Don’t You Believe It—-The Melt-Up Madness

Don’t you believe it!

The melt-up madness now underway marks the most dangerous, unstable and combustible financial bubble in human history. It was fostered by Keynesian central bankers who were making it up as they went along.

So doing, they had no central banking playbook or theory—just a dog-earned revival of Phillips Curve macroeconomics. Yet the latter was discredited 40 years ago at the national economy level; and is a complete intellectual joke in the context of massive, fluid, integrated global markets for labor, goods, capital and finance.

For crying out loud, how much money printing at the Eccles Building does it really take to drain the rice paddies of East Asia and the fecund villages of India of their last increments of cheap labor?

And given the trillions of worldwide trade in goods and internet enabled services how can it be denied that there is a steeply inclined global labor cost curve with the US near the top?

That is, an economic dynamic in which the China Price for goods and the India Price for technology-based services causes downward pressures to ripple through the world’s labor value chain—-even as it causes production on the margin to be shifted to the lowest cost regions of the planet.

Yet Janet Yellen and her brain dead posse are constantly squinting through the in-coming data with a magnifying glass hoping to find a second decimal place acceleration in the rate of domestic hourly wage gain. Thus, the most recent three month rolling gain for non-supervisory and production workers was 2.44% versus prior year (August-October 2016) .

That was actually a slight deterioration from the 2.53% Y/Y during the same period in 2016; and it compares to Y/Y gains of 2.22%, 2.36% and 2.34% during the same three month period in 2015, 2014 and 2103, respectively. S0 squint very hard and you might possibly detect the difference.

Stated differently, these foolish monetary central planners are maniacally focused on what are actually random fluctuations of a few basis points in the rate of domestic wage gains. If after 107 months of ZIRP or near ZIRP and $3.5 trillion of balance sheet expansion, the needle has not moved at all—-then it’s never going to move on account of central bank machinations in the Wall Street money and debt markets.

Yet the Fed continues to embrace Einstein’s definition of insanity—-doing the same thing over and over and expecting a different result. So doing, it has essentially destroyed financial market price discovery in the process of a futile effort to pump the nation’s bathtub of labor demand full to the brim, thereby validating their Phillips Curve excuse for endless monetary accommodation.

To the contrary, domestic wage gain fluctuations of the type posted since 2010 are just plain noise in the context of a dynamic global labor markets roiled by huge waves of currency and monetary distortion. The latter, in turn, stem from the machinations of Keynesian central bankers elsewhere on the planet and the mercantilist policies (e.g. export subsidies and import barriers) of almost every major trading partner that even the Donald can’t manage to lay a glove on.

In fact, the Donald’s failure to make a dent in actual US trade policies (versus cancelling the completely prospective Trans-Pacific Partnership) or to move the needle on the massive US trade deficit tells you all you need to know about the Fed’s giant Phillips Curve fallacy.

The only way to re-install the Phillips Curve is to place towering Trumpian trade walls all around the US economy so that domestic demand stimulus would not leak off into incremental demand for cheaper foreign goods and services, but be forced exclusively into higher spending for domestic goods, services and wages. In theory, that would generate the wage inflation that has remained AWOL amidst the greatest bout of money printing in recorded history.

Even then, the Fed would have a long row to hoe. That is, there are approximately 41 million jobs in what we have termed the Part-Time Economy—retail, restaurants, bars, ballparks and domestic services. The jobs generate an average of 27 hours per week of paid employment, according to the BLS.

Yet virtually all of these job holders would surely accept another 5 hours per week to generate desperately needed income, given that they are currently earning only $20,000 per year at existing hours and wage rates. This means that there is the equivalent of 7.5 million additional Part Time Economy workers available from they already “employed” population at current wage rates!

It also means that the Phillips Curve is a relic of the 1930s-1950s industrial age when men punched a 40-hour per week factory clock, women worked at home in the unmonetized (and uncounted) household economy, and there wasn’t much opportunity to hang out on welfare, food stamps, disability or mom and pops basement.

Needless to say, given the realities of the global labor market and the domestic gig economy in which work is parsed by the hour, not the standard 40-hour workweek, the Fed’s  pursuit of domestic wage inflation via Phillips Curve economics is truly misbegotten. It could only work (and then only after huge inefficiencies and wealth reductions) under a system of total trade autarky—-that is, the kind of ultra-high tariff economy based on “homespun goods” advocated by the JM Keynes in 1931.

But that’s not going to happen in 2017— even after all of the Donald’s blatant demagoguery. Nor should it.

Still, even a casual inspection of the data tells you that the Fed is operating from a completely vestigial and obsolete macroeconomic framework. Prior to the complete internationalization of trade in goods and services with the rise of China and India after the turn of the century, there was a faint trace of Phillips Curve effects in the cyclical wage data, as shown below.

For instance, prior to the 1990 cycle peak, the rate of  domestic wage gains rebounded from 2.0% to 4.3% on a Y/Y basis. After the 1990-1991 recession, in turn, 2.5% per annum gains  reaccelerated to 4% as the domestic labor supply tightened through the end of the century; and this pattern recurred a final time during the Greenspan housing boom.

