The Great Unmasking

Last month, Donald Trump caused a stir in the economic world, with his analysis of the Federal Reserve and its monetary policy during an interview he did with CNBC.

In it, he was adamant that the zero interest rate policy of the Federal Reserve had created a ‘false stock market.’ This was after last week, in which he had said that the interest rate policy had created a ‘false economy.’ His reasoning for both was that the decisions were political in nature.

According to Trump, Janet Yellen, the Federal Reserve Chair, was embarking on these policies in order to help President Obama, in order to make sure he ends his term with a positive economy.

Politics aside, the administration, and most left leaning economists have quick to point to the job numbers as a sign of the recovering health of the economy. The fact that the stock market has made fresh all time highs in 2016 has been used to tout the strength of the business community and commerce. Indeed, at a campaign rally last month, President Obama vociferously patted himself on the back for an economic job well done:

Janet Yellen, during her remarks explaining the Federal Reserve’s interest rate decision on September 21, painted a rosy picture of the economy, repeatedly citing the employment figures along with household income increases as evidence.

It is my view that these data points – mainly the employment data, and the performance of the broad stock markets – are merely masks which give the perception of strength and improvement, while concealing a deteriorating reality underneath.

The Labor Market Mask

Let’s look at the employment data.

While it is true that the unemployment rate has come down to 5%, from about 10%:

Part of that is because the labor force participation rate has declined throughout President Obama’s tenure and is at multi-decade lows:


With a ‘normal’ labor force participation,  the unemployment rate would be much higher, at least 10%.

The problem isn’t just with the totality of the workforce and the employment rate, but with the types of jobs which are being created in this economy, and who is filling them. Even a cursory look at the below surface trend reveals some problems.

The following is a breakdown of the labor force participation rate by age group: (Credit to the excellent Doug Short, who is a tremendous resource with his charting)


The following chart shows the breakdown in cumulative job gains for prime age workers versus those over 55, from 2007 through August 2016:


The following chart shows the cumulative gains in the food and hospitality industry versus manufacturing:


These charts show that the labor force is getting older, and the jobs that are being created are mostly of lower quality, in terms of goods producing. The bartenders vs manufacturing chart is somewhat tongue in cheek, but it does highlight the fact that most of the jobs that are being created are in the service sector, which are less paying jobs. The jobs that are being lost are the higher paying goods producing jobs.

Also concerning is he fact that the jobs data for September 2016 showed an increase in part time jobs of 430,000, compared to a loss in full time jobs of 5,000. In addition, there was a spike in the amount of individuals who hold multiple jobs of roughly 300,000, from 7.5 million to 7.8 million. The following two charts highlight these developments:

part-vs-full multiple-oct

Put it all together, and what we have is an economy which appears to be creating low paying jobs, which are being filled by people who may already have jobs, but need second and third jobs. Or, individuals who were laid off from a full time job, and are replacing it with multiple part time jobs, at lower pay.

Regardless, these are not signs of a robust economy, and those who point to headlines touting ‘X million jobs created since the recovery’ are being duped by an attractive mask that hides a horror show.

The Asset Price Mask

But what about the stock market? Isn’t it at all time highs?

It is, but masks are present here as well. Namely, the Federal Reserve. For nearly 8 years, the Federal Reserve has been engaged in unprecedented levels of monetary accommodation, with the Federal Funds rate resting at 0% until the most modest of raises in December 2015.

That raise was supposed to be the start of an easing cycle, which many experts predicted would result in four rate hikes for 2016. However, the stock market subsequently began 2016 with the worst start in the history of the stock market. This prompted an abrupt about face from the Fed, and then the ‘experts,’ with respect to the rate hiking schedule. Four rate hikes became two, and two became one, and as of this writing there is talk that there will be none at all.

That 12% stock market sell off in the first three weeks of 2016, on the back of the Fed raising rates for the first time in 7 years, from 0% to a negligible 0.25%, is indicative of the whole story: This market lives by the Fed and dies by the Fed. Some, myself among them, would call that a bubble.

The Fed’s persistence in keeping interest rates as low as possible is ultimately rooted in its flawed belief that elevated asset prices are the key to prosperity. Consider Ben Bernanke’s 2010 explanation of accommodative monetary policy and its intended result, the ignition of the ‘wealth effect.’

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

This is a description of an economic growth model that starts with the Fed lowering interest rates, pumping money into the economy, continues with various actors in the economy increasing their borrowing, and ends in them buying assets, which increase their prices, emboldening the owners of those assets to further spend or take on more debt as a result of their increased ‘collateral.’

The hope Bernanke and all Keynesian influenced central bankers had, and still have, is that this process continues and feeds on itself, a phenomenon known as the ‘virtuous cycle.’

Indeed, the Federal Reserve has accomplished this, expanding its balance sheet from roughly $800 billion in 2008 to roughly $4.5 trillion today:


Which has led to skyrocketing corporate debt:


Which has, in part, led to a substantial rise in the S&P 500, which I will use as a proxy for ‘asset prices’:


The problem with this, the Fed’s preferred model for growth, is that continued asset price increases rely on ever expanding debt, to provide the impetus to buy. It is a simple fact that debt cannot expand in perpetuity. It is limited by the ability to service that debt, which is in turn limited by the productive capacity of the borrower in question.

With respect to corporate borrowers, that productive capacity is seen in earnings. If corporates can produce increasing earnings, they can sustain larger debt loads, which justifies the higher debt-induced prices. The following chart, of the S&P 500 index compared with earnings of the companies in that index, tells an interesting tale:


In short, the continued rise in stock prices are not justified based on the diminishing productive capacity of the companies themselves. A reason for this diminished capacity is general weakness in the economy itself, evidenced by the labor market situation which was discussed earlier.

