December 2016 CPI

Yikes! I skipped the November release of the Consumer Price Index. I think I was still in election mode or caught up in the end of the school semester. Nevertheless, the December CPI was released last week. Time to catch up.

The incoming Trump administration is talking about major changes to the government and fiscal spending. This will affect what the Federal Reserve does. The widely anticipated rate hike in December was performed and there are expectations of three rate hikes in 2017. I mentioned in the commentary on the October release the Federal Reserve was falling behind. Let’s look at December.

The year over year CPI rose from 1.45% to 2.07%. The 2.07% level hasn’t been seen since June of 2014. The annualized ten-year rate of change fell from 1.98% to 1.96%.

I break out the components of the index into three groups. The first group consists of components experiencing increasing inflation (this is the second derivative where the rate of change is increasing). The components of this group constitute 77.9% of the index and on a weighted basis have a year over year inflation rate of 2.71%. The weight of this group increased from 65.9% last month and the weighted rate increased from 2.33%. The components in this group are Housing, Apparel, Transportation, Medical Care, Recreation, and Other.

The second group is the decreasing inflation group (this is where the first derivative is positive and the second derivative is negative). For the first time in two years, no components were members of this group.

The third group is the deflation group (this is where the first derivative is negative). This group includes 25.2% of the index and has a weighted inflation rate of -0.16%. The weight of this group is down from 40.5% last month and the inflation rate is up from 0.44%. Members of this group are Food and Beverage, Apparel, and Education and Communication.

Apparel is in both the increasing inflation and deflation groups because it is increasing, but it is also still negative.

From my perspective, the Federal Reserve is justified to raise rates again soon. Looking at the changes in the groups leads me to think there are increasing price pressures in the economy that need to be arrested. I know there are significant delays in the impact of rate changes, but the Fed was already behind and now needs to catch up. I suspect there won’t be any change expected until the March meeting. I will look forward to a change then.

Update: It occurs to me there are core items that I skipped talking about. Core items are different from Components in that Components are subsets of individual measures and Core consists of four categories: Food, Shelter, Medical Care, and Energy. There are two Core items that merit attention due to their differentials. Food is currently in the Deflation group while All Items Less Food is in the Increasing group. Energy is in the Increasing group while All Items Less Energy is in the Slowing group. Energy is now up 5.4% year over year. The time when Energy was a key measure that was slowing the entire index has passed.

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Every Account Needs a Job

One of the consequences of having two jobs is a lack of time to spend reading. I subscribe to several free economic and investment newsletters. Thus, when the quarter ends, I spend some time catching up. It was yesterday afternoon when I read an essay by Ben Hunt of Epsilon Theory. He was writing on how every part of a portfolio needs a job. This was intriguing to me because I have been caught in the past with accounts trying to serve the same purpose.

My investing philosophy has evolved significantly over the years. I now have multiple accounts with distinct purposes. The latest account is with Lending Club. I had originally designated this account as a fixed income account, but I think that is changing slightly. I was surprised to see how quickly rates can change on the platform. I had assumed they would change as market rates change, but it appears they change with risk as well. Recently, there has been an increase in losses by investors. As a result, interest rates on new loans has increased. While I am pleased to see this reaction, I am forced to acknowledge the heightened risk in the investment. Because I am making a new investment each week, the possibility of changes in interest rates paid on principle has me considering this is no longer strictly a fixed income investment.

Instead, this is a counter cyclical investment. When the economy is doing poorly, interest rates on new investments will rise. When the economy is doing well, interest rates on new investments will fall. That should be the opposite of the two equity investment accounts I have, providing a level of stability to the overall portfolio. 

July 2016 Wrap

After announcing that I had no interest in making purchases on the secondary market, less than one week later, I had made two purchases. Prices on the secondary market are really quite diverse. There are some extraordinarily large premiums associated with some loans and some have very low premiums. I looked at the list of offered securities twice in the month and found none that were offered below par.

