Tag Archives: monetary policy

The Problem With Pragmatism… and Inflation

Pragmatism is seeking immediate solutions with little to no consideration for the longer-term benefits and consequences. An excellent example of this is the Social Security system in the United States. In the Depression-era, a government-sponsored savings plan was established to “solve” for lack of retirement savings by requiring contributions to a government-sponsored savings plan.  At the time, the idea made sense as the population was greatly skewed towards younger people.  No one seriously considered whether there would always be enough workers to support benefits for retired people in the future. Now, long after those policies were enacted and those that pushed the legislation are long gone, the time is fast approaching when Social Security will be unable to pay out what the government has promised.

Pragmatism is the common path of governments, led by politicians seeking re-election and the retention of power. Instead of considering the long-term implications of their policies, they focus on satisfying an immediate desire of their constituents.

In his book Economics in One Lesson, Henry Hazlitt made this point very clear by elaborating on the problems that eventually transpire from imprudent monetary and fiscal policy.

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Nine-tenths of the economic fallacies that are working such dreadful harm in the world today are the result of ignoring this lesson.”

Inflation

One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. When asked to define inflation, most people say “rising prices,” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation is a disequilibrium between the amounts of currency entering an economic system relative to the productive output of that same system.

In today’s world, there is only fiat (“by decree”) currencies. In other words, the value of currencies are not backed by some physical commodity such as gold, silver, or oil. Currencies are only backed by the perceived productive capacity of the nation and the stability of the issuing government. If a government takes unreasonable measures in managing its fiscal and monetary affairs, then the standard of living in that society will deteriorate, and confidence in it erodes.

Put another way, when the people of a nation or its global counterparts lose confidence in the fiscal and monetary policy-makers, the result is a loss of confidence in the medium of exchange, and a devaluation of the currency ensues. The influence of those in power will ultimately prove to be unsustainable.

Inflation is an indicator of confidence in the currency as a surrogate of confidence in the policies of a government. It is a mirror. This is why James Grant is often quoted as saying, “The gold price is the reciprocal of the world’s faith in central banking.”

Confidence in a currency may be lost in a variety of ways. The one most apparent today is creating too many dollars as a means of subsidizing the spending habits of politicians and the borrowing demands of corporations and citizens.

Precedent

There is plenty of modern-day historical precedent for a loss of confidence from excessive debt creation and the inevitable excessive currency creation. Weimar Germany in the 1920s remains the modern era poster child, but Zimbabwe, Argentina, and Venezuela also offer recent examples.

Following the 2008 financial crisis, many believed that the actions of the Federal Reserve were “heroic.” Despite failing to see the warning signs of a housing bubble in the months and even years leading up to the crisis, the Fed’s perspective was that it exists to provide liquidity. As the chart below illustrates, that is precisely what they did.

Data Courtesy Bloomberg

That pragmatic response failed to heed Hazlitt’s warning. What are the longer-term effects for the economy, the bailed-out banking system, and all of us? How would these policies affect the economy, markets, society, and the wealth of the nation’s citizens in five, ten, or twenty years?

Keeping interest rates at a low level for many years following the financial crisis while the economy generally appears to have recovered raises other questions. The Fed continues to argue that inflation remains subdued. That argument goes largely undisputed despite credible evidence to the contrary. Further, it provides the Fed a rationalization for keeping rates well below normal.

Politicians who oversee the Fed and want to retain power, consent to low-rate policies believing it will foster economic growth. While that may make sense to some, it is short-sighted and, therefore, pragmatic. The assessment does not account for a variety of other complicating factors, namely, what may transpire in the future as a result? Are seeds of excess being sown as was the case in the dot-com bubble and the housing bubble? If so, can we gauge the magnitude?

Policy Imposition

In the mid-1960s, President Lyndon Johnson sought to escalate U.S. involvement in the Vietnam War. In doing so, he knew he would need the help of the Fed to hold interest rates down to run the budget deficits required to fund that war. Although then-Fed Chairman William McChesney Martin was reluctant to ease monetary policy, he endured various forms of abuse from the Oval Office and finally acquiesced.

The bullying these days comes from President Trump. Although his arguments for easier policy contradict what he said on the campaign trail in 2016, Jerome Powell is compliant. Until recently, the economy appeared to be running at full employment and all primary fundamental metrics were well above the prior peaks set in 2007.

Additionally, Congress, at Trump’s behest and as the chart below illustrates, has deployed massive fiscal stimulus that created a yawning gap (highlighted) between fiscal deficits and the unemployment picture. This is a divergence not seen since the Johnson administration in the 1960s (also highlighted) and one of magnitude never seen. As is very quickly becoming clear, those actions both monetary and fiscal, were irresponsible to the point of negligence. Now, when we need it most as the economy shuts down, there is little or no “dry powder”.

Data Courtesy Bloomberg

President Johnson got his way and was able to fund the war with abnormally low interest rates. However, what ensued over the next 15 years was a wave of inflation that destroyed the productive capacity of the economy well into the early 1980s. Interest rates eventually rose to 18%, and economic dynamism withered as did the spirits of the average American.

The springboard for that scenario was a pragmatic policy designed to solve an immediate problem with no regard for the future. Monetary policy that suppressed interest rates and fiscal policy that took advantage of artificially low interest rates to accumulate debt at a relatively low cost went against the American public best interests. The public could not conceive that government “of, by and for the people” would act in such a short-sighted and self-serving manner.

Data Courtesy Bloomberg

The Sequel

Before the COVID-19 pandemic, the Congressional Budget Office (CBO) projections for U.S. budget deficits exceeded $1 trillion per year for the next 10-years. According to the CBO, the U.S. Treasury’s $22.5 trillion cumulative debt outstanding was set to reach $34.5 trillion by 2029, and that scenario assumed a very optimistic GDP growth of 3% per year. Further, it laughably assumed no recession will occur in the next decade, even though we are already in the longest economic expansion since the Civil War. In the event of a recession, a $1.8 trillion-dollar annual deficit would align with average historical experience. Given the severity of what is evident from the early stages of the pandemic, that forecast may be very much on the low end of reality.

The 1960s taught us that monetary and fiscal policy is always better erring on the side of conservatism to avoid losing confidence in the currency. Members of the Fed repeatedly tell the public they know this. Yet, if that is the case, why would they be so influenced by a President focused on marketing for re-election purposes? Alternatively, maybe the policy table has been set over the past ten years in a way that prevents them from taking proper measures? Do they assume they would be rejected despite the principled nature of their actions?