An economy in which more and more people are working multiple lower paying part time service jobs instead of higher paying full time goods producing jobs is going to be an economy in which fewer and fewer people have incomes which allow them to spend freely. These household budgets are further constricted when taking into account the fact that the Fed is trying to engineer prices higher, so as to kick start the ‘virtuous cycle’ of the ‘wealth effect.’

The math just doesn’t work. Rigid incomes lead to constrained household budgets, which do not lend themselves to increased spending at higher price points, nor do they lend themselves to increasing borrowing to spend at higher price points.

Despite this roadblock, share prices continue to remain elevated, because the continued low interest rate environment established by the Fed enables corporates to take up the burden of spending. They can borrow at record low rates, and buy back stock. Or, other investors, banks, foreign central banks and others can borrow at low rates, in order to buy elevated stock prices. The rationale here is less a belief in a prospective restoration of business fundamentals, and more in a belief that buyers will buy for the sake of buying, rendering elevated prices becoming even more elevated.

Even the Fed is worried about the developments they have created:

In the minutes of the Fed’s September meeting, released this week,some officials “expressed concern that the protracted period of very low interest rates might be encouraging excessive borrowing and increased leverage in the nonfinancial corporate sector.”


Despite these worries, investors continue to demand corporate debt, helping fuel a years-long rip-roaring rally in corporate credit that shows few signs of stopping. Corporate bond issuance this year is set to total $1.5 trillion, nudging past last year’s tally, according to the credit strategists at HSBC, led by Edward Marrinan. Issuance of high-grade debt is expect hit [sic] another record high this year.


It’s all a sign that, in the words of the bank’s strategists, “Market participants seem to be downplaying—or looking past—the risks associated with the steady deterioration in the credit fundamentals of the US corporate sector,” such as rising leverage, contracting earnings, and stressed revenues.


After the financial crisis, many companies focused on rebuilding their balance sheets to withstand another shock. But as the prolonged period of low interest rates continued, cheap borrowing costs prompted, well, more borrowing. Much of that went to fund shareholder-friendly activities like dividend increases and share buybacks. It also funded big mergers and acqusitions.

Emphasis mine. The preponderance of ‘shareholder-friendly activities,’ not least of which being the explosion of asset prices themselves, looks very good on the surface. Indeed, many law makers, academics, and market cheerleaders (such as President Obama) have been in a celebratory mood over the last few years, boldly declaring that the Federal Reserve’s actions had worked.

However, the divergence described by the WSJ – that the Fed itself worries about – between elevated asset prices and the fundamental deterioration of those prices is real, and cannot persist in perpetuity.

Removing the Mask

Deteriorating fundamentals cannot support the further debt burdens that are required to keep asset prices rising even further beyond these levels. And the Fed knows it. This is why they abandoned the original plan for multiple rate hikes in 2016, as that would have slowed down borrowing and thus slowed down the impetus for asset price increases.

In this manner, the market going from four expected rate hikes to now one or zero rate hikes is an effective rate cut. This is what the Fed has been relegated to, sitting on its hands and hoping a miracle happens. If they are proactive in doing anything more accommodative, such as another round of QE, they will put themselves in an untenable position. They can’t on one hand tout the robustness of the economy  yet embark on further emergency policies, such as QE would be. The situation would be exposed for all but the most die-hard believers in the Fed.

Regardless of their games, or ‘forward guidance’ as they would call it, reality will assert itself at some stage. The mask will eventually come off. How exactly it will happen is uncertain. But this situation has happened several times before in financial history. There is no escaping a scenario in which too much debt has been taken on relative to the ability to service it. All the Federal Reserve (and central banking in general) can accomplish is to push the date of reckoning out into the future. But even that does damage.

The current boom/bust episode is merely the latest in a 40 plus year credit binge following the ending of the gold standard in 1971. This has eventually led to constantly rising asset prices, which fooled the majority of the public into eschewing the idea of accumulating real savings.

Most used their home or 401k as their savings account. This was fine as long as the stock and housing markets kept rising, which they did, temporary bear market corrections notwithstanding. That all changed in 2008, when the bubble burst in earnest, and asset prices crashed.

This resulted in mass layoffs, but more importantly, many who had counted on elevated real estate and stock prices for retirement were now out in the cold, just at the moment they were ready to retire. This meant they were forced to return to the labor market, because they had built up no real savings over the preceding decades. This explains the surge in labor force participation for the over 55 segment, discussed earlier.

The under 55s have struggled to regain a foothold during this latest ‘recovery,’ still being several million jobs underwater from where they began the Great Recession. Some of this is down to competition from the over 55 workers, who flooded the market. Many of them, closed off from their former occupations, went into parts of the market usually populated by younger workers. Hence the proverbial ‘Wal-Mart Greeter.’

That position really should be filled by a 16 year old kid, working his first job and acquiring the basic skills involved with employment. Instead, the position is filled by a 60 year old who is working one of his last jobs because he didn’t accumulate savings during most of his productive years.

This phenomenon doesn’t bode well for the economy as a whole going forward. When you have an economy which is severely under-employing those who are in their peak earning years, not only is the economy not going to be moving as robustly as it should, but in the future, as those workers persist with decades of under-employment, they too will have to encroach on future younger generations as they try to get their careers off the ground. Multiple generations impaired at once.

And therein lies one of the ultimate problems with central banking, played out over decades. It, like most of government, prioritizes political expedience over longer term sustainability, papering over the cracks instead of repairing them, thus consigning the ultimate costs to be dealt with in the future.

In this greater sense, reality will assert itself here as well. The exponential increase in debt and increases in money supply papering over business cycle after business cycle can only end in a currency crisis, as it has done many times in the past. One can only hope we correct course before such an event occurs.