Deutsche: "This Is The Most Dangerous Development The Fed Wants To Avoid"

In the first week of February, in the trading session just before the February 5 VIXtermination, the market tumbled as a result of a January average hourly earnings number that surged (even though as we explained at the time, the market had wildly misinterpreted the print), prompting speculation that the Fed was dangerously behind the curve and would need to accelerate its tightening, potentially hiking rates more than just 4 times in 2018, leading to an accelerating liquidation of risk assets which eventually culminated in the record VIX spike.

Since then, inflation fears moderated following several downward revisions (as expected) and more tame hourly earnings prints, with market concerns instead shifting to trader wars, the return of populism to Europe, the tech bubble, and the sustainability of record margins and net income.

But according to a recent analysis by Deutsche Bank's Aleksandar Kocic, traders are ignoring the risk of an imminent, "phase shift" spike in wages at their own risk. Specifically, Kocic looks at the current locus of the Philips curve - which many economists have left for dead due to its seeming failure to explain how the plunge in unemployment to record low levels has failed to boost wages - and notes that as the economy approaches the full employment, "wages tend to become more responsive." This, to the Deutsche Bank analyst, "is the inflection point that the Fed is monitoring."

Looking at the Phillips curve over the past 4 economic cycles, Kocic compares it to the Cheshire cat's smile from Alice in Wonderland, which is present even when the actual cat body is no longer there: "In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role."

Specifically, what Kocic highlights, is the sudden phase transitions between the end of one cycle and the start of another, in which one observes a "near vertical" spike in inflation to the smallest favorable change in underlying conditions. In the DB chart below, each cycle has a different color which implicitly marks their beginning and end.

In the current context, the most important message of this graph is the finale of each recovery. In the past, this stage always exhibited a dramatic (practically straight line) rise in wages in response to infinitesimal improvements in economic activity. These periods are highlighted with (almost) vertical lines in the chart.

Of course, as economists have long lamented, what has prompted many to speculate that the Phillips curve is broken or even dead, is the failure of the economy to respond with a sharp increase in wages to the already near record low unemployment rate, which is over 0.5% below what the Fed currently believes is the NAIRU (non-accelerating inflation rate of unemployment), or the unemployment rate which does not cause inflation to rise or decrease.

The NAIRU level corresponding to the 1990 is 6%, and 5% in 2000 and 2006. Currently, NAIRU is around 4.5%. This is the territory where the Fed is likely to become concerned. Allowing the economy to overheat would jeopardize Fed’s ability to control inflation if it rises too fast.

Another way of visualizing the potential risk facing both the Fed and traders is whosn in the next chart, which looks at the Phillips curve within the latest economic cycle, starting with the early stagflationary months of 2007, then progressing into several years of recession, before ultimately emerging into the recovery and, finally, "growth and inflation" phase. According to Kocic, "we are currently in the final stages of the recovery. If we enter the goldilocks region (upper left corner) too fast, the Fed could be caught behind the curve and might be forced to hike aggressively which could have a negative impact on growth while leaving only inflation behind"...  a recipe for progressing straight into another recession.

As the Deutsche strategist warns, and as the events of early February so vividly demonstrated, "this is the most dangerous development which the Fed would want to avoid."

Underscoring why it is only a matter of time before the Phillips curve, which he believes is not dead, but merely waiting to erupt in "a near vertical spike" reveals some fireworks, Kocic notes that "in addition to the distance from the NAIRU and the inflation target, the actual non-linearity of the curve is the key development to watch, in particular the change in response of inflation to the decline in unemployment" and adds:

The economy is currently operating below NAIRU and just slightly below the target and has shown a sustained support for higher slope which has been persistent since the end of 2016. This has caught the market’s attention.

But it's not just the Phillips curve that has caught the attention of Kocic. As regular readers will recall, back in the summer of 2013 we first speculated that Okun's law is either broken, or there is a giant, and inexplicable output gap forming in the US economy, in which GDP was trending far below where the unemployment rate suggested it should be.