But not this time. Wage gains have been effectively capped at 2.5% per annum and show no sign of breaking out of that straight-jacket—-one which flows from a virtually unlimited worldwide labor supply operating lower down on the global cost curve.

On the margin, off-shoring now drives domestic wage gains. Monetary stimulus, therefore, can not fill up the domestic labor bathtub with Phillips Curve tightness, and thereby stimulate rising wage gains and the ballyhooed 2.00% rate of PCE inflation.

Indeed, the whole  Keynesian central banking experiment defies everything that was learned about finance since 1715. As recently as Greenspan’s capitulation to the so-called bond vigilantes in 1994, only monetary cranks and populist hayseeds would have touched the idea of endless ZIRP and massive balance sheet expansion.

Such notions were literally beyond the pale and for good reason: They are crack-pottery based on the money illusion and the fallacious idea that wealth can be generated by free lunch policies of the state rather than the work and enterprise of private capitalism.

Moreover, as we have demonstrated elsewhere, the domestic credit channel of monetary stimulus is broken and done. That’s because households have reached the point of Peak Debt.

On the margin, they are no longer supplementing tepid growth of incomes with spending based on incremental borrowings. Despite a sector-specific surge in student loans and auto credit, in fact, household debt is still slowly falling relative to wage and salary earnings.

Accordingly, Keynes has already been set-aide after a multi-decade LBO of the domestic economy; household consumption spending is now driven by production and earnings alone: The Fed is effectively stimulating not the main street economy, but the gamblers and speculators within the canyons of Wall Street.

The same is true of business spending. Ultra-low rates were supposed to stimulate business borrowing to fund expanded investment in plant, equipment and technology. As shown in the chart below, that part has clearly happened—with corporate debt now at the highest ratio to income in 70 years.

But none of this incremental debt has gone into productive assets. More than 100% has flowed back into the canyons of Wall Street in the form of financial engineering—stock buybacks, M&A deals and leverage recaps of every type and kind.

In fact, $15 trillion of financial engineering since 2006 has turned the C-suites of corporate America into stock trading rooms. But the damage from that monumental mis-allocation of capital is not merely the stunted growth and low productivity evident in the domestic US economy; it has also shunted this flood of corporate liquidity into the secondary markets for existing assets, thereby fueling a financial asset inflation of a scale and duration never before recorded or even imagined.

Needless to say, the conversion of capital and money markets into gambling casinos has corrupted the very warp and woof of the financial system. Speculators have been rewarded so massively and for so long that momentum rules the casino.

By contrast, all of the normal mechanisms of two-way trade and financial discipline have been virtually destroyed. For instance, there are essentially no short sellers left, and the demand for financial insurance (i.e. S&P puts which require market makers to position an opposing short) has nearly evaporated owing to the complete disappearance of volatility.

We will address the “vol” matter at greater length tomorrow, but consider today’s headline story in MarketWatch. Even the bullish megaphones and robo-writers employed there noticed the chart below.  That is, the long ETF on the VIX has plunged relentlessly since the bottom in March 2009.

Inexorably, with the passage of time and the endless gains from shorting the index, the trade has become “crowded” beyond all historic precedent. At length, the unprecedented collapse of vol has promoted panic buying of the long-only ETFs and what amounts to a “sellers strike” from existing popular holdings by even the fast money hedge funds.

Indeed, the massive short on volatility is the financial equivalent of the today’s actual eruption in Bali. The smoke and rumblings had been coming for months; and then came the fire.

As even MarketWatch noted, the above metaphor is no exaggeration:

You’d have to be living under a rock — or maybe just a normal person who doesn’t fixate on the stock market — to not notice the incredible lack of volatility in this bull run. This persistent trend has lined the pocket of any investor who’s been savvy/lucky enough to bet against the VIX.

Count Seth Golden, a former Target manager, is among those fortunate to be on the right side of it. He told the NYTimes this summer his net worth exploded from $500,000 to $12 million in about five years thanks to his VIX shorts.

This chart shows insane it’s been:

 

That’s right. Since the 2009 bottom, the VXX ETF (adjusted for reverse splits) has gone from $120,000 per share to just $32, thereby recording a 99.99% decline.

No wonder Kevin Muir of the Macro Tourist blog did not spare the rod in warning investors

A VIX spike is dangerous not only for everyone that is playing in the VIX square, but for all market participants……Given the size of the VIX complex, it has the potential to destabilize the entire financial system on its own. If the move is abrupt and large enough, it will not only bankrupt many different parties, but will cause a ripple effect in other markets.”

 Muir went on to warn the real worry here is not just that those who have made enormous sums on shorting the VIX are about to give it all back…..“Shorting VIX, at these low levels, in the size they are doing, is not only dumb, but crazily dangerous, not only to the parties trading it, but also to the stability of the entire financial system,” he said.

So yes, this is the mother of all melt-ups. This market is now to be avoided with malice aforethought.