December 2002

It Takes Two To Tango

The Dirty Dozen...Clearly the Fed wasn't fooling around as it cut the Fed Funds rate in early November by a relatively resounding 50 basis points.  You have to go back to 1961 to find a Fed Funds rate as low as we now experience.  Interestingly, the move to a neutral bias sure seemed a bit out of place given the implicit message contained in a rate cut of current magnitude this far into an in-process monetary easing cycle that can only be characterized as generational in nature.  Fed Governors have subsequently referred to the move as "extra" insurance.  In less charitable circles, it has been described as outright panic.  The truth probably lies somewhere in between.  

In this most extraordinary of modern day monetary accommodation cycles, and despite what have so far been relatively short term equity bear market rallies, the macro stock market response to interest rate cuts by the Fed has been classically uncharacteristic of postwar US financial market experience to date.  Simply put, so far the equity markets have been fighting the Fed all the way through the process.  Pay particular attention to the "1 Year" column for each index characterized:

It is quite interesting that in the Fed communiqué accompanying the Fed Funds rate decrease, concerns over spending, production and employment were mentioned for the first time in recent memory.  In the nuances of Fed speak, quite significant.  In recent weeks it has become much clearer that the Fed is indeed worried about pricing pressures in the economy.  Pressure commonly defined in the popular media as deflation.  Recent Fed farm club member, Ben Bernanke, now an official FOMC knight of the roundtable, was quite blunt in a speech a few weeks back entitled "Deflation:  Making Sure It Doesn't Happen Here".  Bernanke clearly stated that zero percent interest rates were a possibility.  Monetization (Fed purchasing of Treasuries, etc.) of the debt a ready tool in the Fed toolbox.  The Fed stood ready to print money (expand credit).  And that there was certainly a tolerance for an orderly decline in the dollar relative to major global currencies.  As you know, it's rare that Fed officials literally lay it on the line.  Apparently Bernanke has not yet been schooled in Fedspeak obfuscation.  Rookies, whata ya gonna do?

In his own charming way, Greenspan has also made it clear in recent public soliloquies that the Fed has not run out of monetary bullets by a long shot.  We don't need to be hit over the head to realize that the Fed now intends to embark on probably one of the greatest reflationary efforts of recent US financial history.  The gauntlet has been thrown down.  Short sellers, hedgies, foreign holders of US dollar denominated assets and conservatively diligent Treasury and CD savers in this country, you have been warned, and warned big.  Our humble observation in this accelerated period of philosophical transition for the Fed is that it takes two to tango.  The Fed is relying on many a constituency to play ball if reflationary efforts are to be successful.  As can be seen in the table above, the equity markets are not yet sure these constituencies are ready to follow the Fed in the Arthur Murray dance steps to come.

There is simply no disputing that the supply of money and credit has been expanding at relatively extraordinary rates over the last few years, last half decade and last few decades respectively.  Inflation, no?  In like manner, the value of the dollar relative to global currencies has been on a steady increase for many years now, pausing for occasional time-out periods in its cyclical ascent.  In the past few years at the very least, this has put pricing pressure on the US domiciled corporate sector who for all intents and purposes competes against other global corporations in a less trade restricted global environment than has possibly ever been witnessed in modern times.  So this characterizes deflation?  Anecdotes that frame the domestic economy of the recent past are essentially turning the strict academic definitions of deflation and inflation on their proverbial heads.

But certainly this implied meaning of deflation, or price pressure, addresses a symptom or a result as opposed to a direct cause.  The popularization of the current "fight" against deflation is really a fight first and foremost to keep prices from falling through the natural process of supply and demand at any point in time.  When the popular media speaks of deflation, they are referring to the broad level of prices.  Prices of stocks.  Prices of houses.  Prices of consumer goods sold, etc.  Prices that in many cases achieved previously higher levels in conjunction with and at least in part due to aggregate systemic credit expansion.  But in our current circumstance, the potential for prices to fall has absolutely nothing to do with a classic contraction in the money supply as a root cause.  It's the "indy" period.  Price pressures in broad portions of the economy completely independent of the current rate of change in money supply growth.  

