War?

First to markets: We have raised a cash reserve in US ETF portfolios, and we are realigning bonds now that credit spreads are tightening and yields are low as quality flight occurs. We have rebalanced gold miners using an ETF. We remain overweight the financial sector and defense sector using selected ETFs. That strategy was underway before the North Korea story made the top of the news, and that strategy is validated by it.

Now let’s offer some commentary about North Korea and war risk.

It was a coincidence of timing that had me seated with Alix Steel and David Westin on the set at Bloomberg TV on Wednesday morning, August 9, after the POTUS versus North Korean dictator Kim Jong-un bellicosity ripped up the script. Here is the TV clip link about markets and war: (bloomberg.com/news/videos/2017-08-09/cumberland-ceo-warns-of-great-n-korea-market-risk-video).

Right before this clip the anchors had posted the similarly dire warning President Harry Truman made regarding Japan on August 6, 1945, some 16 hours after the US had dropped an atomic bomb on the city of Hiroshima: “If they do not now accept our terms they may expect a rain of ruin from the air, the like of which has never been seen on this earth.” (newsweek.com/trump-north-korea-threat-truman-hiroshima-648304)

Though Trump’s message to North Korea, promising to meet North Korean threats “with fire and fury like the world has never seen,” is similar in intensity to Truman’s language directed toward Japan at the culmination of WWII,  the circumstances are vastly different. In 1945, the United States had spent years engaged in a world war, had secretly developed the world’s first nuclear weapon, and had used it at Hiroshima. President Truman’s threat was credible because he had taken action.

President Trump, however, is in an entirely different place. He has, as president, established a pattern of tweeting bellicosity and messaging without consistency, and his administration was clearly unprepared for Trump’s ad-libbed threat. Secretary of State Tillerson tried to walk back the Trump statement by saying, “I have nothing that I have seen and nothing that I know of would indicate that the situation has dramatically changed in the last 24 hours. Americans should sleep well at night.” (cnn.com/2017/08/09/politics/north-korea-donald-trump/index.html)

Senator John McCain, who chairs the Armed Services Committee, reacted to the Trump statement with concern: “I take exception to the President’s comments, because you’ve got to be sure that you can do what you say you’re going to do…. The great leaders I’ve seen don’t threaten unless they’re ready to act, and I’m not sure President Trump is ready to act.” (axios.com/mccain-trumps-threat-to-north-korea-very-very-very-serious-2470752413.html)

Trump’s warning to North Korea put US Defense Secretary James Mattis in a particularly difficult position. Mattis has long advocated a diplomatic approach to dealing with North Korea because of the potential for catastrophe should conflict escalate. He issued a follow-up warning to North Korea on Wednesday, August 9, to discourage an overreaction: “The DPRK should cease any consideration of actions that would lead to the end of its regime and the destruction of its people,” Mattis said. Here is a link to his entire written statement: defense.gov/News/News-Releases/News-Release-View/Article/1273247/statement-by-secretary-of-defense-jim-mattis/.

Meanwhile, North Korea dismissed Trump’s warning as “a load of nonsense” and said it was pushing ahead with its plan to launch four missiles that would overfly Japan and land near Guam. North Korean media released the following statement:

“General Kim Rak Gyom, commander of the Strategic Force of the Korean People’s Army (KPA), released the following statement on 9 August.

“As already clarified, the Strategic Force of the KPA is seriously examining the plan for an enveloping strike at Guam through simultaneous fire of four Hwasong-12 intermediate-range strategic ballistic rockets in order to interdict the enemy forces on major military bases on Guam and to signal a crucial warning to the US….

“On Tuesday, the KPA Strategic Force through a statement of its spokesman fully warned the US against its all-round sanctions on the Democratic People’s Republic of Korea (DPRK) and moves of maximizing military threats to it.

“But the US president at a gold [should be “golf”] links again let out a load of nonsense about ‘fire and fury,’ failing to grasp the on-going grave situation….

“Sound dialogue is not possible with such a guy bereft of reason and only absolute force can work on him. This is the judgment made by the service personnel of the KPA Strategic Force.

“The military action the KPA is about to take will be an effective remedy for restraining the frantic moves of the US in the southern part of the Korean peninsula and its vicinity….

“The Strategic Force is also considering the plan for opening to public the historic enveloping fire at Guam, a practical action targeting the U.S. bases of aggression….

“The Hwasong-12 rockets to be launched by the KPA will cross the sky above Shimane, Hiroshima and Koichi Prefectures of Japan. They will fly 3 356.7 km for 1 065 seconds and hit the waters 30 to 40 km away from Guam.

“The KPA Strategic Force will finally complete the plan until mid-August and report it to the commander-in-chief of the DPRK nuclear force and wait for his order.

“We keep closely watching the speech and behavior of the US.” (NightWatch)

Having issued his warning and seen a response, Trump now faces a daunting task. Doing nothing invites more threatening behavior from Kim Jong-un, who is an unpredictable despot. Doing something has risk attached no matter what the something is. For the United States this issue of North Korea and nukes is a classic Hobson’s choice of the worst kind. Yet today Trump affirmed his tough talk, saying, “If anything, maybe that statement wasn’t tough enough” (cnbc.com/2017/08/10/trump-maybe-fire-and-fury-statement-on-north-korea-wasnt-tough-enough.html).

Clearly, America is building the military coalition it needs to respond to Kim’s threat, as demonstrated by this report from Guam:

PACIFIC (GUAM) DAILY NEWS: “The U.S. Air Force has said that members of the 37th Expeditionary Bomb Squadron, deployed to Guam from Ellsworth Air Force Base in South Dakota are ready to ‘fight tonight’ from Guam. During a 10-hour mission from Andersen Air Force Base, Guam, on Monday, two B-1s were joined by Japan Air Self-Defense Force F-15s as well as Republic of Korea Air Force KF-16 fighter jets. ‘These flights with Japan and the Republic of Korea (ROK) demonstrate solidarity between Japan, ROK and the U.S. to defend against provocative and destabilizing actions in the Pacific theater,’ according to a release from the Air Force.” (Politico)

Meanwhile, Iran, a longtime North Korea ally, is paying close attention to the unfolding of events. See nydailynews.com/opinion/player-north-korea-crisis-iran.

So what happens next? A good outcome is a China intervention and a Kim Jong-un exit and regime change. But we all know hope is not a strategy, and waiting for China or depending on China’s assistance is fraught with complications and additional risks.

Do we utilize a naval blockade?  Shoot down missiles when they’re launched? Engage in other limited actions? All options risk a full shooting war, with South Korea in range of North Korean artillery.

