By Doug Noland
Upon the public release of Jerome Powell’s Wednesday speech came the Bloomberg headline: “Powell: No Preset Policy Path, Rates ‘Just Below’ Neutral Range.” When the Fed Chairman began his presentation to the New York Economic Club just minutes later, the Dow had already surged 460 points. From Powell’s prepared comments: “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.” When he read his speech, he used “range,” as opposed to “broad range” of estimates.
Equities responded to the Chairman’s seeming dovish transformation with jubilation (and quite a short squeeze). It certainly appeared a far cry from, “We may go past neutral, but we’re a long way from neutral at this point, probably,” back on the third of October. Powell’s choice of language was viewed consistent with the ‘much closer’ to the neutral level, as headlines ascribed to vice chair Richard Clarida. What he actually said in Tuesday’s speech: “Although the real federal funds rate today is just below the range of longer-run estimates presented in the September [Summary of Economic Projections], it is much closer to the vicinity of r* than it was when the FOMC started to remove accommodation in December 2015. How close is a matter of judgment, and there is a range of views on the FOMC.”
The “neutral rate” framework is problematic. Back in early October, the Fed was almost three years into its “tightening” cycle (first rate increase in December 2015). Yet the Atlanta Fed GDP Forecast was signaling 4% growth; consumer confidence was near decade highs; manufacturing indices were near multi-year highs; corporate Credit conditions remained quite loose; and WTI crude had just surpassed $75 a barrel. The S&P500 traded only fractionally below record highs in the hours before Powell’s evening of October 3rd “long way from neutral…” With unemployment at (a multi-decade low) 3.7% and CPI up 2.3% y-o-y, there was a reasonable case at the time that significantly higher interest rates would be necessary for policy to reach some so-called “neutral rate.”
In our age of speculative financial markets dictating overall financial conditions, major backdrop shifts unfold in spans of days and weeks. The S&P500 dropped about 10% from early-October highs, while corporate Credit conditions tightened meaningfully. The Atlanta Fed GDP forecast has dropped to 2.6%. Consumer confidence has weakened, and housing has slowed. WTI is trading near $50, down about one-third from early-October. One could argue the so-called “neutral rate” has collapsed in recent weeks. Did it jump, along with hyper-volatile stocks, this week?
I’m not taking exception with the market’s view of a more dovish Fed. Of course, they are going to turn more cautious in the face of a significant tightening of financial conditions. At the same time, I expect they’ll be keen to jump back on the normalization track if markets rally and financial conditions loosen. When the Fed says “data dependent,” I would read “market dependent.” Market conditions will lead the data. The substance of both Powell and Clarida’s presentations were more balanced than dovish.
Powell’s Wednesday presentation was titled, “The Federal Reserve’s Framework for Monitoring Financial Stability” (with a reference to Hyman Minsky!). The Fed’s introductory Financial Stability Report had been published the previous day. “This report summarizes the Federal Reserve Board’s framework for assessing the resilience of the U.S. financial system and presents the Board’s current assessment. By publishing this report, the Board intends to promote public understanding and increase transparency and accountability for the Federal Reserve’s views on this topic. Promoting financial stability is a key element in meeting the Federal Reserve’s dual mandate for monetary policy regarding full employment and stable prices.”
I appreciate the Fed’s attention to financial stability, stating explicitly the central role it plays within its broader mandate. Powell’s speech offered a definition of “financial stability:” “A stable financial system is one that continues to function effectively even in severely adverse conditions. A stable system meets the borrowing and investment needs of households and businesses despite economic turbulence. An unstable system, in contrast, may amplify turbulence and prolong economic hardship in the face of stress by failing to provide these essential services when they are needed most.”
It’s a commendable effort to craft such complex subject matter into a characterization accessible to the general public. However, I would broadly argue that unfettered contemporary finance – dominated by securities markets, derivatives and speculative trading – is an “unstable system.” Conditions will gravitate to excessive looseness during booms, only to tightened dramatically come the inevitable eruption of “risk off.” The monetary policy approach that evolved from serial boom and bust dynamics has been to backstop marketplace liquidity, while assuring participants that central banks will respond aggressively in the event of market or economic instability. By extending boom phases, this policy doctrine has created the illusion of stability for an innately unstable system.
