Topic Tags: U.S Economy

The Fed Is Adding Repos to Its Toolbox

A repurchase agreement (“repo”) is a transaction in which a dealer sells securities to an investor and agrees to repurchase the securities at a future date. Typically, the dealer sells the securities at a discount to the repurchase price.  The repo market is relevant because it is a critical mechanism for the U.S. financial system to facilitate short-term lending between major financial institutions, money market vehicles, and the Federal Reserve.

A repurchase agreement (“repo”) is a transaction in which a dealer sells securities to an investor and agrees to repurchase the securities at a future date. Typically, the dealer sells the securities at a discount to the repurchase price. Effectively, the arrangement is akin to a collateralized loan with the difference between the sales price and repurchase price equating to an interest payment and the securities serving as collateral in the event of default (i.e., failure to repurchase).

The repo market is relevant because it is a critical mechanism for the U.S. financial system to facilitate short-term lending between major financial institutions, money market vehicles, and the Federal Reserve. The credit crisis in 2008 was preceded by heightened leverage in the repo market. When the fragile state of banking institutions’ balance sheets became apparent, money market funds and private lenders collectively barred access to capital for borrowers perceived to be weak. Due to a general lack of transparency as well as market fear, access to capital from the repo market dried up and sealed the fate of the likes of Lehman Brothers and Bear, Stearns & Co. who depended on it as a source of borrowing. Since then, the Federal Reserve has been aware of the need for reforms to reduce reliance on private banks and money market funds for liquidity in the repo market during times of stress.

This week’s chart shows evidence of the Fed’s intervention in the U.S. repo market to manage liquidity in lending markets and promote the stability of the financial system. In 2008, the Fed acted as a lender of cash, increasing its position in repurchase agreements, attempting to supply much needed capital to the banking system. More recently, the Fed has done the opposite. On September 23, 2013, the Fed began testing its reverse repurchase agreement program. As part of the new program, the Fed has been increasing its position in reverse repurchase agreements which means it absorbs cash from private institutions, thus acting as a borrower. While some believe this is simply a measure of monetary tightening, a more compelling argument is that the Fed is maintaining its role as a provider of liquidity despite taking the other side of the trade. In the face of high demand for U.S. Treasury securities as collateral for private institutions and money market funds, the Fed is using reverse repos to increase the availability of those securities in the market by drawing them from its own balance sheet. Meanwhile, the New York Fed is monitoring the weighted average maturity of banks’ borrowings in the repo market to identify vulnerable institutions with an overreliance on borrowing. Though the program has not yet been permanently instituted, it seems probable that the Fed hopes to use this new tool to stabilize bond markets ad infinitum.

A Stock Picker’s Market?

So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market.

So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market. When dispersion is low and correlations are high, it is difficult for active managers to outperform a benchmark. During periods of high correlation, the market reacts to macro-type factors, punishing or rewarding all equities at once with little regard to stock specific fundamentals.

In 2014 however, correlations have once again begun to exhibit a downward trend, allowing active managers more opportunities to separate themselves from a benchmark. As measured by rolling 21-trading day windows, average correlations between the 10 sectors of the S&P 500 and the index itself reached a low of 63% in May, a level not seen since late 2010. If the trend of lower correlations continues throughout the year, expect greater dispersion between individual equities to be closely followed by greater dispersion between active managers and their benchmarks.

Tackling Unemployment: Significant Job Growth Still Needed

This week’s Chart of the Week takes a closer look at the current employment situation compared to pre-recession numbers. Recently, the U.S. hit a new high water mark for the number of private sector employees, though the total amount of workers employed is still behind by approximately 900k jobs when compared to its previous high set in November 2007. Considering that over 8.5 million jobs were lost during the recession, with total employment falling at one point to about 138 million, the economy has come a long way.

This week’s Chart of the Week takes a closer look at the current employment situation compared to pre-recession numbers. Recently, the U.S. hit a new high water mark for the number of private sector employees, though the total amount of workers employed is still behind by approximately 900k jobs when compared to its previous high set in November 2007. Considering that over 8.5 million jobs were lost during the recession, with total employment falling at one point to about 138 million, the economy has come a long way.

However, there are two additional factors that should be taken into account when discussing the improvement in employment. The first is population growth. To achieve the same unemployment rate as November 2007 (4.9%), total employment would need to increase by about 2.5 million to 148.1 million. The second, and much larger factor, is the difference in participation rate, which measures the labor force as a percentage of the total population over 16. Prior to the recession, the participation rate was 66%, and it has been steadily declining since then to 62.8%. To look at it another way, the civilian population has grown by almost 14.5 million people but the labor force has only grown by about 1.5 million. All else being equal, if the participation rate today was 66% unemployment would be at 10.8%. At this level, nearly 10 million jobs would need to be added to reach the pre-recession unemployment rate.