It is now without current question that the Fed appears hell-bent on reflating the economy.  We'd guess it's in our very near future that the ECB and Bank of England join in the fun and festivities of increasing monetary accommodation.  The Fed has now made it clear that they will fight domestic pricing pressure (let's get it straight, although they call it deflation) tooth and nail by virtually whatever means possible.  But maybe the key question that should be answered in the greater scheme of things is whether the corporate and household sectors will participate in reflationary efforts.  We can't recall the Fed having asked them as of yet.  For without their help, the Fed isn't quite as omnipotent as the Street may hope or believe.  And as has been interlaced through our commentary recently, those reflationary possibilities can only be built on the back of corporate and household sectors willing to borrow and spend ahead.  Simple enough?  For unless the Fed can convince the corporate and household sectors that aggregate prices are going up "tomorrow", what is the incentive to borrow and spend today?  Especially in what is clearly the post peaking period of one of the greatest credit expansions ever witnessed on this planet.  After all, hasn't the Fed really already been reflating in torrid spurts ever since the Asian currency crisis five years ago?  One look at household and corporate balance sheets will make the answer to that question as clear as a bell.  Has the macro reflation already occurred, or can we once again take the domestic financial system to whole new level?  Near term, when it comes to the financial markets, at least for now, we need to respect the fact that the Fed has now publicly admitted it is going to give it one hell of a try.

Setting the Standards...In the past we have shown you chart after chart testifying to the fact that the household and corporate sectors are as heavily levered today as possibly any other time in modern financial history.  In fact, it is plainly obvious that the corporate sector is in the direct midst of a very significant deleveraging phase as we speak.  Anecdotes attesting to this very fact surround us daily.  Successful reflation depends on these two sectors becoming more levered ahead, not less.  Factual information concerning the corporate appetite for borrowing can be found in a number of recent reports.  The Fed's Senior Loan Officer Opinion Survey released a few weeks back gives a bit of insight regarding commercial bank willingness to lend out their precious capital.  When mixing a bit of this data with actual commercial lending experience, a story of lack of demand for loans on the part of the macro corporate sector emerges.

In the following graph we chart the loan officer survey from the early 1990's to present along with the quarterly year over year rate of change in absolute dollar commercial and industrial loans outstanding.
       

As a first comment, the current year over year rate of change in C&I loans outstanding rests near a half century low.  If that fact alone doesn't say something, we just don't know what does.  But relative to the pictures of human decision making seen above, we have a few simplistic observations.  First, although well down from levels of fear seen a little over a year ago, bankers are not exactly standing on Street corners begging corporate executives to borrow money.  Their caution has receded, but they are still keeping one hand on their wallets.  Secondly, and maybe most importantly, as you can seen in the experience of the early 1990's, it was easily two to three years after the official recession concluded that year over year borrowing actually went positive and never looked back.  Lastly, when corporate borrowing eventually poked it's head out from negative rate of change territory in 1993, relative tightness in bank lending standards had already dropped like a rock.  We're nowhere near that environment yet.  In the Loan Officer survey, participant domestic banks directly cited a decrease in loan demand from credit worthy borrowers as the primary reason that C&I lending volume has contracted over the past few years.  The Fed can surely lead the corporate horses to the credit trough, but can they make them drink on already bloated stomachs?

We consider the contraction in C&I lending as serious, especially given that the commercial paper markets have literally frozen many a corporation out of the short term financing game over the last few years. As you can see in the following chart, absolute dollar commercial paper outstanding in the non-financial corporate arena currently stands at a level that was seen in the early 1990's.
     

For the folks banished, at least for now, from the land of commercial paper milk and honey, current longer term financing volume is clearly a gauge of forward corporate spending plans.  A lowered Fed Funds rate may help out those still able to access the CP markets, but that crowd has shrunk mightily in the recent past.  Given that the broader capital markets have developed a whole new respect for corporate credit risk over the last few years, watching what the banks do in terms of C&I lending will be quite the telling data point ahead.

This Is War...To suggest that the Fed is fighting a war may simply be an understatement.  But the fact is that there are multiple "wars" going on at the moment which influence price levels in the broad economy.  In the recent industrial production report, capacity utilization tells a story of its own.  Although the official recession is theoretically behind us for now, capacity utilization in this country has turned down anew over the past three months.  In prior recessions of past decades when broad utilization had reached the depths seen over the recent past, bottoms in this indicator have been spike reversal events.  After having bottomed and reversed late last year and into the early part of this 2002, capacity utilization has now reversed again in a southerly direction.  This type of pattern was seen in the early 1990's, but from a much higher level of utilization than we now experience.  Simply put, relative to the early 1990's, we have a much deeper hole from which to crawl before utilization rates even hint at pricing power potential.  Does it really make sense for corporations to borrow more money for spending just to increase the depth of the current hole?  The fact that the Fed Funds rate has dropped from the mid-6% level to near 1% with accompanying serious deterioration in capacity utilization, a complete lack of pickup in capital spending, and no sustainable boost to industrial production strongly suggests that something is quite different this cycle.
     