Summary

Inflation currently seems to be the very least of our worries. Impeachment, Iran, North Korea and climate change were all crisis head fakes.

The Fed was also distracted by what amounted to financial dumpster fires in the fall of 2019. After a brief respite, the Fed’s balance sheet began surging higher again and they cut the Fed Funds rate well before there was any known threat of a global pandemic. What is unclear is whether imprudent fiscal policies were forcing the Fed into imprudent monetary policy or whether the Fed’s policies, historical and current, are the enabler of fiscal imprudence. Now that the world has changed, as it has a habit of doing sometimes even radically, policymakers and the collective public are in something of a fine mess to understate the situation.

Now we are contending with a real global financial, economic, and humanitarian threat and one that demands principled action as opposed to short-sighted pragmatism.

The COVID-19 pandemic is clearly not a head fake nor is it a random dumpster fire. Neither is it going away any time soon. Unlike heads of state or corporate CEOs, biological threats do not have a political agenda and they do not care about the value of their stock options. There is nothing to negotiate other than the effectiveness of efforts required to protect society.

Given the potential harm caused by the divergence between stimulus and economic fundamentals, it would be short-sighted and irresponsibly pragmatic to count out the prospect of inflation. Given the actions of the central bankers, it could also be the understatement of this new and very unusual decade.

Yeah…But

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets. 

Black Monday – Can It Happen Again?

The 1987 stock market crash, better known as Black Monday, was a statistical anomaly, often referred to as a Black Swan event. Unlike other market declines, investors seem to be under the false premise that the stock market in 1987 provided no warning of the impending crash. The unique characteristics of Black Monday, the magnitude and instantaneous nature of the drop, has relegated the event to the “could never happen again” compartment of investors’ memories.

On Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) fell 22.6% in the greatest one-day loss ever recorded on Wall Street. Despite varying perceptions, there were clear fundamental and technical warnings preceding the crash that were detected by a few investors. For the rest, the market euphoria raging at the time blinded them to what in hindsight seemed obvious.

Stock markets, like in 1987, are in a state of complacency, donning a ‘what could go wrong’ brashness and extrapolating good times as far as the eye can see. Even those that detect economic headwinds and excessive valuations appear emboldened by the thought that the Fed will not allow anything bad to happen. 

While we respect the bullish price action, we also appreciate that investors are not properly assessing fundamental factors that overwhelmingly argue the market is overvalued. There is no doubt that prices and valuations will revert to more normal levels. Will it occur via a long period of market malaise, a single large drawdown like 1987, or something more akin to the crashes of 2001 and 2008? When will it occur? We do not have the answers, nor does anyone else; however, we know that those who study prior market drawdowns are better prepared and better equipped to limit their risk and avoid a devastating loss.

History provides us with the gift of insight, and though history will not repeat itself, it may rhyme. While we do not think a 1987-like crash is likely, we would be remiss if we did not at least consider it and assign a probability. 

Fundamental Causes

Below is a summary of some of the fundamental dynamics that played a role in the market rally and the ultimate crash of 1987.

Takeover Tax Bill- During the market rally preceding the crash, corporate takeover fever was running hot. Leveraged Buyouts (LBOs), in which high yield debt was used to purchase companies, were stoking the large majority of stocks higher. Investors were betting on rumors of companies being taken over and were participating in strategies such as takeover risk arbitrage. A big determinant driving LBOs was a surge in junk bond issuance and the resulting acquirer’s ability to raise the necessary capital. The enthusiasm for more LBO’s, similar to buybacks today, fueled speculation and enthusiasm across the stock market. On October 13, 1987, Congress introduced a bill that sought to rescind the tax deduction for interest on debt used in corporate takeovers. This bill raised concerns that the LBO machine would be impaired. From the date the bill was announced until the Friday before Black Monday, the market dropped over 10%.

Inflation/Interest Rates- In April 1980, annual inflation peaked at nearly 15%. By December of 1986, it had sharply reversed to a mere 1.18%.  This reading would be the lowest level of inflation from that point until the financial crisis of 2008. Throughout 1987, inflation bucked the trend of the prior six years and hit 4.23% in September of 1987. Not surprisingly, interest rates rose in a similar pattern as inflation during that period. In 1982, the yield on the ten-year U.S. Treasury note peaked at 15%, but it would close out 1986 at 7%. Like inflation, interest rates reversed the trend in 1987, and by October, the ten-year U.S. Treasury note yield was 3% higher at 10.23%. Higher interest rates made LBOs more costly, takeovers less likely, put pressure on economic growth and, most importantly, presented a rewarding alternative to owning stocks. 

Deficit/Dollar- A frequently cited contributor to the market crash was the mounting trade deficit. From 1982 to 1987, the annual trade deficit was four times the average of the preceding five years. As a result, on October 14th Treasury Secretary James Baker suggested the need for a weaker dollar. Undoubtedly, concerns for dollar weakness led foreigners to exit dollar-denominated assets, adding momentum to rising interest rates. Not surprisingly, the S&P 500 fell 3% that day, in part due to Baker’s comments.

Valuations- From the trough in August 1982 to the peak in August 1987, the S&P 500 produced a total return (dividends included) of over 300% or nearly 32% annualized. However, earnings over the same period rose a mere 8.1%. The valuation ratio, price to trailing twelve months earnings, expanded from 7.50 to 18.25. On the eve of the crash, this metric stood at a 33% premium to its average since 1924. 

Technical Factors

This section examines technical warning signs in the days, weeks, and months before Black Monday. Before proceeding, the chart below shows the longer-term rally from the early 1980s through the crash.

Portfolio Insurance- As mentioned, from the 1982 trough to the 1987 peak, the S&P 500 produced outsized gains for investors. Further, the pace of gains accelerated sharply in the last two years of the rally.

As the 1980s progressed, some investors were increasingly concerned that the massive gains were outpacing the fundamental drivers of stock prices. Such anxiety led to the creation and popularity of portfolio insurance. This new hedging technique, used primarily by institutional investors, involved conditional contracts that sold short the S&P 500 futures contract if the market fell by a certain amount. This simple strategy was essentially a stop loss on a portfolio that avoided selling the actual portfolio assets. Importantly, the contracts ensured that more short sales would occur as the market sell-off continued. When the market began selling off, these insurance hedges began to kick in, swamping bidders and making a bad situation much worse. Because the strategy required incremental short sales as the market fell, selling begat selling, and a correction turned into an avalanche of panic.

