a plaque from a YPG commander who used to be, as Turkey shrieked, a member of the PKK. Washington appears to be quietly encouraging the Kurds to grab more territory, even at the expense of moderate rebels it has aided and trained, to ensure that Assad’s Russian-backed forces don’t get there first.

All of this is adding to Turkish fury, and Turkey’s Kurds say they are paying the price. The pain that Turkey would like to inflict on their Syrian brethren, their argument runs, is being meted out on them instead.

Washington’s insistence on maintaining the fiction that the PKK and the YPG are completely separate organizations is only making things worse. Indeed, it would not be surprising if the United States were to step up its military and intelligence cooperation with Turkey against the PKK to tamp down anger over its relations with the YPG.

The longer the conflict continues, the more alienated — and radicalized — Turkey’s Kurds will become. For many, the borders separating them from their Syrian cousins have ceased to exist.

Kurdish youths who honed their urban warfare skills against the Islamic State in Syria are now using them against security forces in Turkey. Others continue to take up arms with the YPG in Kobani.

Meanwhile, Turkish nationalist sentiment has been further inflamed by the Ankara bombing.

Erdogan’s polarizing politics have already divided the country. The specter of intercommunal violence looms.

Achieving some rapprochement between Turkey and the Kurds would be a sure step toward defeating the Islamic State. More critically, it’s the only way to ensure that Turkey does not descend into civil war — or go to war in Syria.

Some suggest the United States should use its leverage over the YPG to get the PKK back to the negotiating table. But it is the YPG that takes its cues from the PKK — not the other way around.

Either way, the idea that the Syrian Kurds would ditch their ties with the PKK to preserve their alliance with Washington is outright naive. There will always be others — the Russians or the region’s perennial mischief-maker, Iran — to step into the breach.

The only true way forward is for the United States to lean on both Turkey and the PKK to come to their senses. But the reality is that there is only so much prodding Washington and Turkey’s other Western friends can do. It ultimately falls on Turkey’s elected leaders to extricate themselves from this mess. Unfortunately, past experience suggests that Erdogan is more likely to dig his country into an even deeper hole.

Buttonwood

Liquid leak

Can weak markets be explained by changes in bank balance-sheets?
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ECONOMISTS have been a bit puzzled by the market turmoil of early 2016. It seems to be driven, in part at least, by fears of either an American recession, or a sharp Chinese slowdown, neither of which looks likely from the data. Perhaps the answer to the conundrum is that market movements are not being driven solely by fundamentals but by recent developments in market liquidity.

Central banks’ support for markets, via quantitative-easing (QE) programmes, is well known.

Emerging-market central banks have also been big buyers of government bonds as they have built up their foreign-exchange reserves. But the Federal Reserve stopped its QE programme in 2014 and, in recent months, Chinese foreign-exchange reserves have fallen by around $700 billion. This means the Chinese authorities are net sellers, rather than buyers, of financial assets. Low oil prices mean that sovereign-wealth funds in oil-producing countries may also be selling assets.

CrossBorder Capital, a research firm, says that the combined balance-sheets of the Federal Reserve and the People’s Bank of China were growing at more than 10% a year for much of the past decade—and reached a peak of 64.5% growth in 2008. But over the past year, they have actually contracted (see chart). Both the European Central Bank and the Bank of Japan are still adding assets, of course. Nevertheless, CrossBorder’s global liquidity index, which reflects changes in the balance-sheets of a range of central banks, has fallen to 35; a world recession, says the firm, is signalled when the index drops below 30.

Central banks may not be the only factor affecting market liquidity. Matt King, a credit strategist at Citigroup, highlights a number of oddities in a recent research note. The first is the relationship between government-bond yields and the cost of interest-rate swaps. A swap involves two parties agreeing to exchange a fixed-rate payment for a floating rate based on a variable measure, such as Libor. Since the counterparties to such deals tend to be from the private sector (notably banks), the fixed-rate element of the swap has tended to pay a higher yield than the equivalent government bond, to reflect the greater risk. But the cost of swaps has fallen below Treasury-bond yields, a phenomenon dubbed a “negative swap spread”.

The other shifts are in the corporate-bond market. Investors with a strong view on where the bond market is heading can buy or sell individual bonds, or they can use a derivative called a credit default swap (CDS). A CDS is a kind of insurance policy, which pays out if the bond defaults; when corporate-bond prices are falling, the cost of a CDS rises. Mr King points out that the cash market has recently, and unusually, underperformed the derivative (ie, the spread, or excess interest rate, on corporate bonds has risen faster than the cost of insuring against default via a CDS).

In a similar shift, the cost of insuring against the default of individual companies has risen faster than the cost of insuring a corporate-bond index. These changes in relative prices are the opposite of what happened in the crisis of 2008. Back then, the most liquid markets were the quickest to show the pain.