Do we do nothing and hope that a nuclear-armed North Korea would restrain itself, as Pakistan and India have? What evidence do we have that supports such a hope?

Our view is that hope fails as a strategy. And allowing North Korea to advance its missile and nuclear capabilities raises the odds that it will sell them to other rogue nations or terrorist organizations.

We in America face a serious risk and a Hobson’s choice — an awful combination that requires all the collective wisdom and leadership our nation can assemble.

We will close this note with the full situational analysis offered by George Friedman, who graciously gave us permission to reproduce it.  His website is https://geopoliticalfutures.com/.

We thank George for allowing us to share this piece in its entirety with our readers.

North Korea, Nukes and Negotiations

(us11.campaign-archive1.com/)

By George Friedman

The narrative about North Korea, a narrative I believe to be true and have since early March, is simple: The North Koreans have reached a point in their nuclear and missile programs where they could soon have the capability to strike the United States. The U.S. isn’t prepared to let itself be vulnerable to the whims of what is seen as a dangerously unpredictable regime in Pyongyang. Therefore, the U.S. is prepared to strike at North Korea’s nuclear and missile facilities.

At the same time, the U.S. is extremely reluctant to attack. The nuclear program sites are dispersed and hardened, making airstrikes difficult, and North Korean artillery concentrated near the demilitarized zone could devastate Seoul. So as it considers not just whether a strike should be made, but whether one is even possible, the U.S. has been trying to motivate China to use its influence in North Korea to get Pyongyang to halt its weapons development. The U.S. position is that a strike will take place if diplomacy fails, but also that a conflict with North Korea would be difficult, dangerous and potentially devastating to allies. Thus, the U.S. is postponing such an action as long as possible.

As time passes, it is important to re-examine old assessments. The United States didn’t suddenly in the last few months conclude that an attack on North Korea was dangerous. The Americans had to have known the North Korean nuclear development program was dispersed and hardened, and they have publicly spoken about the artillery threat to Seoul. But they might have been galvanized by indications that the North Koreans had a miniaturized and ruggedized warhead and were close to having an intercontinental delivery capability. Given the degree of U.S. focus on North Korea, however, the appearance of sudden apprehension is odd.

One way to look at this is that the North Koreans were also aware of the hurdles involved in attacking them and knew that the U.S. would hesitate. They therefore decided to rush forward to complete a weapon that would threaten and deter the United States at a time when U.S. relations with Russia and China were unstable and the new American president hadn’t yet settled in. They saw an opening they could push through to complete their weapon and hold the United States at bay.

The problem with this theory is that North Korea didn’t really need to keep the U.S. at bay. The U.S. has no real interest in North Korea. It has no desire to overthrow the regime, to reform it, to trade with it or to visit it. The idea that a nuclear weapon would make North Korea safer was dubious, and the regime must have known that. Since 1953 and the armistice, the U.S. was formally hostile and practically indifferent toward North Korea. On the surface, it would seem that North Korea had more to fear from actually threatening the United States.

In thinking about this, I have begun to reconsider a model that I had used to explain U.S.-North Korea relations since the 1990s until this past March and the beginning of this crisis. That model is what I call North Korea’s “ferocious, weak and crazy” posture.

Ferocious, Weak and Crazy

This strategy emerged after the fall of the Soviet Union and the transformation of China from a nation hostile to the United States into one that depended on it for trade. North Korea found itself in an extraordinarily dangerous position. Japan and South Korea were seen as hostile toward it, if passive. Russia was incapable of protecting it, and China had bigger fish to fry. The U.S. was emerging as a global power, no longer challenged by other great powers. North Korea was isolated, and in its mind, the U.S. was rampaging and toppling regimes of which it didn’t approve. There was no reason for it to think North Korea wouldn’t be a target. Pyongyang’s goal was regime survival, and guaranteeing that was enormously different.

The solution was to position itself, at least in perception, as something not to be disturbed. First, the North Koreans sought to appear ferocious. At the beginning, they accomplished this with their massive military (however poorly armed) and by zeroing their artillery in on Seoul. True, they had limited resources, but the fanatical nature of the regime and its forces made the country appear dangerous and powerful beyond its means. Fanaticism was its force multiplier. No one wants to mess with a fanatic unless they have to, and no one had to.

The second element of the plan, paradoxically, was to look weak. The famines of the 1990s were real, but they also made outsiders believe that the regime had only months to live. The regime knew better. It knew that the internal ferocity could be sustained and that unrest would not turn into an uprising. But from the outside, it appeared that the regime was tottering. If the regime were on the verge of collapse, why should anyone take the trouble of bringing it down? Weakness was a deterrent.

A Korean People’s Army soldier pointing to the Korean Demilitarized Zone (DMZ) CC BY-SA 3.0

Finally, the North Koreans said things that made them appear insane. They acted as if they could destroy the world, threatened the U.S. with annihilation, and occasionally sank a ship or blew up a group of South Korea diplomats. Ferocious as they were, why take the risk of engaging them? Weak as they were, why bother? Crazy as they were, prudence dictated avoidance.

In this theory, the decades-long nuclear program fit in. Having nuclear weapons might invite military counters, but working on nuclear weapons fit with the doctrine of ferocity. North Korea’s weakness made it appear as though it were a futile attempt. Its insanity made it seem like another act of frivolity. Guarded by those principles, the North Koreans could develop a nuclear force.They could also use their nuclear program as a negotiating tool and a way to inflate their importance. The United States didn’t want North Korea to even try to develop nuclear weapons. Success might be distant, but the risks were high. Since military action was not a reasonable option, extensive negotiation took place to convince North Korea to give up its program. The U.S. put together a group consisting of itself, Japan, South Korea, China and Russia to negotiate with North Korea. Step back and observe the brilliance of Pyongyang’s strategy. An impoverished tyranny was sitting across the table from five major powers that treated it not only as an equal, but as the equal of all five powers together. The effect on domestic perception had to be electric. It had been crazy to speak of North Korea as a great power; now the negotiations confirmed its place.

There were other benefits as well. Periodically, North Korea won material concessions from these countries in return for halting its program. This was certainly the case when the North Koreans took the benefits, resumed their program and returned to the negotiating table for another round of affirmation and aid.

The Mother of All Negotiations

But there was one principle embedded in this strategy: North Korea would have a nuclear program but not obtain a deliverable weapon. The former allowed it to manipulate great powers; the latter could bring catastrophe, even at a high price to the attacker. In March, it began to appear that the North Koreans had abandoned the key element of this strategy. Rather than a perpetual program, they were actually going to get nuclear weapons. They appeared very close to having one – mere months away – and they did this very publicly.