Price Activity- The rally from 1982 peaked on August 25, 1987, nearly two months before Black Monday. Over the next month, the S&P 500 fell about 8% before rebounding to 2.65% below the August highs. This condition, a “lower high,” was a warning that went unnoticed. From that point forward, the market headed decidedly lower. Following the rebound high, eight of the nine subsequent days just before Black Monday saw stocks in the red. For those that say the market did not give clues, it is quite likely that the 15% decline before Black Monday was the result of the so-called smart money heeding the clues and selling, hedging, or buying portfolio insurance.

Annotated Technical Indicators

The following chart presents technical warnings signs labeled and described below.

  • A:  7/30/1987- Just before peaking in early August, the S&P 500 extended itself to three standard deviations from its 50-day moving average (3-standard deviation Bollinger band). This signaled the market was greatly overbought. (description of Bollinger Bands)
  • B: 10/5/1987- After peaking and then declining to a more balanced market condition, the S&P 500 recovered but failed to reach the prior high.
  • C: 10/14/1987- The S&P 500 price of 310 was a point of both support and resistance for the market over the prior two months. When the index price broke that line to the downside, it proved to be a critical technical breach.
  • D: 10/16/1987- On the eve of Black Monday, the S&P 500 fell below the 200-day moving average. Since 1985, that moving average provided dependable support to the market on five different occasions.
  • E: August 1987- The relative strength indicator (RSI – above the S&P price graph) reached extremely overbought conditions in late July and early August (labeled green). When the market rebounded in early October to within 2.6% of the prior record high, the RSI was still well below its peak. This was a strong sign that the underlying strength of the market was waning.  (description of RSI)

Volatility- From the beginning of the rally until the crash, the average weekly gain or loss on the S&P 500 was 1.54%. In the week leading up to Black Monday, volatility, as measured by five-day price changes, started spiking higher. By the Friday before Black Monday, the five-day price change was 8.63%, a level over six standard deviations from the norm and almost twice that of any other five-day period since the rally began.   

A longer average true range graph is shown above the longer term S&P 500 graph at the start of the technical section.

Similarities and differences

While comparing 1987 to today is helpful, the economic, political, and market backdrops are vastly different. There are, however some similarities worth mentioning.

Similarities:

  • While LBO’s are not nearly as frequent, companies are essentially replicating similar behavior by using excessive debt and leverage to buy their own shares. Corporate debt stands at all-time highs measured in both absolute terms and as a ratio of GDP. Since 2015, stock buybacks and dividends have accounted for 112% of earnings
  • Federal deficits and the trade deficit are at record levels and increasing rapidly
  • The trade-weighted dollar index is now at the highest level in at least 25 years. We are likely approaching the point where President Trump and Treasury Secretary Steve Mnuchin will push for a weak dollar policy
  • Equity valuations are extremely high by almost every metric and historical comparison of the last 100+ years
  • Sentiment and expectations are declining from near record levels
  • The use of margin is at record high levels
  • Trading strategies such as short volatility, passive/index investing, and algorithms can have a snowball effect, like portfolio insurance, if they are unwound hastily

There are also vast differences. The economic backdrop of 1987 and today are nearly opposite.

  • In 1987 baby boomers were on the verge of becoming an economic support engine, today they are retiring at an increasing pace and becoming an economic headwind
  • Personal, corporate, and public Debt to GDP have grown enormously since 1987
  • The amount of monetary stimulus in the system today is extreme and delivering diminishing returns, leaving one to question how much more the Fed can provide 
  • Productivity growth was robust in 1987, and today it has nearly ground to a halt

While some of the fundamental drivers of 1987 may appear similar to today, the current economic situation leaves a lot to be desired when compared to 1987. After the 1987 market crash, the market rebounded quickly, hitting new highs by the spring of 1989.

We fear that, given the economic backdrop and limited ability to enact monetary and fiscal policy, recovery from an episodic event like that experienced in October 1987 may look vastly different today.

Summary

Market tops are said to be processes. Currently, there are an abundance of fundamental warnings and some technical signals that the market is peaking.

Those looking back at 1987 may blame tax legislation, portfolio insurance, and warnings of a weaker dollar as the catalysts for the severe declines. In reality, those were just the sparks that started the fire. The tinder was a market that had become overly optimistic and had forgotten the discipline of prudent risk management.

When the current market reverses course, as always, there will be narratives. Investors are likely to blame a multitude of catalysts both real and imagined. Also, like 1987, the true fundamental catalysts are already apparent; they are just waiting for a spark. We must be prepared and willing to act when combustion becomes evident.

What is Bill Dudley Thinking?

On August 27, 2019, Bill Dudley, former Chief Economist for Goldman Sachs and President of the Federal Reserve Bank of New York from 2009-2018, published a stunning editorial in Bloomberg (LINK). After reading the article numerous times, there are a few noteworthy observations worth discussing.

Dudley’s Myopic View

Before we dissect Bill Dudley’s opinions and try to understand his motivations, consider the article’s subtitle- “The central bank should refuse to play along with an economic disaster in the making.”

There is little doubt that Trump’s hard stance on trade and the seemingly impetuous use of tariffs and harsh Twitter commentary presents new challenges for economic growth. Global trade has slowed and manufacturers are retrenching to limit their risks.

Whether the trade war is or will be an “economic disaster” as Dudley says, is up for debate. What is remarkable about this comment is the lack of understanding of the economic instability prior to the trade war and how it got to that point.   

As we have discussed on numerous occasions, the Fed has used excessive monetary policy over the last decade to promote economic growth. Dudley and the Fed fail to recognize that their actions have led to rampant speculation in the financial markets, encouraged significant uses of debt for nonproductive purposes, and have fueled the wealth and income divergences. More concerning, their actions have reduced the natural economic growth rate of the country for years and possibly decades to come. Dudley and colleagues arranged the tinder for what will inevitably be an economic disaster. Trump may or may not be the spark.

Dudley sets up his article with a leading question-“This manufactured disaster-in-the-making presents the Federal Reserve with a dilemma: Should it mitigate the damage by providing offsetting stimulus, or refuse to play along?”

He answers, in part, by saying that, based on the Fed’s obligations and “conventional wisdom”, the Fed should respond to economic weakness due to the trade war by “adjusting monetary policy accordingly.” Historically, the Fed has changed policy to counter outside, non-economic factors.