Now, five years later, that output gap is finally closing, and according to Kocic if past is prologue, it may do so in an "explosive" manner. This is how he frames it:

The figure below shows the Okun’s law which captures the interplay between the social and economic response to the crisis in terms of distance of unemployment rate from NAIRU (social) and output gap (economic). Historically, output gap closes roughly when unemployment reaches NAIRU (the long term intercept / beta is close to zero). Post-2007, there has been a structural break in this relationship: The economy was slower to recover – it required a more aggressive improvement of labor market in order for the growth to reach its potential. This is shown in the figure through lower intercept: unemployment has to decline about 0.8% below NAIRU for the gap to close.

So, according to Kocic, if the unemployment rate is already low enough to potentially trigger a "near vertical" spike in wages (Phillips), it is also low enough to launch a sharp reversal in the output gap (Okun) leading to a Fed that is behind the curve on the parameters, or as the DB analyst says, with "current unemployment rate already 0.5% below NAIRU it is only a quarter of a percent away from closing the output gap. This justifies possible Fed’s concerns."

Then again, if Kocic's historical analog for the current situation is correct, "nightmares" may be a better word than "concerns." The reason for that is that the appropriate historical period to compare the current regime to is the 1960s, when the output gap "exploded":

While we think that history might not be the best guide for the future at the moment, the lessons of the 1960s are difficult to be completely ignored. The figure below shows the unfolded Okun’s law. 1960s are a screaming example of the effect of “exploding” output gap as a consequence of injection of fiscal stimulus when the economy was already operating at full employment, a situation that bears keen similarity to the present.

If the DB analysis is accurate, the implications would be profound for the market, which would find itself not only observing a sudden spike higher in wages, but also an economy where the actual GDP is suddenly soaring far above the potential, resulting in a 1960s output gap rerun and a Fed that has never been so far behind the curve.

The outcome of both would be even more aggressive rate hikes by the Fed, which - if the scenario plays out as Kocic envisioned - would be forced to raise rates well more than the 7 or so hikes the latest dots currently envision for 2018 and 2019, resulting in another bout of exploding volatility as the market finds itself not only chasing the dots, but in a rerun of "February" where to catch up to inflation, first the Fed, and then the market would be forced to aggressively tighten financial conditions.


Dragon HAwk Sun, 06/17/2018 - 21:12 Permalink

I think he said the Roofer ain't gonna put a roof on your house unless you pay his kids first year of College, and that is gonna cost some big bucks.

Heros Ahmeexnal Mon, 06/18/2018 - 03:40 Permalink

When salaries finally rise enough that all those millions of U6 long term but not in the job market unemployed start working, the middle class will be wiped out by inflation. 

With NIRP/ZIRP the pension funds were plundered, the price of gold supressed, and the credit "markets" were destroyed.  The only way out of this would be austerity and starving boomer retirees.  

In reply to by Ahmeexnal

Endgame Napoleon Dragon HAwk Sun, 06/17/2018 - 22:10 Permalink

Employers do not have to raise wages for all of the employees who face rent that absorbs more than half of their earned-only income, when Congress keeps raising the paychecks of the womb-productive citizens & noncitizens via refundable and non-refundable child tax credits. Many of the same employees have major household bills, like rent & food, that are covered by things like spousal income, child support that pays the rent or monthly welfare for out-of-wedlock reproduction, prompting interviewers for office jobs to explain to childless, single people: “The women we have working here (moms, all moms) have somethin’ comin’ in.”

In reply to by Dragon HAwk

Dewey Cheatum … philipat Sun, 06/17/2018 - 23:30 Permalink

The Phillips Curve is a time tested metric

Whats not time tested is a decade of coordinated global monetary interventionism.

This Bullshit has never been tried naturally fundamental tools can't accurately reflect $50 Trillion + of Monopoly money supervously  injected into a long term deflationary market.

Fucking with free markets, with this amount weight and duration..has some nasty consequences.

In reply to by philipat

Alexander De Large Sun, 06/17/2018 - 21:15 Permalink

Ahhh walls of indecipherably esoteric text and several low-resolution fuzzy 1972 Norwegian porn movie quality charts!

