Thoughts on the Fed and their agenda

The latest US jobs report will have supported the optimistic view of the outlook for the US economy, but we need some caution given that much of the jobs growth came from the public sector and average hourly wage inflation on a three month annualised basis remains below the average for the period following onset of the global financial crisis, albeit that the economy is doing significantly better than it was a few months ago.

To put the jobs data in context and looking forward, for the US economy to achieve a rate of real growth of GDP of 2%-2.5% for 2014 as a whole, annualised GDP growth for the second half of this year needs to be substantially above 3%, and the latest jobs data are only just consistent with this hypothetical target. On the basis of the latest jobs numbers, US GDP growth in 2014 will likely be a little lower than it was in 2013 and the pattern of there being two strong quarters followed by two weak quarters and then two strong quarters, which has been in place since 2009, remains intact. For the economy to achieve at least 3% GDP growth for 2014, there likely needs to be half a million new jobs growth per month on average from here.

Equity markets are optimistic on this front and anticipate that interest rates will need to rise to head off inflationary risks and see the revival of China’s economy as an additional reason for the Fed to consider some form of tightening.

Based on the data, there is even a rationale for the Fed to consider tightening right now, given that although the average rate of GDP expenditure growth in real terms has only been 1.7% since end 2008, and 0.7% since 2005, demand pressure measures of capacity utilisation suggest that the economy may already be operating at a rate that is slightly above its ‘natural rate’, with the result that the current account deficit has seemingly ceased improving and some signs of non-traded goods price inflation have begun to appear, including with regards to property rents. But this doesn’t mean that the Fed may actually want to tighten here, as Mrs Yellen has been signalling over recent weeks, and central banks are giving the impression that few if any of those engaged in QE would raise interest rates without nominal GDP growth having accelerated to a 5% or perhaps even a 7% annualised rate of growth. We may suspect that many central banks probably expect or believe that as soon as they signal ‘proper tightening’ there will be a poor market reaction as in 1994, certainly in fixed income markets, that will both damage wealth and raise effective borrowing rates within their economies – and it looks to be the case that most central banks do not intend to tighten before there is considerable momentum within their economies and this 5–7% nominal GDP ‘target’ seems to be about the norm. Moreover, given that trend GDP growth in the USA may now be around 1.7%, and only 0.5% in Japan, these 5-7% nominal GDP targets imply that inflation rates will likely have to go a lot higher than they are today before the central banks will actually react.

We may also suspect that most governments around the world hope for a dose of unanticipated inflation to erode the real value of their debt burdens, and there is therefore probably a political bias within the developed world economic systems towards inflation rates rising over the medium term. But hope is one thing, delivery potentially another, and it may be quite difficult for developed economies to achieve sustained higher inflation rates.

Meanwhile, a clear consequence of US QE is the extent to which the US corporate sector has re-geared itself. For example, in 1986 when Kaufmann et al were fretting about rising debt levels in US corporations, the total debt liabilities of incorporated non-financial businesses in the US stood at 37% of annual GDP. By the end of the NASDAQ boom, this ratio had increased to 45% of GDP, and by 2007, at the height of the global credit boom, corporate indebtedness had risen to 49% of GDP. Today, the ratio is 56% of GDP – an all-time high, and data from SIFMA suggest that US corporate bond net issuance is now running at the equivalent of 9% of GDP per annum, and this is 50% higher than it was only two years ago and perhaps as much as five times the post-WWII average.

Importantly, this massive corporate borrowing is being used to fund stock buy-backs, dividend payments and perhaps as much as $500 billion of stock option related pay-outs per annum. These operations are in turn producing considerable wealth gains for equity owners, and in so doing in effect discourage investment in the real economy, and hence the fall in trend GDP growth.

It’s also worth noting that during 1998-9 and the peak of the NASDAQ Bubble, corporate bond issuance was relatively high by historical standards but High Yield debt issuance amounted only 15–20% of total issuance, and during the bond issuance boom of 2006, only 16% of the debt issuance was High Yield, but today, 30%-32% of corporate bond issuance is High Yield.

Based on these figures, with the corporate sector’s debt burden rising at more than three times the rate of nominal GDP growth, the implied financial fragility of the US corporate sector has increased markedly over recent years, both in terms of total indebtedness and also the likely ‘credit quality’ of much of the borrowing but whereas in the early 1990s, the average maturity of corporate debt issuance was well below 10 years and in the mid-2000s, the average maturity was around a decade, today the average maturity is almost 14 years. This suggests that companies which have succeeded in issuing debt are well protected from most risks bar an absolute collapse in nominal GDP and an outbreak of deflation, and the flip-side question is why, given that most investors appear to believe that inflation rates will rise over the long term, so much funding was provided to support issuance of ultra-long duration low yielding bonds.

At present US companies have about $800bn of ‘free cash’ which in the event of Fed tightening could fall to around $400bn, assuming that capex trends remain soft and if corporate bond issuance were to return to a more ‘typical’ $600bn per annum following a tightening of policy be the Fed.

Currently, stock buy-backs are costing the corporate sector roughly $500bn per annum, dividends around $300bn and share option schemes $400bn. But if Fed tightening led to a halving in bond issuance, companies would only have around $100bn available to pay for buy-backs and the exercising of share options. The latter could fall on the back of lower share prices, and without buy-backs lower share prices might well be achieved but this would not be an objective of the Fed.

The conclusions that we can draw are that despite lacklustre GDP growth this year, there is a high probability that the Fed will feel that it needs to continue tapering, but that there is little danger that they will actually raise interest rates until nominal GDP growth accelerates appreciably. Nevertheless, rising demand pressures and weak trend growth rates will likely leave the Fed with a ‘quantity’ tightening bias. While such a bias may pose no particular threat to corporate solvency, despite the bond issuance mania of recent years, any form of tightening (via quantity or even price) that leads to a slowdown in corporate bond net issuance will have a very marked and possibly quite painful impact on asset markets. Fed tightening could both change the supply and demand balance in the fixed income markets directly and lead investors to reconsider the idea of buying long duration low nominal yield corporate debt. This could then lead to an unraveling of the market’s enthusiasm for higher-geared equity markets. There are signs that the Fed is finally tapering quite aggressively and US liquidity is suffering, but markets are calm. Should there be any sign that the corporate bond markets are struggling, this should be taken as overall cause for concern over risk asset markets.