Dudley, however, takes a different tack and asks if easier Fed policy would encourage “the President to escalate the trade war further.” This is where the editorial gets political. He goes on to state his case for the Fed taking a hard line and not adjust monetary policy if the trade war negatively affects economic activity. Dudley believes that by doing nothing, the Fed would:

  • Discourage further trade war escalation
  • Reinforce the Fed’s independence
  • Preserve much needed “ammunition”, as there is little room to cut rates

In the next paragraph, he stresses Trump’s attacks on Chairman Powell and provides more reasoning for the Fed to leave policy alone. Dudley believes the Fed, by not adjusting monetary policy to offset the effects of the trade war in progress, would send a clear signal to the President that he bears the risks of a recession and losing an election. The Fed, thereby, would not be complicit.  

Before going on, we think it’s appropriate to re-emphasize that the next recession will be amplified due to Fed actions over the last ten years. Bernanke should never have extended extraordinary measures beyond the first round of quantitative easing, and Janet Yellen had ample opportunities to raise interest rates and reduce the Fed’s balance sheet during her tenure. Trying to place all of the blame on the current President, or anyone else for that matter, may work in the media and even the populace but it does not line up with the facts.

Dudley’s Summary

Dudley concludes with a stunning and politically motivated statement- “There’s even an argument that the election itself falls within the Fed’s purview. After all, Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives. If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”   

Dudley is essentially imploring Powell to base monetary policy on the coming election. If Fed independence is what Dudley cherishes, he certainly did not do the Fed any favors. This implicates elites like Dudley, one of the “Davos Men,” who think they know better than the collective decisions of people engaged in free-market exchanges. It also makes him guilty of an effort to manipulate an election.

Summary

Here is an important question. Is this editorial solely Dudley’s thoughts, or was Jerome Powell and the Fed involved in any way?  The Fed has already come out against the article, but in Washington, nothing is ever that clear cut.

If the editorial was in some way subsidized or suggested by Powell, the implications of the Fed going after the President will call into question their independence in the future. No matter how deeply improper that is, it certainly leaves open the question of whether or not people are justified in those efforts. In the same way that no Fed official should ever be viewed as complicit, no President should impose his will from the bully pulpit of the Presidency to influence monetary policy.

From an investment perspective, this is not good. The markets have benefited from a Fed that has promoted asset price inflation and sought to convince us that the economic cycle is dead. Despite sky-high valuations, investors tend to believe that these valuations are fair and that the Fed will always be there as a reliable safety net.

We do not know how this saga will end, but we do know that if confidence in the Fed is compromised, investors will likely vote with their feet.

Caroline’s Summary

We leave you with some thoughts on the subject from Caroline Baum of MarketWatch:

“It is hard to fathom what Dudley was thinking in advocating such an off-the-wall idea of factoring political outcomes into policy decisions. The Fed has a dual mandate from Congress to promote maximum employment and price stability. There is nothing in that mandate, or in the Federal Reserve Act, about influencing election outcomes. Nothing in there either about being part of “the Resistance” to this president.

That would be a dangerous expansion of Federal Reserve’s operating framework.”

The Mechanics of Absurdity

Over the past few decades, the central banks, including the Federal Reserve (Fed), have relied increasingly on interest rates to help modify economic growth. Interest rate management is their tool of choice because it can be effective and because central banks regulate the supply of money, which directly effects the cost to borrow it. Lower interest rates incentivize borrowers to take on debt and consume while dis-incentivizing savings.

Regrettably, a growing consequence of favoring lower than normal interest rates for prolonged periods is that consumers, companies, and nations grow increasingly indebted as a percentage of their respective income. In many cases, consumption is pulled from the future to the present day. Accordingly, less consumption is needed in the future and a larger portion of income and wealth must be devoted to servicing the accumulated debt as opposed to productive ventures which would otherwise generate income to help pay off the debt.

Today, interest rates are at historically low levels around the globe. Interest rates are negative in Japan and throughout much of Europe. In this article, we expound on the themes laid out in Negative is the New Subprime, to discuss the mechanics of negative-yielding debt as well as the current mindset of investors that invest in negative-yielding debt.

Is invest the right word in describing an asset that when held to maturity guarantees a loss of capital?

Negative Yield Mechanics

Negative yields are not only bestowed upon sovereign debt, as investment grade and even some junk-rated debt in Europe now carry negative yields. Even stranger, Market Watch just wrote about a Danish bank offering consumers’ negative interest rate mortgages (LINK).

You might be thinking, “Wow, I can take out a negative interest rate loan, receive payments every month or quarter and then pay back what was lent to me?” That is not how it works, at least not yet. Below are two examples that walk through the lender and borrower cash flows for negative-yielding debt.

Some of the bonds trading at negative yields were issued when yields were positive and therefore have coupon payments. For example, in August of 2018, Germany issued a 30 year bond with a coupon of 1.25%. The price of the bond is currently $143, making the yield to maturity -0.19%. Today, it will cost you $14,300 to buy $10,000 face value of the bond. Going forward, you will receive coupon payments of $125 a year and ultimately receive $10,000 in 2048. Over the next 29 years you will receive $3,625 in coupon payments but lose $4,300 in principal, hence the current negative yield to maturity.

Bonds issued with a zero coupon with negative yields are similar in concept but the mechanics are slightly different than our positive coupon example from above. Germany issued a ten-year bond which pays no coupon. Currently, the price is 106.76, meaning it will cost an investor $10,676 to buy $10,000 face value of the bond. Over the next ten years the investor will receive no coupon payments, and at the end of the term they will receive $10,000, resulting in a $676 loss. The lower the negative yield to maturity, the higher premium to par and the greater loss of principal at maturity.

We suspect that example two, the zero-coupon bond issued at a price above par, will be the issuance model going forward for negative yielding bonds.

Why?

At this point, after reviewing the cash flows on the German bonds, you are probably asking why an investor would make an investment in which they are almost guaranteed to lose money. There are two predominant reasons worth exploring.

Safety: Investors that store physical gold in a gold vault pay a fee for safe storage. Individuals with expensive jewelry or other keepsakes pay banks a fee to use their vaults. Custodians, such as Fidelity or Schwab, are paid fees for the safekeeping of our stocks and bonds.