Yet consider this: They may get a deliverable nuclear weapon, but they acknowledge that they don’t have one yet. Perhaps at this point they can’t be more secretive than they are, but the fact is that they are waving warning flags for all to see. The military balance makes the U.S. extremely cautious about an attack, the South Koreans horrified at the thought, the Japanese ambiguous, and the Chinese and Russians hostile. The North Koreans look at the group they had negotiated with before, and they undoubtedly wonder whether the U.S. will act.

Certainly, the U.S. must be cautious. The North Koreans are ferocious, still a small, weak power in most ways, and crazier than ever, threatening to set the U.S. on fire. Therefore, ask this question: Do the North Koreans truly intend to obtain a nuclear weapon, or to come so close that it is within reach? Having gotten close, do they mean to set up the ultimate negotiation in which they exact massive concessions from the United States and others, including diplomatic recognition, economic concessions and perhaps even a type of confederation with South Korea in which the benefits flow north? After all, South Korea stands to lose the most if there is a war. Perhaps the South would consider some sort of deal?

North Korea doesn’t know what it can get, but one interpretation is that it is creating the framework for a negotiation in which it holds all the cards. The North Koreans likely can’t get all of what they can imagine, but given the American fear of North Korean nuclear weapons, the South Korean fear of war, and tensions between China and the U.S., the Americans would have to consider not only a nuclearized North Korea, but also a North Korea supported by Russia and perhaps China. The public American statement on the reluctance to go to war and its constant search for a diplomatic solution might convince North Korea that it is on the right track.

This is not a forecast but a consideration of an oddity. North Korea exposes itself to more risk by obtaining nuclear weapons. It increases its leverage by being close to having them but not actually having them. The value of nuclear weapons is low; the value of a program has always shown itself to be high. The more reluctant North Korea is to talk, the crazier it appears, and the crazier it appears, the more at a loss the United States is as to how to deal with it. According to this theory, those who argue that there is no military option and that we must accept North Korea as a nuclear power may actually have a point, but it’s not the point they think. If the U.S. accepts a nuclearized North Korea, North Korea will be the dog that chased a car and caught it, and will now have to figure out what to do with it.

I continue to think war is the most likely outcome. But as time has gone on, I’ve noted the complexities of such a war for the United States and have recalled other, much less extreme moments when the North Koreans used their nuclear program as a tool for bargaining. That was my view until March, when the level of urgency spiked, and I abandoned it and took the view that war was the likely outcome. I am obligated, however, to point out my previous view, which would have held this to be the mother of all negotiations. If that is going to happen, it must happen quickly. The U.S., South Korea and Japan all have said they want negotiations. But every sign indicates that North Korea is rushing to acquire a deliverable weapon and deter any country from tampering with it. War would occur before North Korea can reach that point, in my view. But in the back of my mind, I have to be open to the possibility that the ferocious, weak and crazy cripple is alive and well. If so, the North Koreans believe they have a precise understanding of the red line. In the end, I don’t believe they do.

The post North Korea, Nukes and Negotiations appeared first on Geopolitics | Geopolitical Futures.


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Debt Ceiling

When the Treasury Secretary of the United States has to manage federal finances as the calendar propels the country toward an artificially created fiscal cliff, he typically writes a letter like this one: treasury.gov/initiatives/Documents/Mnuchin to Ryan on DISP – 7-28-17 (2).pdf. Such is the nature of our political system. We play a game of brinksmanship with the debt limit.

No one expects the United States to default. It won’t. Even the House Freedom Caucus has indicated it will not use the debt ceiling debate to threaten an American default. But the group still threatens while the Republican appointed Treasury Secretary asked for a “clean” debt ceiling bill.

That said: Those politicians ignore the costs imposed by this brinkmanship while we the people go on about our daily business, assuming that there is no serious risk and pretending all is okay.  We are able to measure those costs with the credit default swap pricing on US debt. Worldwide US debt, including derivatives, is about $150 trillion. CDS pricing is up about 5 basis points. So we can estimate that the global cost of the debt ceiling charade is running at an annualized rate of $75 billion. Let’s call it $6 billion a month.

The debt-limit debate is a farce and a sham, but it is not “fake news.” The funding resolutions and congressional actions that will be signed by the president are places where other law (hence changes in policy) can occur. We expect congressional scrutiny to occur after our hard-working politicians return from their restful summer vacations.

Bottom line: Debt limit politics itself will have minimal impacts on interest rates and financial markets. A few billion is not a lot for a $20 trillion size US economy. It is the other stuff associated with debt-ceiling changes that has the potential for mischief.

There is one technical effect. The Federal Reserve acts as the nation’s bank. When the Treasury is operating normally, it keeps its cash at the Fed. That cash is one of the items on the liability side of the Fed’s balance sheet.

In a debt-limit political calendar run-up, the Treasury has to run down its cash balance. When it does so, that cash ends up in banks as part of ’their excess reserves”. The size of the Fed’s balance sheet remains unchanged – that is, the asset side is unchanged. But the liability side shifts until the new debt limit is resolved and until the Treasury resumes normal operations.

During this interim period banks have excess cash. So they tend to offer lower CD rates, since they don’t need to compete for deposits as strenuously as they otherwise would. Thus money market rates are lower, and other short-term rates are kept lower, too.  That means savers and depositors pay for political charade with an opportunity cost.

All this reverses after the debt limit politics have run their course. Market agents can enjoy this temporary excess liquidity now, but let’s not be fooled into thinking it is permanent. It isn’t.

As the Fed normalizes policy and after the debt-limit political charade is complete, we expect some system tightening and short-term interest rates to resume their gradually ascending trend.


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Oracle of Delphi

In June, the European Central Bank published a must-read working paper entitled “Communication of monetary policy in unconventional times” (ecb.europa.eu/pub/pdf/scpwps/ecb.wp2080.en.pdf). We highly recommend this 46-page working paper for any serious investor, academic, student, or other person interested in interest rates and central-bank-driven monetary policy.

Eight coauthors and five additional contributors have collaborated to offer readers extensive analysis of central bankers’ forward guidance (FG). They have produced evidence with statistical support and included coverage of major and diverse national central banks, not just the ECB. We believe their findings offer insights for every reader and can be particularly helpful to every central banker, everywhere.

The authors divide central banks’ forward guidance (FG) into two forms: Delphic and Odyssean. Readers know the Delphic Oracle and the epic hero Odysseus from their studies of ancient Greek history and literature, but ECB’s use of these terms in the context of central bank FG merits further explanation below. The authors then measure the results obtained by these two types of FG in terms of market-based pricing references (think interest rates).