Significant thought and effort went into crafting the Fed’s 37-page document. It is full of important data and insight. And, from my perspective, it as well illuminates key holes in the Fed’s approach to monitoring financial stability. There’s certainly a “generals fighting the last war” predisposition embedded within the Fed’s analytical framework.
The Fed’s “framework focuses primarily on monitoring vulnerabilities and emphasizes four broad categories based on research:” “Elevated Valuation Pressure;” “Excessive Borrowing by Businesses and Households;” “Excessive Leverage in the Financial Sector;” and “Funding Risks.”
The Fed’s current “financial stability” framework would have been generally suitable for the previous “tech” and “mortgage finance” Bubbles. These periods were characterized by major expansions in corporate debt, household borrowings and U.S. financial sector leverage, with financial intermediaries issuing huge quantities of perceived safe short-term liabilities to finance increasingly risky long-term assets.
Today’s “global government finance Bubble” has markedly different dynamics. Most consequential, rapid expansion and leverage have characterized government and central bank balance sheets – across the globe. The U.S. cycle, in particular, has experienced an extraordinary expansion of government borrowings. After ending 2007 at $6.051 TN, outstanding Treasury debt expanded 182%, to end June at $17.091 TN. Treasury debt growth is now projected to surpass $1.0 TN annually for the foreseeable future.
For this cycle, traditional analysis of household and corporate balance sheets will underrate systemic risk. The problematic balance sheet expansion has been in the government sector, debt growth that has worked to this point to bolster Household and Corporate finances. The federal borrowing and spending boom has inflated Household incomes, while inflating Corporate sector profits. Nonetheless, according to the report, “After growing faster than GDP through most of the current expansion, total business-sector debt relative to GDP stands at a historically high level.”
Traditional analysis has also been distorted by the past decade’s extraordinary monetary policy backdrop. Low rates and QE (growth in central bank liabilities) significantly reduced debt service costs (slowing Household debt growth), while dramatically inflating Household Net Worth (Net Worth up 80% since the crisis to a record $107 TN). For the Corporate sector, unprecedented loose finance reduced debt service and the overall growth in corporate borrowings, while providing inexpensive finance for stock buybacks, M&A and easy EPS growth. QE-related liquidity was funneled into corporate coffers already bloated from enormous federal deficit spending.
With ongoing extraordinarily low market yields and federal deficits, I would argue that traditional valuation metrics will also understate systemic vulnerabilities. The previous crisis illuminated how quickly a perceived sustainable profit boom can implode spectacularly. Fed analysis has stock market valuation on the high-end of the historical range. I would argue that today’s inflated profits are unsustainable and extremely vulnerable to the downside of a phenomenal boom cycle.
Ignoring the federal government balance sheet is a critical shortcoming of the Federal Reserve’s “financial stability” framework. Fed officials would surely prefer to stay clear of fiscal politics, but the harsh reality is that monetary policy promoted unprecedented debt issuance and a tolerance for fiscal irresponsibility that has run unabated throughout a protracted economic boom. Treasury yields remain extraordinarily low in the face of a rapid deterioration in the Treasury’s Credit profile. The report also didn’t address potential financial stability issues associated with the scantly-capitalized government-sponsored enterprises and their almost $9.0 TN of outstanding agency (debt and MBS) securities. A spike in yields – a scenario not to be dismissed considering the risk trajectory of Treasury and agency obligations – would have a momentous impact on U.S. and global financial stability.
The Fed’s analysis of “leverage in the financial sector” is interesting, especially considering their own balance sheet provided much of the leverage for this cycle. “Leverage at financial firms is low relative to historical standards…” “A greater amount and a higher quality of capital improve the ability of banks to bear losses…” “Capital levels at broker-dealers have also increased substantially relative to pre-crisis levels, and major insurance companies have strengthened their financial positions since the crisis.”
The Fed then turns nebulous. “…Some indicators suggest that hedge fund leverage is at post-crisis highs.” “Several indicators suggest hedge fund leverage has been increasing over the past two years.”