Storing money, as a deposit in a bank, is a little different from the prior examples. While banks are a safer place to store money than a personal vault, mattress, or wallet, the fact is that deposits are loans to the bank. Banks traditionally pay depositors an interest rate so that they have funds they can lend to borrowers at higher rates than the rate incurred on the deposit.

With rates negative in Europe and Japan, their respective central banks have essentially made the storing of deposits with banks akin to the storage of gold, jewelry, and stocks – they are subject to a safe storage fee.  Unfortunately, many people and corporations have no choice but to store their money in negative-yielding instruments and must lend money to a bank and pay a “storage fee.”  

On a real return basis, in other words adjusted for inflation, whether an investor comes out ahead by lending in a negative interest rate environment, depends on changes to the cost of living during that time frame. Negative yielding bonds emphatically signal that Germany will be in a deflationary state over the next ten years. With global central bankers taking every possible step, legal and otherwise, to avoid deflation and generate inflation, betting on deflation via negative yielding instruments seems like a poor choice for investors.

Greater Fool Theory: Buying a zero-coupon bond for 101 today with the promise of receiving 100 is a bad investment. Period. Buying the same bond for 101 today and selling it for 102 tomorrow is a great investment. As yields continue to fall further into negative territory, the prices of bonds rise. While the buyer of a negative-yielding bond may not receive a coupon, they can still profit, and sometimes appreciably as yields decline.

This type of trade mindset falls under the greater fool theory. Per Wikipedia:

“In finance and economics, the greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. In other words, one may pay a price that seems “foolishly” high because one may rationally have the expectation that the item can be resold to a “greater fool” later.”

More succinctly, someone buying a bond that guarantees a loss can profit if they can find someone even more willing to lose money.

Scenario Analysis

Let’s now do a little scenario analysis to understand the value proposition of holding a negative-yielding bond.

For all three examples we use a one year bond to keep the math simple. The hypothetical bond details are as follows:

  • Issue Date: 9/1/2019
  • Maturity Date: 9/1/2020
  • Coupon = 0%
  • Yield at Issuance: -1.0%
  • Price at Issuance: 101.00

Greater fool scenario: In this scenario, the bondholder buys the new issue bond at 101 and sells it a week later at 101.50. In this case, the investor makes a .495% return or almost 29% annualized.

Normalization: This next scenario assumes that yields return to somewhat normal levels and the holder sells the bond in six months.If the yield returns to zero in six months, the price of the bond would fall to 100. In this case, our investor, having paid 101.00, will lose 1% over the six month period or 2% annualized.

Hold to maturity: If the bond is held to maturity, the bondholder will be redeemed at par losing 1% as they are paid $100 at maturity on a bond they purchased for $101.

Summary

Writing and thinking about the absurdity of negative yields is taxing and unnatural. It forces us to contemplate basic financial concepts in ways that defy common sense and rational thought. This is not a pedantic white paper discussing hypothetical central bank magic tricks and sleight of hand; this is about something occurring in real-time.

Excessive monetary policy has been the crutch of growth for decades spurred by an intense desire to avoid and minimize otherwise healthy and routine economic corrections. It was fueled by the cult of personality which took over in the 1990s when Alan Greenspan was labeled “The Maestro”. He, Robert Rubin, and Lawrence Summers were christened “The Committee to Save the World” by Time magazine in February 1999.  Greenspan was then the subject of a biography by famed Watergate journalist Bob Woodward infamously titled Maestro in 2000.

Under Greenspan and then Bernanke, Yellen and now Powell, rational monetary policy and acknowledgement of naturally occurring business cycles has taken a back seat to avoidance of these economic cycles at all cost. As a result, central bankers around the world are trying justify the inane logic of negative rates.

Comparing Yield Curves

Since August of 1978, there have been seven instances where the yields on ten-year Treasury Notes were lower than those on two-year Treasury Notes, commonly referred to as “yield curve inversion.” That count includes the current episode which only just occurred. In all six prior instances a recession followed, although in some cases with a lag of up to two years.

Given the yield curve’s impeccable 30+ year track record of signaling recessions, we think it is appropriate to compare the current inversion to those of the past. In doing so, we can further refine our economic and market expectations.

Bull or Bear Flattening

In this section, we graph the seven yield curve inversions since 1978, showing how ten-year U.S. Treasuries (UST), two-year UST and the 10-year/2 year curve performed in the year before the inversion.

Before progressing, it is worth defining some bond trading lingo:

  • Steepener- Describes a situation in which the difference between the yield on the 10-year UST and the yield on the 2y-year UST is increasing. Steepeners can occur when both securities are trending up or down in yield or when the 2-year yield declines while the 10-year yield increases.
  • Flattener- A flattener is the opposite of a steepener, and the difference between yields is declining.  As shown in the graph above, the slope of the curve has been in a flattening trend for the last five years.
  • Bullish/Bearish- The terms steepener and flattener are typically preceded with the descriptor bullish or bearish. Bullish means yields are declining (bond prices are rising) while bearish means yields are rising (bond prices are falling). For instance, a bullish flattener means that both 2s and 10s are declining in yield but 10s are declining at a quicker pace. A bearish flattener implies that yields for 2s and 10s are rising with 2s increasing at a faster pace.  Currently, we are witnessing a bullish flattener. All inversions, by definition, are preceded by a flattening trend.

As shown in the seven graphs below, there are two distinct patterns, bullish flatteners and bearish flatteners, which emerged before each of the last seven inversions. The red arrows highlight the general trend of yields during the year leading up to the curve inversion.  

Data for all graphs courtesy St. Louis Federal Reserve

Five of the seven instances exhibited a bearish flattening before inversion. In other words, yields rose for both two and ten year Treasuries and two year yields were rising more than tens. The exceptions are 1998 and the current period. These two instances were/are bullish flatteners.

Bearish Flattener

As the amount of debt outstanding outpaces growth in the economy, the reliance on debt and the level of interest rates becomes a larger factor driving economic activity and monetary and fiscal policy decisions. In five of the seven instances graphed, interest rates rose as economic growth accelerated and consumer prices perked up. While the seven periods are different in many ways, higher interest rates were a key factor leading to recession. Higher interest rates reduce the incentive to borrow, ultimately slowing growth and in these cases resulted in a recession.

Bullish Insurance Flattener

As noted, the current period and 1998 are different from the other periods shown. Today, as in 1998, yields are falling as the 10-year Treasury yield drops faster than the 2-year Treasury yield. The curve thus flattens and ultimately inverts.