They dissect further into time dependency (short-term, medium-term, etc.). For open-ended time, the authors find little value in FG. The Fed may wish to take notice of weakening market dependency on their dot plots.

There is deep work done in the paper on state dependency and the “trade-off between simplicity and accuracy.” For example, the authors discuss the Fed’s simplistic references to the unemployment rate and how that rate proves possibly misleading, such that the Fed may have had to “renege.” The reduction in the unemployment rate has actually resulted mostly from a falling labor participation rate, not from a robustly increasing percentage of the population being employed. Readers are invited to note that Bob Brusca’s statistical information indicates that over 90% of the supposed improvement in the unemployment rate is attributable to the decline in labor participation (see: http://robertbrusca.blogspot.com). Were participation held constant since the financial crisis began 10 years ago, the unemployment rate today would be close to 9%, not the present rate near 4.5%.

Let’s return to the authors’ calling upon antiquity to characterize the two key types of forward guidance.

Delphic refers to the pronouncements or predictions of the famous Oracle at Delphi. For some history and an easy discussion of this subject, see coastal.edu/intranet/ashes2art/delphi2/misc-essays/oracle_of_delphi.html. Readers may note how pronouncements about the future, such as those proffered by the Oracle, are merely assertions or opinions, which may have some basis or not. Just as in antiquity, believers who follow opinions do so at their peril. That’s true enough that central bankers would do well to take notice.

In contrast to the Oracle’s prophecies, the epic adventure recounted in Homer’s Odyssey represents an active “commitment” as to time and purpose as the epic hero Odysseus pits his wits and strength against all obstacles to reach his targeted goal: his home on Ithaca, his wife, and his son. The goal remains clear, and Homer’s undaunted hero eventually achieves it. The lesson for central bankers is that markets will respect clarity in the data target (inflation, balance sheet size, employment statistic) if that target is articulated unambiguously. Central bankers, markets want to know where you are going, how you will measure your progress, and what your ETA is.

Buried in the ECB paper is thoughtful analysis of the events that occur when there is disagreement between central bankers and market agents. The authors find that different types of FG result in different market reactions. Any central banker worth her/his salt is invited to study this section and reflect on the positive or negative outcomes of FG in which she/he participated or voted.

We will close with a full quote of the paragraph about “removing monetary accommodation.”

“The ECB has resorted to FG, which has evolved over time, and placed increasing emphasis on its state-contingent nature. Following its meeting on 4 July 2013, the Governing Council of the ECB initially communicated that it ‘expects the key ECB interest rates to remain at present or lower levels for an extended period of time.’ The expectation was based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics prevailing at that time. Following its meeting on 10 March 2016, and complementing the announcement of a comprehensive package of measures, including the expansion of the ECB’s monthly asset purchases, the Governing Council clarified its qualitative FG on future policy rates, stating that it ‘expects the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.’ Thus, a new interconnected element in the ECB’s FG was introduced linking the future path of policy rates to the ECB’s APP, which, at that time, was ‘intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim’, i.e. was subject to a mix of time-dependent and state-dependent FG itself. Finally, a third leg of the ECB’s FG has been introduced in December 2015, when it was announced that the principal payments on the securities purchased under the APP will be reinvested as they mature, ‘for as long as necessary’, constituting a case of open-ended FG.”

The eight dedicated professionals and their five additional colleagues who crafted the ECB paper have tackled a critically important subject and delivered valuable assistance to those of us whose role is to guide clients’ portfolios during this extraordinary period of monetary policy evolution.

We applaud the brilliance exhibited in this working paper. We will leave it to serious readers to take the time needed to fully absorb this valuable research. Don’t skip the appendices, as they cover major OECD countries and their respective national central banks.

At this moment we at Cumberland find value in certain bond market sectors (munis) for reasons my colleagues and I have written about. Similarly, we have selected stock markets and sectors using ETFs to capture opportunities.

We are not the Oracle of Delphi. Instead, we strive to be Odyssean, as we would wish central banks to be; and our choices of state dependencies are data-driven and continuously reviewed. Our path (growth or income) resembles Odysseus’s epic adventure in that events may intervene at any time. Thus our portfolio constructions may change.


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Midsummer Muni Musings

As the summer doldrums roll on, we thought it was a good time to recap where the muni market has come since the Trump sell-off of last fall.

A number of factors have helped the overall muni market.

The general level of interest rates has fallen as a result of congressional inertia on tax bills, healthcare, and fiscal spending in general. Markets, both equity and fixed income, generally like congressional gridlock, and we have it now, even with both houses of Congress and the presidency controlled by the Republicans. The charts below show the changes in the US Treasury market and the AAA tax-free bond market since the end of the first quarter. The muni outperformance in the long end is evident. The AAA-to-US Treasury yield ratio is now below 100%, though most AA- and A-rated bonds are still at yield ratios that are historically cheap.

*Source: Municipal Market Analytics

 

The original tax bill, which included a cut in the marginal tax rate, is now being discussed with a RISE in the top tax rate and cuts further down the tax curve. For the highest earners, that would means that tax-free bonds income would be worth more on a taxable-equivalent basis.

Inflation has been dropping (see graph below). The bond markets, and particularly longer-dated munis, have benefitted from the turnaround in core inflation. This has been a surprise to the Federal Reserve as well as the bond markets. With post-Trump rising yields but falling inflation, extending maturities and durations is a correct strategy, particularly in the muni market beat up by bond fund selling.

Trailing 12-month core Inflation

*Source: Bloomberg

 

Municipal refinancings have picked up again. See chart below.


*Source: SIFMA “US Municipal Securities Holders” Report. (Last Updated 7/06/2017)

 

Refinancings dominated last year’s issuance, particularly as we got into the low yields post-Brexit. With the Trump sell-off in November, which lasted through January, overall issuance is off this year, as refinancings were not feasible earlier in the year and issuers were put off by the overall rise in rates after the election. However, with the recent drop in yields, refinancings started to come back into the market in March and have continued right through the summer. Though the cost savings are not as dramatic as they were last year and yields are still higher than a year ago, municipalities are not willing to let this second opportunity to refinance and prerefund older, higher-coupon debt go by. Plus, there is one less year to call dates than a year ago, which reduces the amount of negative arbitrage. That is the difference between the municipal financing rate and the Treasury rate to escrow older bonds. In other words, longer muni yields are still cheaper than Treasury yields. So, still-considerable cost savings combined with less negative arbitrage means that there is a strong propensity among issuers to refinance their debt. To that end, in the current lower-interest-rate environment, we find that callable, higher-coupon bonds that are candidates to become prerefunded offer compelling yields on a risk/reward basis, given their shorter duration.