While I did purchase two very small loans, each had a premium of less than 2%. While that wasn’t a threshold, I now have an understanding of the secondary market. Purchases settle the next business day, which is as expected. These two fractional loans had a low premium even though the credit rating of the underlying payer had improved. I spent some time trying to figure out prices, but seemingly they were random. Maybe someday I will attempt to sell a loan and see if the system reminds me to update my price. My point being that perhaps these prices were stale.

Of course, people may have placed high prices on their loans just in case someone else was willing to pay it. Like a couple of homes in our neighborhood, it seems the seller is willing to sell but only at a specific price. Zillow calls that the Make Me Move price. I could put an amount on our home, but my wife and I are not at that point. Still, what would be the harm in placing a price that is double the current estimated value?

The new issue that I posted about two weeks ago was funded and issued. That means my portfolio consists of fractional ownership in three loans. My target is to have a portfolio of loans maturing monthly spread across 36 months. By purchasing a new issue plus another on the secondary market with 24 months to maturity, I can reduce the time to create the duration based portfolio from three years to two years. I could reduce it to one year by purchasing loans on the secondary market with one year left to maturity, but the market had extremely small principle amounts for sale. Constructing a list of fractional loans to reach my monthly principle objective seemed too time consuming. For now, I will accept the hole in the duration portfolio. Perhaps looking at the secondary market in August will provide a clue on how to work through the construction of that point in the duration curve.

To close the month, one of the loans purchased on the secondary market had a payment due. It successfully was paid on time. Lending Club takes a fee from the borrower upon loan origination and from the lender at each monthly payment. The loan origination fee seemed high to me and the monthly processing fee seemed low. Of course, the monthly fee happens every month, which is one of the annoying features of our banking system. It was too much for me to hope that Lending Club would be that different.

GDP and Recession Risk

As we face the first increase in the targeted Federal Funds rate in nine years, I hear some analysts complain the Fed is behind the curve and others say the economy is likely to move into recession because it cannot handle the increase in interest rates. No matter which side you are on, there are already some indicators we can follow to see where the economy is headed and what the probability of recession is.

Two of these indicators we are already following. The first is the expected inflation rate for the next five years. This indicator is not based on actual data, but rather is a number tracked by the bond market. Thus it is an indicator of where market participants are betting the inflation rate will likely be. As of December 10th, that number is 1.20%. It was 1.30% at the end of October 2015. It was 1.27% on December 10, 2014. That is a narrow range and stable over the past year. It is also nowhere near the Fed’s stated target of a 2.00% long-term average for inflation. The conclusion we should come to is the Fed does not need to raise rates since the market is saying inflation, one of the key Fed guiding measures, will not be a problem for the next several years.

The next indicator to observe is the two-ten spread. This measure is the difference between the yield on the ten-year U.S. Treasury bond and the yield on the two-year U.S. Treasury bond. When this indicator turns negative, there is a high likelihood of a recession starting within two quarters. As of December 10th, the spread is 1.29%. As of October 31st, it was 1.41%. As of December 10, 2014, it was 1.59%. It has not been a straight line down over the past year, but a thirty basis point move over the past year is something to follow. For now, this indicator is well above zero. I do not expect to get concerned until it drops below 50 basis points. I think the financial media will get interested if it drops below 100 basis points.

The previous two indicators I have been following on the Analytical Road at blogspot. The next two I have just recently been reading about and both are hosted at the Federal Reserve of Atlanta. One uses historical GDP to predict the likelihood the U.S. is currently in a recession. This is useful since the NBER is the official body which can declare a recession but can sometimes have multi-year delays in their decision. The second uses current data and estimates for an in-period forecast of quarterly GDP. We will start with a look at that indicator.

GDPNow is updated at least once per week. On December 4th, the forecast for the fourth quarter was 1.5%. On December 11th, it moved up to 1.9%. The change over the week comes from the increase in real retail sales and the decrease in wholesale trade and retail inventories. At 1.9%, it won’t raise any concern even though that is a low number. A 1.5% number for the fourth quarter would raise concern. Using the current estimate of 1.9%, it appears the economy is not outgrowing its long-term average. There aren’t too many more financial numbers before the end of the quarter and I suspect the estimate will start to decrease volatility and the focus will turn to the first quarter of 2016. For now, this indicator seems to suggest no change is needed.