Seven years into the economic expansion, during the fall of 1998, the Fed cut rates in three 25 basis point increments. Deemed “insurance cuts,” the purpose was to counteract concerns about sluggish growth overseas and financial market concerns stemming from the Asian crisis, Russian default, and the failure of hedge fund giant Long Term Capital. The yield curve inversion was another factor driving the Fed. The domestic economy during the period was strong, with real GDP staying above 4%, well above the natural growth rate.  

The current period is somewhat similar. The U.S. economy, while not nearly as strong as the ’98 experience, has registered above-trend economic growth for the last two years. Also similar to 1998, there are exogenous factors that are concerning for the Fed. At the top of the list are the trade war and sharply slowing economic activity in Europe and China. Like in 1998, we can add the newly inverted yield curve to the list.

The Fed reduced rates by 25 basis points on July 31, 2019. Chairman Powell characterized the cut as a “mid-cycle adjustment” designed to ensure solid economic growth and support the record-long expansion. Some Fed members are describing the cuts as an insurance measure, similar to the language employed in 1998.

If 1998-like “insurance” measures are the Fed’s game plan to counteract recessionary pressures, we must ask if the periods are similar enough to ascertain what may happen this time.

A key differentiating factor between today and the late 1990s is not only the amount of debt but the dependence on it.   Over the last 20 years, the amount of total debt as a ratio to GDP increased from 2.5x to over 3.5x.

Data Courtesy St. Louis Federal Reserve

In 1998, believe it or not, the U.S. government ran a fiscal surplus and Treasury debt issuance was declining. Today, the reliance on debt for new economic activity and the burden of servicing old debt has never been greater in the United States. Because rates are already at or near 300-year lows, unlike 1998, the marginal benefits from borrowing and spending as a result of lower rates are much less economically significant currently.

In 1998, the internet was in its infancy and its productive benefits were just being discovered. Productivity, an essential element for economic growth, was booming. By comparison, current productivity growth has been lifeless for well over the last decade.

Demographics, the other key factor driving economic activity, was also a significant component of economic growth. Twenty years ago, the baby boomers were in their spending and investing prime. Today they are retiring at a rate of 10,000 per day, reducing their consumption and drawing down their investment accounts.

The key point is that lower rates are far less likely to spur economic activity today than in 1998. Additionally, the natural rate of economic growth is lower today, so the economy is more susceptible to recession given a smaller decline in economic activity than it was in 1998.

The 1998 rate cuts led to an explosion of speculative behavior primarily in the tech sectors. From October of 1998 when the Fed first cut rates, to the market peak in March of 2000, the NASDAQ index rose over 300%. Many equity valuation ratios from the period set records.

We have witnessed a similar but broader-based speculative fervor over the last five years. Valuations in some cases have exceeded those of the late 1990s and in other cases stand right below them. While the economic, productivity, and demographic backdrops are not the same, we cannot rule out that Fed cuts might fuel another explosive rally. If this were to occur, it will further reduce expected returns and could lead to a crushing decline in the years following as occurred in the early 2000s.  

Summary

A yield curve inversion is the bond market’s way of telegraphing concern that economic growth will slow in the coming months. Markets do not offer guarantees, but the 2s-10s yield curve has been right every time in the last 30 years it voiced this concern. As the book of Ecclesiastes reminds us, “the race does not always go to the swift nor the battle to the strong…”, but that’s the way to bet.

Insurance rate cuts may buy the record-long economic expansion another year or two as they did 20 years ago, but the marginal benefit of lower rates is not nearly as powerful today as it was in 1998.

Whether the Fed combats a recession in the months ahead as the bond market warns or in a couple of years, they are very limited in their abilities. In 2000 and 2001, the Fed cut rates by a total of 575 basis points, leaving the Fed Funds rate at 1.00%. This time around, the Fed can only cut rates by 225 basis points until it reaches zero percent. When we reach that point, and historical precedence argues it will be quicker than many assume, we must then ask how negative rates, QE, or both will affect the economy and markets. For this there is no prescriptive answer.

The Dog Whistle Heard Around The World

On August 15, 2019 the Washington Post led with a story entitled Markets sink on recession signal. The recession signal the Post refers to is the U.S. Treasury yield curve which had just inverted for the first time in over ten years.

We have been highlighting the flattening yield curve for the past six months. As we have discussed, every time the ten-year Treasury yield has fallen below the two-year Treasury yield, thus inverting the yield curve, a recession has eventually developed.

Blaming the yield curve for market losses because it inverted by a couple of basis points is a nonsensical narrative for talking heads on business television. This article is about a different concern, a second-order effect caused by headlines like the one shown below. The story in the Post and similar ones in many major publications have awoken the public to the real possibility that a recession may be coming. It is a dog whistle that may cause the public to alter their behavior, and even slight changes in consumption habits can produce outsized effects on economic activity.

Reality

The 2s/10s yield curve stood at 265 basis points on January 1, 2014, meaning the ten-year yield was 2.65% higher than the two-year yield. From that date forward, as shown below, it has steadily declined. Like the changing of the seasons, as the days passed, that spread steadily fell. Unlike the seasons, investors are somehow now suddenly shocked to learn that economic winter follows fall.  Since the beginning of 2019, the curve has been as steep as 25 basis points but has flirted with inversion on numerous occasions.

Given that the shape of the yield curve has been steadily flattening for five years, its current inversion ought not to be news. From an economic perspective, who cares, nothing has changed. The difference in a few basis points on the yield curve is truly meaningless. What has changed is investors’ behavioral instincts.

Explanation Bias

Blaming the yield curve for a market downturn is a narrative designed to fill the public need for an explanation on equity market losses. We talked to Peter Atwater, a behavioral specialist and guest on the Lance Roberts Show, to help us understand human behavior.

Per Peter: Confidence requires perceptions of certainty and control. Easily grasped narratives – even when they are woefully incorrect – fulfill both needs. Not sure that there is a formal name to the bias, but I would call it “Explanation Bias” – we need an easy story to fight against the anxiety that would arise from what would otherwise be randomness. And randomness is untenable.

We highly recommend following Peter on Twitter at @peter_atwater

In our need to explain and attempt to understand randomness, the public is now aware of a real and growing threat that was ignored just days prior. The sudden drop in the stock market and a potential catalyst for a much steeper decline is not necessarily about finance and economics; behavioral instincts are now in play.  