Also, the overall muni market got some good news this month as the House of Representatives Financial Services Committee approved the Municipal Finance Support Act. In a nutshell, this act will allow banks to count more of their municipal bond holdings in the calculation of HQLA (high-quality liquid assets). Though the bill still has to clear the hurdle of the Senate, if it goes through it should ensure continued participation of banks in the municipal market and is a large improvement over previous proposals.

Finally, market events in Puerto Rico continue, with a number of noteworthy developments. We now have five entities restructuring under Title III as well as the only FOMB- (Federal Oversight and Management Board)-approved Title VI restructuring to date. Readers may remember from previous commentaries that Judge Laura Taylor Swain is overseeing Title III restructurings along with a five-judge mediation panel appointed to assist with creditor–debtor negotiations. We have identified each entity and the restructuring path they are currently utilizing.


*Source: Debtwire

 

Defaults expanded in July to include the Puerto Rico Electric Power Authority (PREPA) and the Convention Center District Authority (CCDA). The default of PREPA follows a stunning decision by the FOMB to reject the authority’s restructuring support agreement (RSA). Until a month ago PREPA was considered by many to be the most likely candidate to achieve a consensual restructuring under Title VI. The FOMB’s actions imploded a deal that has been years in the making and cost those involved millions of dollars.

Of even more significance than PREPA has been the default and entrance of COFINA into Title III. Following the passage of legislation that would have made COFINA revenues available to the Commonwealth, the trustee, Bank of New York Mellon, issued a notice of default. COFINA entered into Title III shortly thereafter, leaving questions regarding default unanswered, especially those relating to certain accelerator clauses that senior bondholders want to enforce. Judge Laura Taylor Swain escrowed interest payments for June and July until the questions regarding default are remedied. We expect COFINA’s August payment to be escrowed as well.

We continue to watch court proceedings closely and remain confident that the insurers we utilize are capable of meeting their obligations. We would not continue to hold their paper if we thought otherwise.

Enjoy your vacation!

A special thank you to colleagues Shaun Burgess and Gabriel Hament for assisting in compiling the data.


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Cryptocurrency

For an in-depth discussion of blockchain and cryptocurrencies see the June 2017 white paper published by the World Economic Forum: “Realizing the Potential of Blockchain: A Multistakeholder Approach to the Stewardship of Blockchain and Cryptocurrencies” (www3.weforum.org/docs/WEF_Realizing_Potential_Blockchain.pdf).

Bitcoin, Ethereum, Monero, Litecoin, Stratis, and many other strange names now collectively make up an asset class of about $100 billion. Bitcoin is about half of the total.

Wild price gyrations have characterized this speculative asset class with more than a hundred players. Its short history has spawned extraordinary future price forecasts in the new theater of cryptocurrency. I’ve read one forecast arguing that a bitcoin could bring between $12,000 and $55,000 within five years. Readers may follow these price gyrations at coinmarketcap.com/currencies.

In the very beginning, cryptocurrency was viewed as a way to make payments under the radar screen of government regulation and supervision. That is changing. Slowly an expanding number of legitimate businesses accept cryptocurrency as a payment method. They usually immediately convert bitcoins or other currency into the ordinary fiat money in use.

The near immediacy of a blockchain transfer facilitates transactions. Often there is a service fee similar to the charge for using a traditional credit or debit card.

So what started out as a mechanism for secretive transactions that could not be traced easily has now transitioned into broader usage.

But what about those wild price gyrations? Should we consider Bitcoin and its growing list of competing cryptocurrencies money? We think the answer is no.

We can think of a given cryptocurrency as a way to transfer money using a methodology that bypasses the traditional banking system payments we are accustomed to. Cryptocurrency transfer is a version of an electronic debit card. So it does permit the classic function of money as a medium of exchange.

But money is also a store of value. At least that is true of a currency with low or no inflation. And money is used to measure and account. Thus we have price references denominated in dollars or euro or yen. Bitcoin has not yet attained the ubiquity needed to meet those tests.

Will it do so? Here is where the debate intensifies. And the entry of speculators, whether long or short, and now an ETF, add to this fascinating evolution.

Some references are in order. Tom Lee at FUNDSTRAT estimates the total asset sizes of many categories. US Treasury obligations total slightly under $13 trillion. US stocks are the largest, at $22 trillion. Worldwide gold is third, at $7.5 trillion. Investment-grade bonds are about $7 trillion, and munis represent slightly under $4 trillion.

So Bitcoin and all the other cryptocurrencies combined barely meet the threshold of anything other than a speculation for an investor. For now, at Cumberland, we do not hold any cryptocurrency in any managed account, and we do not hold any ETF that represents a cryptocurrency.

We hope that answers reader’s questions that we have received over the last several months since Bitcoin tripled in price and then plunged and since some government intervention (by China) in cryptocurrency altered the landscape. We do not expect any major central bank to hold a cryptocurrency as a reserve for a long time, if ever.

We thank readers for some very thoughtful points raised during the last year. Cryptocurrency and blockchain evolution is fascinating. To that we agree.


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Draghi Reassures as Eurozone Leads Developed Economies

The European Central Bank (ECB) decided on July 20th to maintain its extraordinary monetary stimulus with no change in policy interest rates. ECB President Mario Draghi’s remarks reassured markets that the eventual move towards normalization of rates and the ECB’s balance sheet will not be made prematurely. While the Eurozone recovery is looking robust, inflation dynamics have yet to become stronger. Also, the ECB probably would rather not add at this time to the upward movement of the euro.  Our expectation is still that the ECB will normalize policy only slowly – and later than the US Federal Reserve does.

The strength of the Eurozone recovery thus far in 2017 has been impressive, leading economists to raise their projections for the year. Market and consumer sentiment is quite positive. Summarizing their Purchasing Managers Index data for June, Markit reported that the Eurozone growth outperformed that of other developed economies for the fifth straight month, and second-quarter growth was the strongest for over six years. Industrial production picked up significantly, and retail sales have improved.  Eurozone GDP growth for the year now looks likely to reach 2.3%, significantly above many forecasts made earlier in the year. Concerns about Eurozone banks have eased somewhat as national and European authorities have moved to address problems. Forecasts that the euro would decline to par with the US dollar or lower have disappeared as the euro has risen about 10% year-to-date. Indeed, the main risk facing the Eurozone economy in the coming quarters is that the strong euro will have an adverse effect on trade growth.