Our central bank (along with others) doesn’t have a good handle on speculative leverage. They place hedge fund “total assets” at $7.27 TN, having expanded 13.5% over the most recent year (2017). “A comprehensive measure that incorporates margin loans, repurchase agreements (repos), and derivatives-but is only available with a significant time lag-suggests that average hedge fund leverage has risen by about one-third over the course of 2016 and 2017.” “The increased use of leverage by hedge funds exposes their counterparties to risks and raises the possibility that adverse shocks would result in forced asset sales by hedge funds that could exacerbate price declines.”
Without a well-defined and comprehensive analysis of global speculative finance, an insightful appraisal of financial stability will remain forever elusive. There are questions fundamental to gauging financial stability. Rest of World (from the Fed’s Z.1) holdings of U.S. financial assets have more than doubled since the end of 2008 to $27.5 TN. U.S. Debt Securities holdings were up 55% to $11.252 TN. How much foreign-sourced leverage has been behind the enormous flows into U.S. securities and financial assets – speculative, financial sector and central bank leverage? How vulnerable is global dollar liquidity to a bout of “risk off” speculative deleveraging? How vulnerable are inflated U.S. asset markets to the end of global QE and the deleveraging of central bank balance sheets (i.e. EM central banks selling U.S. securities to support faltering local currencies)?
The Fed’s financial stability report touches on global risks, including Brexit, Europe, dollar-denominated EM debt and China. But I would argue that the U.S. economy and markets are more susceptible to global forces today than ever before. It’s difficult to envisage a scenario of a bursting Chinese Bubble and faltering EM and Europe that doesn’t have profound consequences for U.S. financial stability. Global fragilities alone pose great systemic risk for the U.S. Combined with our stock market and asset Bubbles, escalating fiscal risk, corporate Credit vulnerability and deep structural economic maladjustment, the prognosis for financial stability is dire.
The Fed’s fourth broad category is “Funding Risk.” “A measure of the total amount of liabilities that are most vulnerable to runs, including those issued by nonbanks, is relatively low.” I don’t disagree that “bank funding is less susceptible to runs now than in the period leading up to the financial crisis.” “An aggregate measure of private short-term, whole- sale, and uninsured instruments that could be prone to runs-a measure that includes repos, commercial paper, money funds, uninsured bank deposits, and other forms of short-term debt-currently stands at $13 trillion, significantly lower than its peak at the start of the financial crisis.”
But… “Total assets under management in corporate bond mutual funds and loan mutual funds have more than doubled in the past decade to over $2 trillion… The mismatch between the ability of investors in open-end bond or loan mutual funds to redeem shares daily and the longer time often required to sell corporate bonds or loans creates, in principle, conditions that can lead to runs, although widespread runs on mutual funds other than money market funds have not materialized during past episodes of stress.”
Throughout this Bubble period, I have referred to the “Moneyness of Risk Assets.” A “run” on perceived money-like Credit instruments sparked the collapse of the mortgage finance Bubble. Runs unfold when holders of perceived safe and liquid instruments suddenly recognize risk is much greater than previously appreciated. Past crises have typically originated in the money markets. But never have central bank and government policies so fostered the perception of safety and liquidity (“moneyness”) for risk assets – equities and corporate Credit, in particular. I would argue the proliferation and massive growth of index fund products poses a major risk to financial stability. And when it comes to policy-induced distortions, already extraordinary risks to financial stability are only compounded by the proliferation and growth of derivative trading strategies, both retail and institutional.
One might ponder the notion of financial stability when the S&P500 sinks 3.8% one week and then rallies 4.8% the next. Expectations are now high that the Fed will be soon winding down “normalization,” and that President Trump is hankering to strike a deal with the Chinese. Should be an interesting weekend. It was an interesting market rally – or lack of a rally in corporate Credit. Leveraged loans had a notably poor week. High yield debt remains suspect with crude at $50. Weak link GE was notably weak in the face of market strength. And while some Powell-induced dollar weakness stoked the short squeeze in EM, the Shanghai Composite struggled to end the week little changed. Moreover, seeing German bund yields decline another three bps (to 0.31%) hardly conjures bullish imagery. Financial Instability.
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