Recession is still a possible outcome

Outlook:

Let's call it the "second time around." The PMI data, and specifically the drop in employment in the service sector, seems to imply the US is starting to feel the first stirrings of recession. We already had the false klaxon of the drop in yields and the yield curve inversion, but then that faded as retail sales and other favorable data came in, including consumer confidence.

We are now taking a more measured and realistic view. Recession is still a possible outcome. It's not as imminent as some have said (arriving before year-end) nor as unrealistic as the current thinking seems to have it (rising yields). We have already reviewed the drop in capital spending (and even put in on our Chart Page). The consensus is that (unless you are a farmer) we're probably okay until employment starts to falter. Now see the chart from Pantheon reproduced by the Daily Shot. A distinct slowdown in payrolls is visible, but so is a flattening out in manufacturing.

We are about to get a slew of new data to add to one side of the ledger or the other. On Thursday we get a new GDP estimate. We have to wait for Friday to get a new GDP estimate from the Atlanta Fed. Also on Friday will be the usual personal consumption data, which incorporates inflation. Critics may say this is too backwards-looking to be useful, but they can't say that about payrolls a week later (Oct 4).

So far the primary effect of the US-China trade war is being felt by Germany. If and when US data starts looking Germanic, we can expect the same central bank response as Mr. Draghi just delivered—in his last speech as ECB chief before handing over the reins to Lagarde on Oct 31. Draghi said, according to the WSJ, "the bank stands ready to cut interest rates again from current record-low levels, amid a ‘prolonged sag' in the eurozone economy that is starting to hurt jobs.

"Speaking at the European Parliament in Brussels, Mr. Draghi said a lingering downturn in the region's large manufacturing sector risked spilling into other areas of the economy. He stressed that the ECB was prepared to act again, but urged the region's governments to step up with fresh spending to support growth. ‘We have seen the labor market losing momentum... The growth outlook has been constantly deteriorating.'" Draghi is referring to contagion without using that word. Just wait. It's about to become the issue of the day. It's tricky to figure out how this plays in the FX market. If we assume the Fed follows the ECB and starts talking about another rate cut before year-end, it's hard to see how the dollar holds up. If we imagine that some emerging market central banks are going to keep rates lofty, EM currencies can thrive. Again. Yield-hunting never stops.

A Note on LIBOR: Nobody is paying very much attention to the demise of LIBOR, scheduled (by the UK Financial Conduct Authority in 2017) for 2021. Yesterday NY Fed chief Williams complained about a lack of compliance, assuring the market that the end of LIBOR is like death and taxes—it will come. But the market doesn't want a new reference rate. It's a total pain to re-calibrate everything and "everything" is somewhere around $250-350 trillion, or many times the size of the US economy.

The FT notes there are two reasons to dump LIBOR. First is the small number of deals done at some maturities so that banks' reports of market prices are really guesses. The second reason is bigger—cheating. "Banks have paid nearly $10bn in penalties for rigging Libor during the financial crisis to boost profits or hide balance sheet weakness." The FT is too kind. More than one player has gone to trial, with the Deutsche Bank guy accused of rigging Euribor (same thing as LIBOR but for euros) still in UK court.

Why doesn't the market like the alternative, SOFR? First, SOFR is not a curve of many tenors but a single number, for overnight. It is therefore subject to month-end, quarter-end, year-end and other volatility-inducing calendar events. And how do you base a 30-year mortgage on an overnight rate? How about a credit card? In addition, LIBOR is unsecured. Banks lend to one another using LIBOR on the basis of credit, aka trust. But SOFR is collateral-based. No collateral, no borrowing. When the decision to end LIBOR was announced in 2017, everyone said the credit market could contract disastrously. We still do not see a cogent countervailing argument to that generalization. But then, we grasp only about 1% of the swap market, a big use for LIBOR.

One final little thing: LIBOR was invented by London banks to help out Russians who wanted to hold dollars for transactional purposes but not physically in the US (to avoid expropriation). Or so the story went back in the 1970's. The current story leaves out the Russians and says a Greek dude named Zombanakis arranged a $80 million syndicated loan from Manufacturers Hanover to the Shah of Iran in 1969 based on the reported funding costs of a set of reference banks. The point is not who started it. The point is that all the big commercial banks embraced it with open arms; and don't forget that because the deposits are held offshore of the US, they are not subject to Fed reserve requirements. This lowers the cost of borrowing by a tiny amount but when you are dealing in billions, a tiny amount adds up.

What's the ending? Nobody knows. But if the government is gobbling up all the cash—remember that $1 trillion deficit—QE can't be far behind, even if it's not used as a tool to goose private businesses via the banking system. Last time the banks just sat on the money and declined to lend it out. The multiplier failed. It didn't help that the banks are paid interest to hold excess reserves. Take that away and things may change. Whatever else, SOFR is a lousy alternative to LIBOR and this is going to end in tears. It's cold comfort that at least it's not going to end in financial institutions failing.

Politics: The wussy Dems are letting their best chance of announcing impeachment pass them by, for reasons nobody knows. We get a speech by House Speaker Pelosi later today. She can be awfully slimy. If the decision is not to impeach because Congress lacks a smoking gun and wants more investigation to get a smoking gun, it's a Trump victory because it shows the Dems are cowards and worse, lack principles. All that self-righteousness is just the same phony and hypocritical posturing that keeps the voters home on election. Come November 2020, Trump can say he must not have anything wrong because he was not impeached. The nitwits that make up his base will find it credible.

We like to go back to the idea that everything Trump says about others is true about himself. We were hardly the first to identify this habit, which the shrinks name projection. Lyin' Ted was really Trump talking about Lyin' Donald. Crooked Hilary was really Trump talking about Crooked Donald. Now Trump's accusation that Biden is corrupt is really a reference to Corrupt Trump. It means, mayb,e that Trump is not as incapable of self-examination as we think. He doesn't accept it, let alone change it, but he does see it, somewhere in the dark recesses of that reptile brain. Seeing this phenomenon doesn't advance the cause of defeating Trump next year, but it's kind of interesting that he is so transparent, and prefers to commit crimes in public, on TV, as though that renders them non-criminal, a childish mentality. Why is he so hard to get rid of?

Politics 2: The WSJ has been taking the lead on the Ukraine crisis. Today it confirms "President Trump asked his acting chief of staff to place a hold on $391 million in aid to Ukraine more than a week before a July phone call in which he urged the country's president to investigate Joe Biden's son."

New Ukraine president Zelenskiy, formerly a comedian playing the Ukrainian president on TV, is getting his moment in the spotlight this week. While Trump refuses to release the transcript of his possibly extortionate phone call and the national security guy refuses to obey the law saying he has to send the whistleblower letter to Congress, Zelenskiy could cut through it all and spill the beans. Then if the US refuses to fork over the $391 million already approved by Congress for military support, he can reasonably claim it's improper punishment for outing Trump as an extortionist and someone seeking political gain from higher office. He can get the money either way—by exposing Trump or refusing to expose Trump. Zelenskiy is the most important man in the world today—to Trump, to the American citizen.

 

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