Over the past several months we have said the window for a potential recession is open. By this, we meant that economic stimulus was waning, global growth was slowing, and the potential for a recession has increased as a result. The hard part of our forecast was to name the catalyst that could tip the economy into recession.

We postulated that it might be the brewing trade war, Iran, slowing global growth, or any number of other topics in the media at the time. The problem, as we pointed out in naming a single catalyst or narrative, was that it really could be something inconsequential or something we have not pondered.

This concept is akin to avalanches. The structure of the hill, weather, and the way the snow is perched determine whether an avalanche will occur. The catalyst, however, is but one snowflake that causes a chain reaction.

It is possible the snowflake in our case is the media and the public’s awareness of the relationship between yield curve inversions and recessions.

If the headlines do spark new concern and even slightly modifies consumption patterns, a recession may come sooner than we think. If you harbor concerns that a recession is coming, aren’t you more likely to eat in or put off buying a new TV? These little and seemingly inconsequential decisions made by a minority of consumers can tip the scale and create negative economic growth.

Here is another way to think about it. Picture your favorite restaurant, one that is always packed and has a waiting list. One day you arrive on a Saturday night expecting to wait an hour for a table, but to your delight, the hostess says you can sit immediately. You look around and the restaurant is crowded, but uncharacteristically there are a few empty tables. Those empty tables, while seemingly insignificant, may mean the restaurant’s sales are down a few percent from the norm.

A few percent may not seem like a big deal, but consider that the average annual recessionary growth low point was only -1.88% for the last five recessions. If economic growth is weak, then small negative changes in output can take an economy from expansion to contraction quicker than if growth rates were stronger. This seems to exemplify the current situation as growth has been fairly tepid post-financial crisis.

Summary

We can follow all the economic data and trends diligently, but consumption accounts for over 70% of U.S. economic growth. Therefore, recessions ultimately tend to be the effect of changes in consumer behavior. If the narrative de jour is enough to trouble even a small percentage of consumers, the likelihood of a recession increases. The evidence of such a change will eventually turn up in sentiment surveys, and when it does, the problem has already taken root. This is not a dire warning of recession but rather offers consideration of a legitimate second-order effect that potentially threatens this record-long economic expansion. 

While the media focuses on the inversion narrative, alerting the public to recession warnings and driving consumers to re-think their planned purchases, we care more about when the yield curve will steepen. The steepening curve caused by aggressive Fed action after a curve inversion is the tried and true recession warning. For more, please read Yesterday’s Perfect Recession Warning May Be Failing You.

Negative Is The New Subprime

What is nothing? What comes to mind when you imagine nothing? The moment we try to imagine what nothing is, we fail, because nothing cannot be envisioned. There is nothing to envision or ponder or even think about. Nothing is no thing.

Yes, the point above is tedious, but the value of nothing in the financial theater is the latest magic trick of the central bankers and the most vital factor governing all investments.

If I invest my hard-earned capital in an asset the guarantees a return of nothing, what should I expect as a return? Nothing is a good answer, and somewhat absurdly, there is the possibility that nothing is the best-case scenario. Let’s take it one step further to beyond nothing. In the current age of financial alchemy, there is nearly $15.5 trillion in sovereign and corporate bonds available that promise a return of not only nothing but actually less than nothing.

If I am hired to steward capital and I invest in something that returns less than nothing, I have knowingly given away some portion of the capital I invested, and I should find another profession. And yet, on this very day, there are trillions of dollars’ worth of bonds that promise a return of less than nothing. Furthermore, there are many professional investors who knowingly and willingly are buying those bonds! The table below shows the many instances of negative-yielding sovereign bonds, with U.S. yields as a comparison.

Data Courtesy Bloomberg

Warped Logic

The discussion and table above highlight just how far astray the financial system has gone in Europe and Japan. What we are witnessing is not just coloring outside the lines; it is upside down and inside out. Central bankers are frantically turning cartwheels to convince us that current circumstances, though deranged and highly abnormal, are perfectly sane and normal. More often than not, politicians, the media, and Wall Street fail to challenge these experiments and worse generally echo the central bankers’ siren song.

How do investors conclude that there will be only good outcomes as a result of what are imprudent and illogical decisions and actions? Is it prudent to expect a bright future when the financial system punishes prudent savers who are most able to invest in our future and rewards ill-advised borrowing beyond one’s means?  

The current market and economic environment beg for lucid evaluation of circumstances and intelligent, honest discourse on the potential implications. Unfortunately, most market participants would prefer to keep their head in the sand. Chasing the stock and bond markets for the past decade has produced handsome returns and, for most investment advisors, delivered praise and a generous wage. As Upton Sinclair said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Compounding wealth is the most important and most difficult financial concept for investors to grasp. Over the last ten years, many investors spent significant time recouping losses from the financial crisis, and they assumed great risk in doing so. Having recovered some or all of those losses, many are back in a position of compounding wealth. At this point, they can continue to look backward and believe that irrational policies will ensure that the past is prologue, or they can exercise some independent thought and recognize that the risk of another serious drawdown is not negligible. Prudent risk management is very generous to those who elect patience over expedience. Most financial advisors will not volunteer a fee-reducing, conservative approach even though it would be in their own best interest to do so at critical times.

Entities empowered with the responsibility of directing traffic and ensuring against bad behavior that wish to “manage” markets are increasingly weighed and found wanting. They have become a part of the bad behavior they were entrusted to prevent, yet again. Actions, or the lack thereof, that resulted in the destruction of wealth in recent history have been on full display for over the past decade. However, with stock markets near record highs today, these actions (or inactions) are cloaked in an artificial façade of success.

Retrospect

It has become cliché to point back to October 1929, the dot.com bubble, and the housing bubble as a reminder of what may transpire. Bulls confidently look at the bears citing those periods, just as Monty Python’s King Arthur looks at the Black Knight after dismembering his arms and legs and says, “What are you going to do, bleed on me?”

Yet, historical episodes are the correct frame of reference. Just as in those prior bubbles, the problem today is right in front of our face. The evidence is clear and the lunacy unmistakable. The poster child in 2000 was Pets.com and the sock puppet; in 2006 it was skyrocketing home prices and negatively amortizing subprime “liar” loans. Today, it is negative interest rates.

It is not hyperbole to say that today’s instance of finance gone wild is more insane than Pets.com, neg-am liar loans and any other absurd Ponzi scheme that has ever been perpetrated, ALL PUT TOGETHER.

