David R. Kotok
Cumberland Advisors, November 11, 2013
To start, we praise the women and men of the armed forces of the United States as we remember them today. The freedom of our nation depends on them. Now to markets.
Three dynamics are at work this week. They may cause market volatility. And they may lead to a revised assessment about the Fed’s (Federal Reserve) tapering policies.
First is the surprise action of the ECB (European Central Bank) to lower interest rates. There is evidence that the vote was mixed and that the dissenting votes originated with the country that holds the largest ECB weight, Germany. The Germans are known to lean in a more hard-money direction than many of their Eurozone colleagues when it comes to central bank policy. Their acknowledgement of low inflation notwithstanding, they resist monetary easing as a vehicle for stimulus. There is division in the ECB; however, the Draghi-led majority now clearly leans towards more central bank QE-type activity.
An action like this one from the ECB may produce dramatic effects in the currency markets. We have seen such effects result from adjustments in foreign exchange rates involving the euro. We have seen them in expectations regarding Japan and the yen. And we have seen them with the dollar in response to the on-again, off-again Fed tapering discussions. Simply put, when all interest rates are near zero, the major transmission mechanism of policy among diverse global agents becomes foreign exchange rates and currency transactions.
Secondly and very importantly for serious readers, there is a superb new Fed staff paper to delve into: “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy” (November 1, 2013), by Dave Reifschneider, William Wascher, and David Wilcox. Dave Reifschneider is the deputy director (retired), William Wascher is the deputy director, and David Wilcox is the director of the Division of Research and Statistics at the Federal Reserve Board. The authors’ skill set and internal positioning within the Board of Governors and the Fed gives them standing for this paper, which they have published as their own research. Here is the link:,
The paper discusses certain impacts and effects (hysteresis) in the evolution of the US labor market. The paper raises serious questions about the nature of prolonged unemployment, how it changes the characteristics of the labor force, and how it may ultimately result in people’s dropping out of the labor force entirely. Thus, extended unemployment leads to a decline in the labor participation rate. The importance of this paper and its conclusions grows with the recognition that the incoming Fed chair, Janet Yellen, is very sensitive to these labor-related issues. She has strong skills as a labor economist, and she has spoken on the subject over the years. We would expect to see her professional history reflected in how she will lead the Fed as it evolves its policy.
Readers should note that the decline in the labor participation rate, not substantive growth in employment, is driving the unemployment rate lower. Robert Brusca, PhD, of Fact and Opinion Economics created and updates a series in which he holds the labor participation rate constant and then calculates what the unemployment rate would be under that regime. The reason that counterfactual series is important is that it reflects how wide the gap is between what is and what might be. It suggests that there are other indicators needing evaluation besides the headline unemployment rate.
Readers may recall that the Bernanke Fed stated it has a 6.5% unemployment rate target. There is now evidence that further discussion within the Fed may lead to some lower target number. Will the Yellen Fed think that 5.5%-6% is a better target, given other changes in the labor force? We shall soon find out.
Brusca’s work suggests that a constant, rather than a falling, labor participation rate applied today would yield an unemployment rate somewhere close to 12%. So his work implies that the declining labor participation rate accounts for about 4.5 points of the drop in the unemployment rate. This does not bode well for robust economic recovery in the US.
The extraordinary November 1 Fed staff paper includes a serious technical discussion of chronic unemployment and where it leads. The paper is thought-provoking. It was not specifically commissioned as a policy paper by the Board of Governors, but clearly the writers that performed the research are involved in the Fed’s internal dialogue with respect to the role of labor data and the formulation of monetary policy. The paper is a must-read for any serious, thoughtful investor or research agent with an interest in this policy area. We thank Torsten Slok of Deutsche Bank for his notes and for forwarding Peter Hooper’s notes regarding this particular paper.
The third factor at work this week is that the political game is about to commence all over again in Washington. There will be confirmation hearings for Janet Yellen. We do not expect those to result in anything but growing support for Yellen and likely embarrassment for the few senators whose misbehavior and misguided policies led to objections about her. We make no bones about it: we are fans of Janet Yellen. She has all the credentials and skills one could ask for. She is the current vice chair of the Fed and the former president of the Federal Reserve Bank of San Francisco. She is an accomplished economist and public servant.
We also believe that if inflation were to rear its head and inflation expectations were to become a serious threat to the US economy, Yellen would act quickly to adjust her policy views. Readers should note that the current level of inflation in the US is far below the Fed’s target and seems to be falling. Add to that the prospect of a falling oil price, and inflation in the US could trend under 1% per year.
The other big show in Washington, DC, is the enormous committee that is going to attempt to meet and resolve something regarding the budget, debt limit, and sequester. That committee is unwieldy in size, and its political composition nearly assures us that nothing is going to happen. Tax-policy targeting that would increase certain taxes could lead to an interim or “mini” deal. A trade-off involving some increase in taxation with a specific target could also be part of a deal that would cap or alter spending. Do we think that is likely? No. Do we think that is possible? Yes. The risks of such outcomes add to market uncertainty.
Meanwhile, markets continue to deal with the worldwide phenomenon of extremely low short-term interest rates. There is nothing on the horizon to suggest that will change in 2014. There is growing evidence that the current trend may persist well into 2015 and perhaps even 2016. Under these circumstances, very low interest rates anchor the bond markets in high-grade credits worldwide.
Cumberland tends to favor longer-duration holdings in its municipal bond portfolios, with some hedging in certain types of accounts. Cumberland’s stock market accounts remain fully invested – somewhat nervously, because part of the driving force for equities investment is the calculation of value based upon very low interest rates. We know low interest rates cannot be sustained forever. We know that the G-4 central banks collectively have tripled the size of their balance sheets since the financial crisis broke out after Lehman-AIG. We know that something must give.
What we do not know is how gradually the alteration of central bank policy making will unfold. We do not know the timing or size of the changes that will occur as the world’s central banks reach for policy neutrality and stability. The best information available to us today suggests that we will not see full stabilization until 2018 or 2020. We do expect the trend toward stabilization to be gradual. Central bankers do not want to trigger another recession or crash by acting abruptly. Collectively, they still favor stimulus wherever one looks around the world.
David R. Kotok, Chairman and Chief Investment Officer