Fucking noooo!  😨  😈 👻 🔪 🔫 🏃 👺

A bunch of, of, of words!  Spoken by a failing kraut bank about what a bunch of Jew counterfeiters should avoid!  It's too much, it's, it's, it's...  zzz zzz 😴 💉 🛌 🌙

CashMcCall Sun, 06/17/2018 - 21:36 Permalink

Jerome Powell, Trump's handpicked Fed Chair... is not an economist. He is a lawyer who provided investment banking services. Trump picked him to raise interest rates. So he is mindlessly doing exactly as he has been told. The dollar is at record highs. Emerging market currencies, at least eight of them are at multi-year lows as a result. And the dollar liquidity has dried up in the commodities space. All of these are dangerous warnings of a global recession. Trump and Powell don't have an operation single neuro between them. 

Milton Friedman said that the only legitimate purpose of the Fed [if there is a legitimate purpose at all] is to assure market liquidity. Friedman said a computer could do a better job. But interest rate price fixing is still price fixing and removes the legitimate market forces from determining interest rates. Jim Grant and others have echoed the same sentiments. 

Because the Fed meddles with interest rates, they have no way of deciding which sectors are overheated from those that are not. This is a foolish approach which virtually guarantees massive recessions. 

Further, the Fed Policies of establishing a baseline inflation rate of 3% is utter insanity as is the Fed balance sheet used for QE. More simply that is not the Fed's job. The singular job of the Fed is to assure liquidity. At present liquidity is drying up and the dollar is surging from speculators wary of geopolitical tensions. This reduces liquidity. This FED has a nil understanding of liquidity. As the dollar pushes higher, the odds of a very significant recession grow with each rate hike. The market at present appears to be ignoring the tightening. That is generally a recipe for disaster. 


philipat CashMcCall Sun, 06/17/2018 - 21:46 Permalink

Um, I thought Trump wanted a soft Dollar to stimulate exports (not that the US exports very much that anyone wants, so maybe he changed his mind in favor of tariffs and trade wars just to reduce imports?).

Re the Fed agree but how is it ever going to change? Turkeys don't vote for thanksgiving and Establishment is controlled by Turkeys. In the next crisis, everyone, starting with the clueless politicians, will be begging the Fed to bail everything out again. Until the sheeple can understand the concept of "debt money versus sound money" I don't see anything changing?

In reply to by CashMcCall

Balance-Sheet philipat Sun, 06/17/2018 - 23:56 Permalink

Debt is used to make it possible to withdraw money if it is ever required to do so. Every day 100s of millions of USD loans mature and disappear as assets. Each day the USG, Fed, and private banking system replace all that disappeared money through new loans. if after a major war the Fed needed to reduce the amount of USD then the amount advanced is held at less than the amount that matured. This causes the amount of money to fall across the system. Rising indebtedness increases the money supply to optimize output at about 2% inflation. 

In reply to by philipat

Balance-Sheet philipat Mon, 06/18/2018 - 00:03 Permalink

Tariffs are a possibility as the goal is to REDUCE the size of the US Trade deficit to Zero or surplus for about 10 years straight then to keep it oscillating along the balance line.  If that means a 60B USD trade surplus with Canada, 60B from Mexico, 400B from China, 300B from Germany why so be it. Exports, tariffs, embargoes- all may help.

In reply to by philipat

philipat Balance-Sheet Mon, 06/18/2018 - 06:46 Permalink

Yeah, good luck with that! The more likely outcome is just to inflate the US economy at a much higher rate. And according to the texts that I read, if a country wants to maintain a reserve currency (and the benefits that accrue) then by definition it must run a trade deficit. Someone might like to point this out to Trump so he can decide which it will be; because it can't be both!!

In reply to by Balance-Sheet

Balance-Sheet CashMcCall Sun, 06/17/2018 - 21:59 Permalink

Interesting interpretation and interest rates are too high. We need real interest rates to be negative in effect so if you feel the need to post a 2% rate return an inflation rate of 3-4% is required to speed the reduction of outstanding loans. When old loans are fully retired due to negative rates new loans can be advanced. Right now we need to see the Fed purchase a wider range of assets at the rate of 70 or so billion per month to supply adequate liquidity. Private banking by non-state owned banks is unable to create new money in adequate volumes or quickly enough.