And despite the technical party in the NASDAQ as of late, particularly in the name brand issues, having led the recent rally in equities broadly, high tech capacity utilization still remains near the lows of the modern technology era.  It's no wonder folks like Intel have chosen to spend their very precious cash resources buying their currently overpriced stock rather than building new plant and equipment or sinking the money into forward thinking R&D.  They are making a clear statement about their business prospects.  They are making a clear statement as to what they believe to be the lesser of the two evils.
    

In addition to trying to fight the domestic price stabilization war graphically characterized in the charts above, just what will Fed actions mean in terms of global capacity and production?   Humble question.  If the Fed prints money here stateside like madmen, just how does that influence the actual cost of hourly production in say China?  From our perspective, the Fed finds itself in all new territory during this cycle.  Perhaps never have the global financial markets and economies been as codependent and intertwined as we now experience.  The Fed finds itself trying to desperately reflate a domestic economy that is subject to final goods and commodity pricing pressures that are now set in the global markets.

Homeland Security...At the household level, it seems hard to imagine the liability side of consumer balance sheets inflating any more than has already been accomplished over the last year plus with auto and residential mortgage lending, but anything is certainly possible.  Clearly the Fed is aware that auto sales as a key component of overall retail sales have quieted down substantially in recent months, despite the continual onslaught of financing incentives.  Likewise, new purchase mortgage applications are now below where they stood when conventional mortgage rates were 75-100 basis points higher, although refi madness continues unabated for now.  In terms of the consumer, we need to be on the lookout for Fed monetization (buying back Treasury and other types of debt) actions.  Although a lowered Fed Funds rate may influence a drop in the prime rate as an important benchmark for home equity lines of credit, very few consumer borrowing "opportunities" are linked in any way to the Funds rate.  It's the all important middle of the Treasury curve that counts the most in terms of household lending.  There's no mystery as to why the Fed has listed their ability to buy long dated debt on the open market as an additional tool for tomorrow.  Our guess would be that the Fed would go directly after the ten year Treasury if, or when, they decide to play the monetization card.  An important signpost benchmark in residential mortgage lending.

But like the corporate sector, despite a Fed driven to stop at nothing in order to reflate the system, can they influence households to drink more of the credit expansion koolaid?  At the margin, the answer is probably yes, but in terms of meaningful or successful reflation, depth and sustainability will be needed characteristics of hoped for household and corporate participation in terms of forward borrowing and spending.  No guarantees on this front.  What is a bit telling at the household level is that liquidity relative to liabilities has simply swan dived over the last decade.  It now stands at a half century low at least.  Maybe no surprise given the general availability of credit in the system.  Liquidity that the corporate sector now knows all too well can vanish in an instant when the capital markets start to perceive heightened risk.

Will consumers be willing to meaningfully increase household liabilities ahead, or perhaps does saving a few dollars in the bank start to strike a resounding chord at this juncture?  Especially given that labor markets have improved quite little over the recent past.  The recent jobless claims data has been somewhat encouraging, but cost cutting measures at the corporate level have been chiefly accomplished by headcount reduction.  If global pricing pressures in manufactured goods continue to persist, labor is not out of the woods by a long shot.  With the recent revision in 3Q GDP to 4% from the prior 3.1% guesstimate, it's virtually a shoe in that productivity will also be revised higher somewhere down the road.  But as the following chart clearly demonstrates, the "miracle" of productivity over most of the last few years was borne on the back of labor.  It's softness in hours worked that gave some of these quarterly increases their punch.  Productivity has been a miracle all right, unless you have contributed to the numbers by forfeiting your paycheck:
     