On the political front, perceived political risk has declined. Markets have welcomed the very strong parliamentary election results for French president Macron and his pro-market economic reforms agenda, along with the continued political strength of Chancellor Merkel in Germany. These two very popular European heads of state are now seen as assuming a leadership role for defending not only the single European currency and the European Monetary Union but more broadly the post–World War II global trade and economic system as US President Trump asserts a populist nationalist position. The two largest Eurozone economies are both advancing strongly. Germany’s GDP looks likely to register an above-trend 2.3% growth this year, compared with its 1.8% advance in 2016, while France’s GDP may well record a 2.0% advance, almost double last year’s 1.1% growth.

Equity markets in the Eurozone have outperformed so far this year. While in the US the SPDR S&P 500 ETF, SPY, is up just 11.52% year-to-date as of July 19 and the iShares MSCI EAFE (Advanced markets ex-North America) ETF, EFA, is up 17.14%, the iShares MSCI Eurozone ETF has gained 21.6% on a total return basis, as calculated by Ned Davis Research. The iShares MSCI Germany ETF, EWG, is up 18.66, and other Eurozone country ETFs have been even stronger. The iShares MSCI France ETF, EWQ, has gained 21.52%; iShares MSCI Italy ETF, EWI, 22.51%; iShares MSCI Netherlands ETF, EWN, 26.04%; iShares MSCI Spain ETF, EWP, 27.31%; and iShares MSCI Austria, EWO, an outstanding 35.84%. These markets are still momentum leaders. We would consider market drawbacks as possible opportunities to add to positions.

Sources: Ned Davis Research, Markit, Oxford Economics, Bloomberg


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Mystery Solved: Why Wages Won’t Rise in Japan

Jeff Uscher’s Japan Insider is one of my daily reads and regularly delivers insights I value and rely upon. Jeff has generously given me permission to share with you his research on why overall wages in Japan are stagnant despite a compelling labor shortage and thus why, despite the best efforts of the BoJ, inflation in Japan will be difficult to achieve for several years to come.

Here’s Jeff:

Mystery Solved: Why Wages Won’t Rise in Japan

It is “One of Those Great Mysteries of Life.” How can it be that, despite more than four years of super-easy monetary policy, laughably low interest rates, and a chronic labor shortage, wages in Japan are barely growing at all?

Everyone pretty much agrees that higher wages are the key to higher inflation. We all hear about higher wages for full-time workers and for part-timers at companies large and small. But, overall, wages have remained stagnant, and inflation has not moved off of the dime.

You can’t blame the Bank of Japan. Under Governor Haruhiko Kuroda, the BoJ has tripled the size of its balance sheet by purchasing several hundred trillion-yen worth of JGBs. BoJ assets have now topped ¥500 trillion—about the size of Japan’s GDP.

Short-term interest rates are negative, 10-year rates have been pegged at “about zero percent,” and USDJPY has risen from 94.18 at the end of March 2013, when Kuroda began his unconventional monetary policies, to 112.67 today. The weaker yen has boosted corporate earnings, and the equity market is trading at multi-year highs—aided and abetted by aggressive BoJ buying of ETFs.

But it seems as if the Japanese economy is immune to easy money. The BoJ has, so far, utterly failed to achieve its target of sustained 2% core CPI (excluding fresh food) inflation. Both the BoJ and Prime Minister Shinzo Abe blame sluggish wage growth for this failure.

Has the BoJ’s aggressive monetary policy achieved anything? In short, yes. Demand for labor has grown dramatically since 2013. Labor shortages, as reported in the quarterly Tankan survey, are worse now than at any time since the March 1992 quarter—the tail end of the Bubble economy.

Just as during the Bubble, the Japanese press is full of stories about restaurants cutting hours because they can’t get enough workers. Japan’s largest parcel delivery company, Yamato Transport (9064) famously told Amazon Japan—its largest customer—that it will no longer accept orders for same-day delivery services because it does not have enough drivers. Technology companies are developing robots and self-driving cars to make up for the chronic labor shortage.

Companies are raising wages for part-time workers in order to attract and keep enough workers. In major cities, fast food restaurants and supermarkets must pay their hourly employees more than ¥1,000/hour to get and keep good workers. Larger companies have offered their full-time employees wage hikes in excess of 2% for four consecutive years—the first time that has happened since the 1990s.

And yet, household income and spending continues to decline.

There is a disconnect between monetary policy and wage growth in Japan. If easy money and a tight job market can’t force companies to raise wages, what can?

I think I have found the answer to this mystery. Several years ago, I did extensive research on Japan’s pension system and on Japanese agriculture for CLSA. Both of these studies required a deep dive into Japanese demographics.

As I thought more about what happens to a person’s income when they retire, it soon became apparent why monetary policy isn’t working and why it can’t be a solution to Japan’s chronic deflation. The problem lies in Japan’s demographics and its employment practices regarding older workers.

First, demographics. The number of births in Japan topped 2.6 million in 1947 and peaked in 1949 at 2,696,638. There were more than 2 million births annually through 1952 and a total of 14.5 million births between 1947 and 1952. All of those people started to retire in 2012. People born in 1952 will retire this year.

Between 1953 and 1960, another 13.5 million people were born in Japan. That means another 13.5 million retirees between 2018 and 2025.

To put this into perspective, between 2012 and 2017, about 2% of the total population hit retirement age every year. Between 2012 and 2017, 11.5% of the total population became old enough to retire. In the thirteen years between 2012 and 2025, 22.2% of Japan’s total population will have reached retirement age.

As we all know, retiring from full-time work means a sharp reduction in income for most people. That is why we save—or should be saving—for retirement. Having 22.2% of your total population retiring in a relatively short period of time is a big hit to Japan’s aggregate income—offsetting higher wages for those people still working.

Second, Japan’s post-retirement employment practices combined with seniority-based pay make the loss of income even worse than it might be otherwise.

Legally, companies are required to allow anyone who wishes to continue working to do so until at least age 70. But the law does not require companies to keep older workers on as full-time employees.

Typically, what happens is that, when an employee retires, he receives a lump-sum cash payment based on years of service and other factors. The lump-sum payment is a buyout of the employee’s full-time status by his employer. By accepting the payout, the retiree agrees that he is no longer a full-time employee, and the company is relieved of its obligation to pay the retiree full-time wages and benefits.

In most cases, workers who retire as full-time employees at age 65 will continue to work for the same company as a contract employee. What this means is that a worker can complete his last day as a full-time employee on Monday and return to work as a contract worker on Tuesday. But, as a contract worker, his compensation will be cut substantially—45% to 55% is not uncommon—even though he is doing the same job for the same number of hours on Tuesday as he did on Monday.