In reply to by CashMcCall

Balance-Sheet Kurpak Sun, 06/17/2018 - 23:48 Permalink

There will be a significant distance between what you want and what policy will be. You may not like negative real rates but they are an effective way of financing USG operations at a profit. The USG owns all the dollars and can recall them at any time or set the terms of your use of those dollars. Buy Gold any time and put yourself on the Gold Standard.

In reply to by Kurpak

Balance-Sheet Sun, 06/17/2018 - 22:06 Permalink

I do NOT know what will happen but it should be clear to all these scribblers like the above scribbler that the Phillips Curve is about 15 years deader than the Bretton Woods Agreement. The economy has changed incredibly since the early 1950s when Phillips fell asleep. Only a cleric thinks like this. Wages may rise but whatever does happen it has nothing to do with the last words of such exhausted academics. Now tomorrow he will show - conclusively- that the number of angels that can dance on the head of a pin predicts the future then after lunch witches will be burned at the stake.

stefan-coast Sun, 06/17/2018 - 22:19 Permalink

So many graphs, so many opinions, so many predictions...And I find pretty much all of them are wrong.. I guess its kinda fun to hear different views, but feel lately as tho I am wasting much of my time...dunno, just sayin

Nelbev Sun, 06/17/2018 - 22:36 Permalink

No one cares about Okun’s law or Phillips Curve except those teaching introductory macroeconomics, and it dies there.

What the Fed is worried about is 1.) wage and price inflation igniting, but moreover 2.) the $1.9 trillion in excess reserves private banks hold at Fed which the could become loans at any time, forget the fed funds rate target, it is the interest rate the Fed will have to hike which it pays on excess reserves to prevent a massive increase in the money supply.  Note this is unprecedented since 2007 crisis, and has not been that long that the Fed has been even paying interest on reserves balances, historically banks keep near zero excess balances, levels now far in excess of required reserves being 10% deposits.  This is uncharted territory for the Fed.  If private banks decide there is a better profit in making loans to public than what Fed pays, all hell could break lose with Fed repeatedly jacking up i rates to prevent an explosion of money, and M1 is just $3.6 trillion.  Theoretical, if banks dumped those balances and made loans instead, which they can legally do, that would be an immediate 52% increase in the money supply, then have the money multiplier process after that.  The Most Dangerous Development The Fed Wants To Avoid is not Okun's law, but what happens to all those excess reserves and if they escape, and if Fed tries neutralizing with open market operations dumping their treasuries, well we have interest rates rising in a spiral faster than they want, then stagflation not too far down line, high money supply growth and high interest rates, debt structure is now such that private sector will hurt, and Federal Government will be paying 25% of budget in debt service.  It is more how long they can keep steady as she goes going with a possible hurricane on the horizon.

Balance-Sheet Nelbev Sun, 06/17/2018 - 23:44 Permalink

I like this post. The excess reserves are there primarily from the selling of assets to the Fed to take them off the banks books. The bank receives a magic deposit at the Fed in these transactions. It is what an asset swap is. Will the private banks actually lend these excess reserves into the economy? They do not have to use excess reserves for this as they create the money they lend out when a loan is advanced. These are accounting entries and it *may* be that the Fed is reducing the Balance-Sheet (if they do) or stop it from growing to move these excess reserves off the books- again no real reason to. It wouldn't be smart to make the Fed intensely upset with an uncooperative bank so any major moves here will be according to plans.  The goal will always be to provide financing to the USG at about zero net cost especially through steady Fed dividends to the UST and negative real rates. Key point is that whatever the USG pays in debt service it is 2-3% LESS than what was originally borrowed in constant terms. Whatever loans the banks make will be securitized and sold in packages and the Fed can buy what it needs at gunpoint, as it were, from the banks at the price it specifies and value that asset according to need. Once the securitized loan packages are sold to the Fed they are OFF the banks books freeing its reserves for more lending and the interest on those packages goes to the Fed. At the same time another magic deposit is made in the excess reserves for said bank.

In reply to by Nelbev

Nelbev Balance-Sheet Mon, 06/18/2018 - 01:40 Permalink

Private banks holding reserves at the Fed does not "take them off the banks books."  Reserves at the Fed are the legal equivalent of vault cash, and asset on the books.  In fact any bank could liquidate its deposit at the fed and as for a few thousand Brinks trucks to deliver the cash, but cash is a hassle, just hold enough for depositor withdraws.

