…but it is what it is

The Albatross Of Debt: Why The Fed’s Wall Street Based Steering Gear No Longer Drives The Main Street Jalopy, Part 6

By David Stockman

The heart of the Fed’s monetary central planning regime is the falsification of financial asset prices. At the end of the day, however, that extracts a huge price in terms of diminished main street prosperity and dangerous financial system instability.

Of course, they are pleased to describe this in more antiseptic terms such as financial accommodation or shifting risk and term premia. For example, when they employ QE to suppress the yield on the 10-year UST (i.e. reduce the term premium), the aim is to lower mortgage rates and thereby stimulate higher levels of housing construction.

Likewise, the Fed heads also claim that another reason for suppressing the risk free rate on US Treasuries via QE was to induce investors to move further out the risk curve into corporates and even junk, thereby purportedly boosting availability and reducing the carry cost of debt financed corporate investments in plant, equipment and technology.

In a word, the modus operandi of Keynesian central banking is to replace free market prices on bonds, loans and other financial assets (including equities) traded on Wall Street with administratively set prices designed to stimulate increased levels of real activity in targeted sectors of main street.

The giant flaw on the whole enterprise, however, is that the central bank does not operate in a vacuum in either space or time. Nor does its crude steering gear of administered financial asset prices have any reliable connecting rods to the main street economy.

That’s especially the case because under conditions of Peak Debt in households, cheap mortgages aren’t efficacious; and owing to Peak Speculation on Wall Street as described below, cheap debt gives rise to financial engineering in the corporate C-suites and pure, undisciplined gambling on Wall Street.

With respect to what we have called the “spatial” dimension, for instance, the artificially suppressed yield on the benchmark UST can easily transmit through the risk curve to cheap junk bond funding for an LBO rather than enhanced investment in capital equipment.

The latter would tend to improve efficiency or capacity and therefore boost broadly based wealth. By contrast, the LBO would tend to actually retard GDP by encumbering existing productive assets with much higher interest expense and also with short-run needs to slash capital and operating costs—even if that diminishes long-run productivity and growth capacity. Having spent 15 years in the private equity business, in fact, that is one thing your editor is especially sure about.

Needless to say, LBO’s also essentially strip-mine financial resources from main street businesses in order to re-cycle them to Wall Street. So doing, this form of financial engineering concentrates existing wealth by transferring income from workers and other factors of production to private equity operators and investors at the top of the economic ladder.

Similarly, even when yield suppression on the UST finds its way into lower mortgage rates via spread-based mortgage pricing, that does not automatically stimulate new housing construction. In  fact, due to the unique embedded put option in fixed rate mortgages (i.e. ability of borrowers to pre-pay without penalty), monetary repression on a long-term basis tends to stimulate a refi treadmill rather than new production: As rates continuously fall, the stock of outstanding mortgages churns at accelerating rates.

As shown in the red and green portions of the bar chart below, refi (including home equity lines) has accounted for 55% to 80% of new mortgage originations during the last decade of heavy-duty Fed rate repression. And while some of the “cash out” proceeds or monthly payment savings from typical mortgage refis go into spending for other consumption items, there is considerable leakage: Some proceeds go into debt reduction on say over-extended credit cards, or get arbitraged into purchase of stock or other investment assets or funds the purchase of foreign made goods, which actually subtracts from GDP.

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