To make matters worse, seniority-based compensation means that a company’s most expensive workers are its oldest workers—at least for as long as they remain full-time employees. Under Japan’s seniority system, older, full-time workers get paid the most. Post-retirement workers and young workers get paid the least. When a person retires, he falls from the top of the pay scale to the bottom, never to rise again.

Looking at Japan’s working population, the number of expensive, older, full-time workers has fallen by 1.05 million since 2011, when baby boomers began to retire. The number of post-retirement and young workers—who are paid the least—has increased by 2.86 million. With so many people facing pay cuts of 50% or more, is it any wonder that income and spending for the total economy is falling?

The problem with demographic issues is that they take a long time to develop and a long time to resolve. I think the tsunami of low-wage, post-retirement workers will finally start to subside around 2025 or so.

Deflation is not a monetary issue but is, instead, based on demographics. Easy money and negative interest rates only make things worse. Set the 10-year peg at 1%—or, better yet, 3%—and watch older workers leave the workforce so they can live happily ever after on the return on their investments.

Then you will see wages and inflation rise.

Jeff Uscher

Jeff Uscher’s Japan Insider: http://www.japan-insider.com


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Taxes, Politics and Mr. Bannon

“Since the Great Recession, which is now 8 years old, we’ve been growing at 1.5 to 2 percent in spite of stupidity and political gridlock, because the American business sector is powerful and strong. What I’m saying is it would be much stronger growth had we made intelligent decisions and were there not gridlock…. It’s almost an embarrassment being an American citizen traveling around the world and listening to the stupid s— we have to deal with in this country.” – Jamie Dimon, CEO, JPMorgan Chase (Hat tip Politico)

Behind the scenes at the White House, we are told that Steve Bannon has been arguing for higher taxes on the wealthy and advising President Trump to advance them, in a move more politically strategic and symbolic than substantive in percentage terms. Several other sources have confirmed that such discussions are underway. See Josh Green’s article at Bloomberg for more:

bloomberg.com/news/articles/2017-07-12/to-survive-the-russia-scandal-trump-should-embrace-his-populist-roots.

So, why is this strategy gaining a hearing and what does it mean?

The early Trump line and Republican euphoria after the election was encapsulated in the tax-cut proposal released by House Ways and Means Committee Chairman, Kevin Brady. We wrote about that proposal at the time: cumber.com/flynn-russia-trump-markets/. The timeline was this year and a possible attachment to a continuing budget resolution. So much for timelines and political gridlock now raises questions about next year.

All that euphoria has faded into history; and many observers, including us, now see little chance of any tax cuts this year. There still seems to be a consensus or majority view to repeal the alternative minimum tax (AMT). And a repeal of the carried-interest provision has a lot of support. Many would also like to see a large repatriation incentive tied to the funding of a national infrastructure program.

Those elements seem to be heavily supported by both political parties and by the majority of independents who think about policy issues and are inclined to swing in elections.

So maybe the Bannon argument can gain traction?  Is that what will move things beyond the gridlock?

Simply put, Democrats cannot blame Republicans for giving breaks to the rich if the top rate goes up. A 40% number is higher than a 30-something number. Also, the healthcare legislative debacle seems to assure that the 3.8% Obamacare tax will remain. And the changes in taxation have already inserted an income threshold (means testing) for Social Security recipients.

The new bottom line for income taxation is a 40-something top federal rate with high-taxation states like New Jersey and California adding enough to drive the top combined marginal rate above 50%. At Cumberland we have such clients and routinely see combined net marginal rates in the low 50s.

This vision also implies that capital gains rates will end up about where they are now, with no breaks coming this year. In high-tax states with restrictive tax codes, the marginal long-term cap gain rate can reach the 30s.

For markets, under the circumstances, those waiting for a lower-cap-gain setting will require a lot of patience unless they decide to forgo thumb twiddling and adjust nimbly to the new reality of no likely tax reform. This outlook makes tax-free munis more desirable since muni investors focus wisely on their net, after-tax investment returns.

And for the majority of Americans who work and earn, this outlook offers no relief, with the present complex tax code eating up the results of labor effort by tagging FICA (Social Security plus Medicare), Obamacare, and state and local taxation onto their federal calculations. For many working Americans, the federal income tax chews through fewer dollars than these other taxes do, taken together.

Meanwhile, our dysfunctional and discredited two-party political system fiddles in Washington in the spirit of an Emperor Nero in a burning Rome. And maybe I should suggest that the new fiddle is a balalaika.

The country wants reparation of a trillion dollars and a rebuilding of our decrepit infrastructure. The politician who understands these national priorities will find resonance in the forthcoming midterm elections. Those who ignore those priorities do so at their peril.


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Still Favoring Japan

Over the past 12 months, as of July 6th, the Japanese equity market  outperformed. The TOPIX index  increased 31.1% and the NKY 225 30.5%. These figures compare with increases of 14.8% for the S&P 500, 19.35% for the STOXX Europe 600, and in Asia, 22.4% for the MSCI AC Asia Pacific ex Japan Index. Similar outperformance was registered over the past three months: TOPIX, 7.9%, and NKY 225, 6.8%, versus S&P 500, 2.2%; STOXX 600, -0.1%; and MSCI AC AsiaPacific ex Japan, 4.6%. Over the past month equity markets around the globe eased, and the Japan market was no exception. iShares MSCI Japan (EWJ), by far the largest Japan ETF listed in the US, lost 3.25% between June 2nd and July 10th. Since then it has recovered by 1.5%. We did not consider this slight market pullback as a reason to reduce exposure to the Japanese market.

Japanese equities joined in the recent global market softness induced by rising interest rates, concerns that central banks will be reducing their quantitative easing, and perceived increasing geopolitical risk, including the North Korea threat and uncertainty about the future course of US actions. Japanese equities also suffered as a result of the substantial defeat of Prime Minister Abe’s Liberal Democratic Party (LDP ) in the Tokyo Metropolitan Assembly election, although that loss appears to have been just of local importance, not significantly affecting the strength of the LDP nationally. Also, Abe has been caught up in several scandals that have affected his popularity. Nevertheless, concerns about Abe’s ability to remain in power and carry forward his economic policies appear unwarranted to us. The LDP’s strong position nationally is not under any credible threat, and there is no serious contender to Abe’s leadership within the LDP. Abe does need to rebuild public trust. The best course would be to redouble his efforts to further economic prosperity.