There is much debate whether or not this participation rate is the new norm. The decrease has mainly been attributed to students staying in school longer. If this trend reverses as job prospects improve and tuition costs grow, the participation rate, and in turn the unemployment rate, could increase substantially. On the other hand, as more baby boomers leave the workforce to retire, there will be continued downward pressure on the participation rate. Depending on how these factors are viewed, the condition of employment and the economy can vary greatly.

Growing Debt in China

This week’s chart of the week examines the difference in private non-financial sector debt levels as a percentage of GDP for the United States and China. Private non-financial sector includes non-financial corporations (both private-owned and public owned), households and non-profit institutions serving households. Rising debt levels are a concern to any economy, as higher debt as a percentage of GDP is a potential drag on growth.

This week’s chart of the week examines the difference in private non-financial sector debt levels as a percentage of GDP for the United States and China. Private non-financial sector includes non-financial corporations (both private-owned and public-owned), households, and non-profit institutions serving households. Rising debt levels are a concern to any economy, as higher debt as a percentage of GDP is a potential drag on growth.

In the chart above, the most striking development is that China’s debt (as a percentage of GDP) is now higher than the U.S. There are a variety of reasons for this, including deleveraging in the U.S. in the wake of the Great Recession, as well as easy credit coupled with massive infrastructure spending in China. Collectively, these trends have driven the relative debt in China higher than the U.S., which is especially worrisome for future growth prospects in China, and by extension, investments in the country. It is not surprising that investor sentiment has cooled regarding China as of late, and investors will closely watch the growing debt level in the coming years.

Drop in Shadow Inventory of U.S. Housing

In this week’s chart we examine the improving housing market and its outlook in terms of pricing stability as it relates to the number of homes in shadow inventory. To be brief, shadow inventory (courtesy of CoreLogic) represents the number of properties that are seriously delinquent, in foreclosure, and/or held by mortgage servicers that are expected to come to market in the future.

In this week’s chart, we examine the improving housing market and its outlook in terms of pricing stability as it relates to the number of homes in shadow inventory. To be brief, shadow inventory (courtesy of CoreLogic) represents the number of properties that are seriously delinquent, in foreclosure, and/or held by mortgage servicers that are expected to come to market in the future. During the recession, experts feared a second major dip in home prices would result from banks unloading the historically high number of distressed homes on their balance sheets.

Since 2009, the number of houses that comprise the shadow inventory has declined from roughly 3M to around 1.7M, thus approaching pre-recession levels. Homes prices, illustrated by the Case-Shiller Index, have continued to rebound from their 2011 lows. This represents a significant improvement in the housing market and as the shadow inventory continues to decrease the chances of a secondary dip in home prices becomes less likely.

Real Earnings Trend Upward

This week’s chart illustrates the year over year real average hourly earnings for all employees-inflation and seasonally adjusted.  Most important in the graph is the recent trend since mid-2012: hourly earnings have been increasing at a rate greater than inflation.  The primary reasons contributing to this are an improving labor force and falling inflation.

This week’s chart illustrates the year over year real average hourly earnings for all employees-inflation and seasonally adjusted.  Most important in the graph is the recent trend since mid-2012: hourly earnings have been increasing at a rate greater than inflation.  The primary reasons contributing to this are an improving labor force and falling inflation.  The U.S. has recovered the bulk of the jobs lost during the recession, and as the unemployment rate continues to decline and we work through some of the slack in labor markets, employers will have to pay higher wages to attract and retain workers.  Assuming the Federal Reserve can adequately control inflation in the future, the trend of improving real hourly earnings should continue.  As earnings continue to increase, GDP should benefit as approximately 68% of GDP is driven by consumer spending.

Note:  Real earnings during the 2008-2009 appear inflated, but this is really the result of the CPI declining precipitously during this time.

Taylor Rule Provides Clues to Future Short-Term Rates

Developed by Stanford economist John Taylor in 1992, the Taylor Rule is a mathematical model designed to estimate the level of short-term interest rates consistent with the Federal Reserve’s mandate to promote price stability and full employment. In making its prediction, the model measures current inflation and unemployment data against a set of ideal targets.

Developed by Stanford economist John Taylor in 1992, the Taylor Rule is a mathematical model designed to estimate the level of short-term interest rates consistent with the Federal Reserve’s mandate to promote price stability and full employment. In making its prediction, the model measures current inflation and unemployment data against a set of ideal targets. Currently, the model utilizes the Fed’s stated inflation target of 2% and an unemployment rate of 5.6% as the ideals for a healthy economic environment.