The other indicator from the Atlanta Fed is called the GDP-Based Recession Index. This indicator uses historical GDP and a large number of probability estimators to estimate the likelihood the U.S. economy entered a recession in the previous quarter. This indicator was last updated on August 10, 2015 and reads 13.3%. This is significantly below the level of 67% which is the trigger to indicate a recession has begun.

Of these four indicators, the forward five-year inflation rate and the two-ten spread are collected daily. GDPNow is updated weekly. The GDP-Based Recession Index is updated quarterly. I have thought about putting these together into a single page, but there is another indicator we need to watch because we have an extraordinary market with the Fed’s zero interest rate policy. This measure also comes from the Federal Reserve of Atlanta and is called the Wu-Xia Shadow Federal Funds Rate. When the Fed moved rates to zero, there was academic talk about the lower bound of zero. While some European economies and the ECB have moved their rates below zero, the Fed has held rates at the zero bound. Researchers Cynthia Wu and Fan Dora Xia used some clever data to calculate what the Federal Funds rate should have been. The shadow rate reached a low in May 2014 at -2.99%. As a saver, I am very pleased the Fed did not lower rates to that level. The rate as of November 2015 is -0.004%. Since that May 2014 low, this shadow rate has been moving very quickly higher. It seems reasonable the Fed would want to stay near this rate as this is what the market and economy indicate is necessary. In that case, a 25 basis point move this week would not be unreasonable.

The result of this walk through our data is to conclude that a rate increase is needed by one measure and not necessary by others. Our two daily indicators are subject to the emotional volatility of the market and based more on what market participants expect rather than what has occurred. The next week will be interesting to see how these indicators react. I am assuming the Fed does increase rates but will also say future increases are data dependent. I am not expecting another date to be explicitly mentioned. I would expect that to be the unwelcome market moving event. Once we move off the zero based policy, the shadow rate will go away. What we will be left with is two market based indicators and two GDP based indicators as a set to indicate what the Fed is likely to do. I will work on making a cohesive case for these over the next few months.

Federal Reserve Doesn’t Change

I am disappointed the Federal Reserve did not change their interest rate target. I have mentioned the length of financial repression that is taking place is unwarranted, but reading reports of the level of mal-investment caused by near zero interest rates means they are well out of bounds. There were extraordinary circumstances in 2008 that required an unusually low interest rate. Those circumstances were resolved by 2010. It’s time to get the productive part of the economy rewarded for doing the right thing. If the economy is so fragile that it cannot handle a change of 0.25%, then all of the QE in the world cannot make a difference either.

Federal Budget in April

This news item came to my Inbox from the newspaper, The Hill.

News from The Hill
House to consider Ryan budget in April
By Russell Berman
House Republicans in April will consider a budget authored by Rep. Paul Ryan (R-Wis.) that sticks to a bipartisan spending level for 2015 but balances within a decade, Majority Leader Eric Cantor (R-Va.) told lawmakers on Friday.
Cantor’s announcement sets up what could be the most difficult budget vote since 2011 for the Republican majority, since it will require dozens of conservatives to endorse a $1.014 trillion spending level that they opposed in December. Ryan, the Budget Committee chairman, will propose deeper cuts in future years to keep the party’s commitment to erasing the federal deficit within 10 years.

I’m uncertain what Rep. Ryan hopes to accomplish, but I will be glad to hear some talk about the budget. There needs to be a candid conversation. My own Senator, Patty Murray, has said she will not bring forward talks regarding a budget for 2015. That seems irresponsible considering what needs to change. At this stage, Rep. Ryan is showing leadership. We will need to see how the conversation goes.

For now, the opening is cast since the phrase “balances within a decade” seems quite impossible to me without significant changes to Medicare and Social Security. That truth needs to be told by a prominent member of Congress. If Rep. Ryan does not mention it, the dis-ingenuity from the Congressional budget committees will continue.