Some investors have been concerned that the Bank of Japan (BOJ) may intend to begin tightening its very-easy monetary policy of quantitative easing soon, while keeping the 10-year Japanese government bond (JGB) rate “around 0.00%,” which appears to mean no higher than 0.10%. Last Friday, July 8th, after the rate moved slightly above 0.10%, the BOJ clearly demonstrated that it is not yielding in its battle to control yields on the benchmark 10-year JGB. It offered to buy an unlimited amount of JGBs and ended up by increasing its 5-year to 10-year operation from ¥450 billion to ¥500 billion. On Wednesday, July 12th, the BOJ also increased its buying operation of 3-year to 5-year JGBs by ¥30 billion. We anticipate that at the July 19th meeting of the BOJ’s Monetary Policy Board, Governor Haruhiko Kuroda will announce that the current monetary policy is being maintained.

The macroeconomic outlook for Japan is positive, with real GDP growth likely to register above-potential annual advances of 1.4% both this year and in 2018. Firm external demand for Japanese exports, supported by a weak yen, continues to be the main driver of growth, supplemented by increases in business investment, consumer spending, and public works.  The latest OECD Composite Leading Indicator for Japan implies stable growth momentum. Also, the Japan Economy Watchers Current Index reached its highest point in six months in June. Similarly, the Markit Nikkei Composite (manufacturing plus services) Output Index for June signaled continued solid expansion, completing its strongest quarter for three years. Business confidence is at its highest level since late 2015 according to the June Tankan Survey. Profit margins are improving, and capital expenditure plans have been revised upward.  Labor conditions are expected to remain tight, but recent wage negotiations have not yet contributed to wage growth, as was hoped. Real earnings growth has been flat recently.

The Japanese government’s efforts to reform corporate governance are a positive consideration for investors in Japanese equity markets. On July 3rd, the Government Pension Investment Fund (GPIF), the world’s largest pension fund, announced the selection of three ESG (environmental, social, and governance) indices for Japanese equities in which it will invest, and began by investing 1 trillion yen in these indices. It expects to increase this amount over time. The GPIF actions have the objectives of improving disclosure at the company level, company dialogue with investors, and more broadly, corporate governance. The some 362 stocks included in the ESG indices will likely attract increased investor interest.

Japan equity valuations look favorable compared with the US market, while not as favorable as the Eurozone. Based on domestic capital weights, the forward price-to-earnings ratios are estimated as 15.7 for Japan, 17.9 for the US, and 13.6 for the Eurozone. Japan’s dividend yield of 3.0% tops both the Eurozone’s 2.3% and the US market’s 2.0%. Net profit margins in Japan are lower than those in the US, which gives them more room to catch up, and they are improving.  The Japanese economy does face some risks and calls for close monitoring: An increase in protectionism would hit Asia particularly hard; a significant period of “risk off” would likely result in a stronger yen that would hurt exports; continued weak wage growth would hamper consumption; and any significant slowdown in China would impact the region.  However, in our view, the base-case scenario for Japan’s economy and its equity market for the second half of this year and for 2018 is positive.

Sources: Ned Davis Research, Jeff Usher’s Japan Insider, BCA Research, Oxford Economics, OECD, Goldman Sachs, Markit, Financial Times


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When Medians Don’t Represent Consensus

The minutes of the FOMC’s June meeting are especially interesting this time. Not for because of what the FOMC said about raising its policy rate this time, but rather because of the insights that the minutes provide regarding participants’ widely divergent views on the policy path going forward. Differing perspectives on further rate changes versus normalization of the Fed’s balance sheet are especially relevant at this juncture because this is the first time since the Accord of 1951 when Federal Reserve Bank presidents (five) have outnumbered the number of sitting Fed governors (four) voting on the FOMC.(1) The range of views on the policy path is striking, but we should not infer that the discussions are contentious. The lack of consensus simply means that we are unlikely to learn much from Chair Yellen’s mid-year testimony this week before Congress, and that the medians in the June SEP (Summary of Economic Projections) are unlikely to tell us much, at the moment, about the policy path going forward.

Exactly what are these divergent views? First, let us look at the SEPs to assess the range of views in play. For 2017, for example, four people think that rates should remain unchanged for the rest of the year; eight see one more rate increase; four see two more increases, while President Kashkari has dissented on both the rate hike in March and the one in June. Thus, we see a Goldilocks’ view of policy, with a third thinking that policy is not tight enough, a third thinking that policy is too loose, and a third thinking that policy is about right. The divergence of views on the policy rate widens for 2018: One participant thinks the policy rate should be unchanged; five see rates between 2 and 2¼ next year; four see rates less than 1¾ and 2%, while seven see rates even higher. Those widely divergent rate assumptions are all associated with very tight distributions of participants’ projections for unemployment, GDP, and inflation.

But the really interesting insights into the dilemma facing policy members emerge in the discussions, reflected in the minutes, regarding the timing of rate hikes, the decision on when to begin normalization of the system’s portfolio holdings, the interaction between the two policies, and uncertainty as to what the effects would be. Several participants argued that the market had been sufficiently prepared and that normalization could therefore begin in a couple of months.(2) On the other hand, “some” argued for delaying the decision to give time to assess progress on growth and inflation. A “few” expressed concern that movement on reinvestment policy might signal to markets a more gradual path for policy rate increases. Indeed, if there were an interaction between balance sheet normalization and policy accommodation such that a de facto tightening were to result, then this effect might be either interpreted by markets as requiring (or might actually require) a change in the path for the policy rate. However, the minutes also note that “some” participants discounted the potential for normalization to be an important consideration affecting the policy-rate decision, while a “few” argued that the firming brought about by normalization of the balance sheet would be modest at best.

These minutes reveal several different views on the relationship, impact, and relevance of the decision to implement a normalization of the Fed’s balance sheet by stopping the reinvestment of maturing securities. Some felt that, in terms of its potential impact, normalization would substitute for a rate hike and prompt a reassessment of the future path of the policy rate. Others felt that the two decisions were independent. Finally, still others were totally uncertain what the impact of the Committee’s June rate hike would be and preferred a wait-and-see attitude before making future changes in policy. Such divergence of views, while understandable, is hardly conducive to forming a consensus, nor should it inspire confidence in the SEPs or reliance upon the median forecast. It also raises the issue of how the Committee would respond in Congressional testimony were a policy rule in place.


(1) The president has just nominated Randall Quarles to fill one of the three vacant seats on the Federal Reserve Board.
(2) In Fed speak, there is a hierarchy for the use of key words like few, some, many, etc. An approximate ranking and implied numbers (in parens) is few (3 or less) ,” some (more than 3 but less than 5), a number (about 5), many, most, and finally, all.


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