Prior to the great recession, the output of the Taylor Rule proved to be fairly accurate in predicting short-term interest rates. As the financial crisis deepened, however, the Taylor Rule began to suggest that a negative level of short-term rates would be necessary in order to restore economic growth. Bound by zero as the floor for interest rates, the Fed was unable to lower short-term rates to meet the level prescribed by the Taylor Rule. With further interest rate decreases no longer an option, the Fed turned to quantitative easing as a means to further loosen monetary policy. Five years later, with the U.S. economy on more stable ground, the level of short-term rates prescribed by the Taylor Rule has once again turned positive. Not surprisingly, the Fed has begun to slow the pace of quantitative easing with the program scheduled to come to an end altogether later this year. As investors eye Fed clues for the future path of short-term rates, consider the Taylor Rule as a useful guide.

Economic Surprise Index Turns Negative

In this week’s chart we take a look at the CITI Economic Surprise Index. As a matter of background, the CITI Economic Surprise Index is a composition of various economic indicators that are released; anything above 0 indicates that economic reports are beating expectations and anything below 0 is underperforming estimates.

In this week’s chart, we take a look at the CITI Economic Surprise Index. As a matter of background, the CITI Economic Surprise Index is a composition of various economic indicators that are released; anything above 0 indicates that economic reports are beating expectations and anything below 0 is underperforming estimates. Since its peak in mid-January, the index has been on a steady decline and just reached its lowest point since June of last year.

The start of 2014 saw several key economic indicators fall short of expectations including retail sales, new jobs, manufacturing, and the consumer confidence index; such trends help explain the decline. On the bright side, many experts have blamed the historically dreadful weather conditions as key contributors to such pull-backs in economic activity, and expect a rebound once spring arrives. Indeed, the market appears to agree: after a negative January (-3.5%), the S&P 500 returned 4.6% in February, shrugging off much of the poor economic data. Given the optimistic outlook shared by most economists for 2014, it is expected that the Economic Surprise Index will swing back to positive territory as winter gives way to spring.

Expect Fed Funds Rate to Remain Unchanged at 6.5% Unemployment

With the unemployment rate (6.6%) approaching the Fed’s forward guidance target of 6.5%, this week’s chart examines two additional labor market indicators: the number of people working part time for economic reasons and the number of individuals who have been unemployed for longer than six months.

With the unemployment rate (6.6%) approaching the Fed’s forward guidance target of 6.5%, this week’s chart examines two additional labor market indicators: the number of people working part-time for economic reasons and the number of individuals who have been unemployed for longer than six months. In her February report to Congress, the new Fed Chairperson, Janet Yellen, identified these two data points as important gauges for evaluating the health of the U.S. job market.

While we have seen steady improvement in the headline unemployment number (down from a high of 10.0%), much of the “recovery” has been due to a decreasing labor participation rate, and overall the labor market remains relatively weak. Many individuals have resorted to working part-time due to poor labor demand and this segment constitutes 5.3% of currently “employed” workers. While below the high (7.0%) it is still above the long-term average of 4.4%. In addition, a large percentage of the unemployed (35.6%) have been so for more than six months. This is above the long-term average of 25.5% yet below the peak of 45%.

With the risk of inflation remaining relatively low, the market expects the central bank to refrain from increasing the fed funds rate at least through the first half of 2014 in an attempt to strengthen the economy and labor market even if the unemployment rate drops below 6.5%.

Youth Unemployment and Aggregate Student Debt

This week we take a look at the unemployment rates among young people and the rising levels of student debt. Following the crash in 2008 the aggregate student debt has more than doubled, rising from $500 billion to over $1 trillion. This is the result of not only traditional students struggling to afford tuition, but also due to many people returning to school in the hopes of improving their skill sets in a tough job market.

This week we take a look at the unemployment rates among young people and the rising levels of student debt. Following the crash in 2008, the aggregate student debt has more than doubled, rising from $500 billion to over $1 trillion. This is the result of not only traditional students struggling to afford tuition, but also due to many people returning to school in the hopes of improving their skill sets in a tough job market. The drastic increase is even more worrisome given the high levels of unemployment facing those who carry the majority of this debt. Workers between the ages of 15 and 24 are significantly more likely to be unemployed than their elders, with their current unemployment rate at 14.2% compared to 6.1% for those ages 25-54.

However, this is not necessarily as bad as it seems. As high as the present unemployment numbers are compared to the rest of the population, they are fairly consistent with historical averages. Additionally, the systematically high youth unemployment is not unique to the U.S. Most recently available data shows this figure in the European Union as 23.3% compared to 10.8% for the total population, and 16.0% and 7.8% respectively, among OECD countries.

Ultimately, there are two primary worries about the massive level of student debt. The first — and most obvious — is a widespread pattern of defaults on this outstanding debt, a potential disruption to the credit markets, and by extension, a headwind for growth. The second — while not as severe but still a threat to economic growth — is a reduction in consumption from students who are spending a larger percentage of their income on debt service, rather than consuming goods and services. Collectively, these two forces could emerge as a drag on economic growth at a time when the U.S. economy seems to need all the help it can get.