Required minimum reserves are $141 billion, actual reserves held at $2,024 billion

The IOER, Interest Rate on Excess Reserves is set at 5 basis points less than the feds funds target, i.e. 1.95% now with fed funds target at 2% (and the irrelevant discount rate at 2.5%) as of last fed meeting.

I agree there will be a political element as most federal debt has short term and a budget crisis is in works with debt service, but if inflation opens up, the treasury will have to compete with the return on commodity market futures when refinancing.  It will be Catch 22, vainly try to keep interest rates low and let money supply rise (and bail out federal gov refinancing) - well that will eventually lead to inflation and nominal interest rates rising no matter what fed does, or keep interest rates rising to head off money supply growth and inflation, does not matter.  Note markets set all other interest rates, fed only sets i rate on deposits at fed and loans from fed, and markets can go anywhere they want.  There is a ridiculous bubble in the bond market now worse than real estate ten years ago, just will be how long till reality sets in.

In reply to by Balance-Sheet

Money_for_Nothing Nelbev Mon, 06/18/2018 - 08:08 Permalink

This about who is in control. The Fed ($FRN) and the US Treasury ($USD) are trying to wrest back control from other Agencies. Fanny May, Pentagon, CIA, EURO dollars (ECB and European national banks), IMF. Petrodollar system papered over all the problems for years. The Fed forced their clients into US Government paper. We will see how that works when the next crisis hits.

In reply to by Nelbev

Balance-Sheet Nelbev Mon, 06/18/2018 - 12:10 Permalink

When the Fed or other buyer purchases securitized products like MBS the ownership of that loan asset is transferred goes to the Fed and the bank will collect a fee for SERVICING the loan only. This releases the banks reserves to support further lending which is then securitized in turn. That is why we have these type of products - to sell the loans off the books. If the Fed IS the buyer the reserves of the selling bank increase by the amount of the purchase.

If any bank does not sell securitized debt assets to the Fed it will not have excess reserves. If you do not want your bank seized and broken up you will do what the Fed wants

Financial crises are inevitable and if there are troubled assets the Fed can simply swap them for cash where there is a 'no bid' situation. In such a case the Fed is the buyer of last resort and the market maker though the Fed might fail as it did until the 1937 Bank Act. With human decision makers failure in position is a possibility especially from nervous collapse.

In reply to by Nelbev

snblitz Mon, 06/18/2018 - 01:17 Permalink

Everyone is well aware of the Fed's dual mandate:

  1. Extract the maximum wealth possible from the people
  2. Keep the scam running for as long as possible

so I need not restate it here.

Money_for_Nothing Mon, 06/18/2018 - 07:54 Permalink

Deutsche doesn't seem to understand. The Fed can give (legal tender) capital to any organization or agency that it deems in its interest to do so. Any organization or agency with intrinsic capital is hiding it. The issue is that we are at the point when productive people are spending large portions of their time and energy hiding their intrinsic capital from confiscation. Because of this price inflation is too high and wages are too low. Low unemployment doesn't mean anything in this context. 20% or less do all the productive work. All the others are effectively kissing bureaucrats asses for a living. This situation is where the term funny-money comes from. The trick is to turn funny-money into spending-money and spend the money on something with real-value. Uncle Warren's empire is mostly based on things with little intrinsic value (insurance and banking). That is why Uncle Warren wags-the-dog and kisses bureaucrats asses.

taketheredpill Mon, 06/18/2018 - 10:20 Permalink

RE: Okun's Law

Real GDP and Unemployment Rate annual % YoY


The drop in Unemployment is being driven by Discouraged Workers dropping out of Labor Force (Yes wages are rising, but only for those people actually in the Labor Force).

I have a hard time when people compare the current cycle to earlier cycles.  Sorry, when was the last time Central Bank rates were AT ZERO?

This cycle is not comparable to previous cycles.  This cycle is the Terminal Station after decades of Debt accumulation.  Central Banks have broken the system and we just have to wait until it finally grinds to a stop.