What is seldom addressed by the Fed, but is certainly hanging over the head of households in terms of forward labor pressure is the fact that global commodity prices have been rising over this entire year while so-called deflationary pressures in the US have been coincidentally increasing to the point of causing the Fed indigestion.  Just how can we have domestic final sales related pricing pressure rising alongside upside commodity price pressures?  There appears to be only one simplistic answer.  The pressure on commodity prices is being driven by the global marketplace.  The same global organism exerting downward pressure on manufactured goods pricing.  In a potentially treacherously simple example, a factory in the US may close and move to China.  For the same total costs of production perhaps a company can make two or three times as many "widgets" in China.  It can lower its per unit retail prices to the global marketplace and increase profits based on volume, labor cost differentials being the key to the entire equation.  BUT, that manufacturer may need two or three times as many commodity related input subcomponents to the higher volume production process with the new China facility.  It's the inputs that are driving commodity prices.  As the US has become more and more of a service oriented economy over time, its influence on global commodity prices due to domestic manufacturing needs set against the total global production equation has declined at the margin.  And yet it is directly subject to those commodity prices as a broader economy both on the production and consumer sides of the ticket.  Over time, energy being one of the central costs to the US economy.  But, of course, everybody knows crude is going below $20/barrel whether we engage Iraq or not, right?  (The current consensus thinking on softer oil prices ahead seems far too complacent for our tastes.)

Before we leave this whole area of prices and the hopes that the Fed can forestall aggregate domestic price weakness through additional shots of money expansion (credit expansion), we have one more chart we hope sparks reflection.  As we mentioned, commodity prices are moving north as we speak.  The CRB Index looks to at least have the potential to take out a multi-year high in the not too distant future.  It just so happens that there has been a fair amount of directional correlation between the CRB and 10 year US Treasury yields over the last 20-plus years.  The years of falling commodity prices and rising financial asset prices.  Correlation that has been plain to the naked eye...until now.
     

The above chart suggests that either commodity prices and financial prices are possibly seriously "out of whack" at the moment, or the directional relationship between these two is changing.  It suggests that the Fed is attempting to fight perceived domestic price weakness while simultaneously the economy is being squeezed on the cost and profitability side of the equation by higher commodity prices.  The cold hard fact is that the domestic system has never "cleared" as of yet during this cycle (capacity coming in line with ultimate demand) due to continual reflationary efforts up to this point that leave the question of healing through the price mechanism completely open to question looking ahead.  How does this ultimately weigh on households?  What was crystal clear in this week's upward GDP revision was that 3Q profits were down quarter over quarter, despite apparent 4% GDP growth.  Year to date corporate profits from operations are down close to 7%, again despite quite positive headline GDP.  In the endgame it's profits that count at the corporate level and if corporations are not improving them, they will continue to cut costs.  And you know the most expedient measure of reducing costs, especially when commodity input costs are not obliging.  Just look at the productivity chart above to have a guess at where those cost cuts will come from.

Although this may sound like a very far-fetched comment, the Fed simply cannot reflate the world.  The very basic laws of global supply and demand will ultimately outweigh Fed Governor Bernanke's "printing press" over the long run.  But in the meantime, the Fed will probably give it all they've got in trying to set a new standard for reflationary attempts in what has been a greater credit expansion cycle that has been going on for decades.  Ultimately successful reflation will depend on the willingness and strength of corporations and households to borrow and spend immediately ahead.  The exact modus operandi that has already played out in multiple Fed tonic administrations over the last half decade.  After all, it takes two to tango. Or in this case, three.

One last and very important note is that attempts to reflate the system ahead will necessarily spill over into the financial markets.  Given what at least appears to be the dogged determination of the Fed, we cannot see how it will play out any other way.  If the corporate and household sectors cannot "make use" of the monetary accommodation most certainly to flow from the largesse of the Fed ahead, just where do you think it will end up?  That's right, in the very place it ended up in late 1998 and late 1999/early 2000.  We're not saying this is good or bad, just that it is a strong possibility and needs to be acknowledged in individual decision making moving forward.  Call it what you will.  The ultimate Greenspan put.  The grand finale in moral hazard.  It's coming and will undoubtedly influence both the real economy and financial markets ahead.  As a last comment, this discussion has been nothing short of a cursory glance at what we perceive to be a significant change in Fed posture.  Notice we did not address the dollar, potential characteristics of flows of foreign capital, the bond market, etc.  Many important direct consequences and unintended consequences of the Fed's new take on life.  More on these later as one of the greatest stories ever told in the land of monetary expansion plays out.