Mr King’s explanation is that this is all to do with the reluctance of banks to tie up their balance-sheets, thanks to new rules on leverage ratios. Derivatives like swaps require banks to put aside very Little capital compared with owning cash bonds, and so reduce demand for the latter. Banks are also unwilling to provide finance to traders who want to arbitrage such price disparities away; profiting from small price differences requires lots of borrowed money.

Another sign that liquidity is shifting can be seen in the world of exchange-traded funds (ETFs)—portfolios of assets that can be traded on the stockmarket. According to BlackRock, which operates the biggest high-yield ETF, daily trading in the fund was briefly worth a quarter of the value of all American corporate-bond trading in December. Buying and selling an ETF has become a more liquid way of shifting an investor’s asset allocation.

Since the crisis commercial banks seem to have retreated from their market-making role. The impact of this shift has been disguised by the huge amounts of liquidity injected by central banks. But as central banks scale back their support, the underlying investors (pension funds, insurers, hedge funds and the like) will have to rely on each other to act as willing buyers and sellers. That seems highly likely to result in more volatile markets than in the past, especially when the outlook for the economy is unclear. Buckle up.

Fed must act on ‘economic anger’, says oficial

 

The US Federal Reserve must do a better job of responding to the rising tide of economic anger in America that is leading to a surge in protectionist rhetoric on the presidential campaign trail, according to the newest member of its policy committee.

 

In an interview with the Financial Times, Neel Kashkari, who took over as head of the Minneapolis Federal Reserve at the start of the year, warned that the Fed needed to work harder to rebuild public trust and communicate with American citizens. Economic anger, he said, was “all around the country and it is non-partisan”.

Mr Kashkari’s first public forays this week have quickly positioned him as an outspoken voice among the central bank’s policymakers.

As a senior treasury official in the administration of George W Bush and during President Barack Obama’s first term, Mr Kashkari was a key architect of Wall Street’s 2008 bailout. But on Tuesday, in his first speech since joining the Minneapolis Fed, he called for regulators to consider breaking up the largest US lenders, which he said remained “too big to fail”.

 

In his interview with the FT he blamed the bailouts he oversaw as one of the “root causes for the loss of trust” in the US’s economic managers. Those actions had “really violated a core American belief” that risk takers had to bear the consequences of things going wrong, he said, and “it really leads to great anger if you violate the core beliefs of a society”.

The impact, he said, had been made worse by a history of opacity at the Fed and a past institutional reluctance to explain monetary policy clearly to the American public.

The Fed was now paying the price for decades of “very poor” communications during which it “adopted this Wizard of Oz routine that ‘We are so mysterious and you can’t understand what we are doing’,” he said, “and that really hurt trust between the people and the institution”.
 
Anger about the economy was also fuelling support for those advocating the erection of new barriers to protect US industry. “I don’t think protectionism is the right path. I think we need to promote free markets around the world. But some of the anger is understandable,” he said.

“We need to promote free markets on both sides. It can’t just be the American economy that is free and our trading partners are not free. So I understand that anger that is there. We need to push back against that [protectionist rhetoric] but also push out globally for free markets everywhere.”

His words come amid a presidential election campaign that is being dominated by frustration among voters about the sluggish growth since the 2007-09 financial crash. Some 72 per cent of the electorate feels the economy is still in recession, according to the American Values Survey released in November — even though economic analysts date the Great Recession as having ended in mid-2009.

 

That frustration has spilled over into antipathy towards the Fed itself, which is being expressed on both sides of the political divide. Democratic lawmakers have questioned the central bank’s decision to lift interest rates, warning it could stifle wage growth, while Republicans are calling for greater scrutiny of the Fed’s decisions amid lingering anger over the scale of its interventions during the crisis.

 

 

But above all it has helped fuel the rise of populist candidates such as Bernie Sanders, a self-described democratic socialist, and Republican frontrunner Donald Trump, both of whom have called for the US to do more to protect its own industry from cheap imports and foreign competition, and found support for those policies.

 

Mr Kashkari praised the work of Janet Yellen, the current Fed chair, in speaking directly and candidly in explaining the central bank’s policies, but said the central bank needed to go even further still.

Mrs Yellen was “trying to do the right thing for the country”, and if people got to know her and other people across the Fed system “they would be very proud we have this institution in our country”. However, he added, “we don’t really let them see in”.

“I think we could do a better job,” he said. “The press conferences [held quarterly by the Fed chair] are a step in the right direction and Chair Yellen is very candid in those press conferences and addresses the questions directly. That’s positive.”

But the Fed needed to “look for more opportunities like that. It has to happen on all levels.”
Monetary policy was hugely complicated, and it was not possible to explain every twist and turn of the debate to the whole population. That meant it was critical that the public trusts the central bank, he explained.

“You are not going to have the population as a whole understand all the nuances of what we are talking about here. They need to trust us. They need to know that we care. If they trust us and know that we care, they are going to give us the benefit of the doubt on some of the complexities they may not fully understand.”

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