The dot.com market collapse cost the economy roughly $8 trillion. The estimate of the cost of the 2008-09 financial crisis is $22 trillion. The market value of debt outstanding with negative interest rates is over $15 trillion.

Data Courtesy Bloomberg

Although $15 trillion is less than the financial crisis losses, what must be considered is the multiplier effect. The losses in prior recessions were in part caused by the factors listed above but magnified by their ripple effect on other aspects of the economy and financial markets. This is the multiplier of the cause or the epicenter. Consider the following:

  • The S&P 500 Information Technology sector market cap was roughly $4 trillion in March 2000. The total market losses from the tech bubble amounted to about $8 trillion; therefore, the damage in that episode was about $2 for every $1 of exposure ($8T losses vs. $4T exposure) to the epicenter of the problem, so the multiplier was 2:1.
  • The toxic sub-prime part of the mortgage market was about $2 trillion. So, the impact of losses was $11 for every $1 of exposure ($22T loss vs. $2T exposure) to the epicenter, or a multiplier of 11:1.
  • If a problem emerged today and we are correct that the epicenter of this problem, negative-yielding debt, is further reaching than those prior mentioned episodes, then using a simple 11-to-1 ratio on $15 trillion is $165 trillion in losses, may be understating the potential problems. Even being very conservative with a 2:1 multiple yields mind-boggling losses.

This is unscientific scenario analysis, but it does provide a logical and reasonable array of possible outcomes. If one had postulated that the sub-prime mortgage market would spark even $2 trillion in losses back in 2007, they would have been laughed out of the room. Some people did anticipate the problem, made their concerns public, and were ridiculed. Even after the problem started, the common response was that sub-prime is too small to have an impact on the economy. In fact, the Fed and other central banks stood united in minimizing the imminent risks even as they were wreaking havoc on the financial system. Likewise, the “scientific” analysis currently being done by Ph.D. economists will probably miss today’s problem altogether.

European Banks

The concept of negative-yielding debt is totally irrational and incoherent. It contradicts every fundamental rule we learn and attempt to apply in business, finance, and economics.  It implies that the future is more certain than the present – that the unknown is more certain than the known!

When the investment/lending hurdle rate is not only removed but broadly disfigured in how we think about allocating resources, precious resources will be misallocated. The magnitude of that misallocation depends on the time and extent to which the policy persists.

As brought to our attention by Raoul Pal of Global Macro Investor and Real Vision, the first evidence of problems is emerging where the negative interest rate phenomenon has been most acute – Europe. European financial institutions are growing increasingly unhealthy due to the damage of negative rate policies. Currently, the Euro STOXX Bank index, as shown below, trades at levels below those of the trough of 2009 and its lowest levels since 1987. More importantly, the index is on the verge of breaking through a vital technical level to the downside. The shares of Germany’s two largest banks, Deutsche Bank and Commerzbank, are at historical lows.  Just as subprime was not isolated to the U.S., this problem is not isolated to Europe. These banks have contagion risk that, if unleashed, will spread throughout the global financial system. 

Data Courtesy Bloomberg

Summary

The market is reflecting a growing lack of confidence in the European banking and financial system as telegraphed through stock market pricing shown above.

The risk facing the global financial system is that, as problems emerge, the second and third-order effects of those issues will be both impossible to anticipate and increasingly difficult to control. Trust and confidence in the world’s central bankers can fade quickly as we saw only ten years ago.

Compounding wealth depends upon minimizing the risk of a large, permanent loss. If markets falter and the cause is monetary policy that advocated for negative interest rates, investors will have to accept accountability for the fact that it was staring us in the face all along.

The Prospects of a Weaker Dollar Policy- RIA Pro

This version, for RIA Pro subscribers, contains a correlation table at the end of the article to help better quantify short and longer term relationships between the dollar and other financial assets.

“Let me be clear, what I said was, it’s not the beginning of a long series of rate cuts.”- Fed Chairman Jerome Powell -7/31/2019

“What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world….” – President Donald Trump – Twitter 7/31/2019

With the July 31, 2019 Fed meeting in the books, President Trump is up in arms that the Fed is not on a “lengthy and aggressive rate-cutting” path. Given his disappointment, we need to ask what else the President can do to stimulate economic growth and keep stock investors happy. History conveys that is the winning combination to win a reelection bid.

Traditionally, a President’s most effective tool to spur economic activity and boost stock prices is fiscal policy. With a hotly contested election in a little more than a year and the House firmly in Democratic control, the odds of meaningful fiscal stimulus before the election is low.

Without fiscal support, a weak dollar policy might be where Donald Trump goes next. A weaker dollar could stimulate export growth as goods and services produced in the U.S. become cheaper abroad. Further, a weaker dollar makes imports more expensive, which would increase prices and in turn push nominal GDP higher, giving the appearance, albeit false, of stronger economic growth.

In this article, we explore a few different ways that President Trump may try to weaken the dollar. 

Weaker Dollar Policy

The impetus to write this article came from the following Wall Street Journal article: Trump Rejected Proposal to Weaken Dollar through Market Intervention. In particular, the following two paragraphs contradict one another and lead us to believe that a weaker dollar policy is a possibility. 

On Friday, Mr. Kudlow said Mr. Trump “ruled out any currency intervention” after meeting with his economic team earlier this week. The comments led the dollar to rise slightly against other currencies, the WSJ Dollar index showed.

But on Friday afternoon, Mr. Trump held out the possibility that he could take action in the future by saying he hadn’t ruled anything out. “I could do that in two seconds if I wanted to,” he said when asked about a proposal to intervene. “I didn’t say I’m not going to do something.”

Based on the article, Trump’s advisers are against manipulating the dollar lower as they don’t believe they can succeed. That said, on numerous occasions, Trump has shared his anger over other countries that are “using exchange rates to seek short-term advantages.”

As shown below, two measures of the U.S. dollar highlight the substance of frustrations being expressed by Trump. The DXY dollar index has appreciated considerably from the early 2018 lows but is still well below levels at the beginning of the century. This index is inordinately influenced by the euro and therefore not 100% representative of the true effect that the dollar has on trade. The Trade-weighted dollar which is weighted by the amount of trade that actually takes place between the U.S. and other countries. That index has also bounced from early 2018 lows and, unlike DXY, has reached the highs of 2002.

Data Courtesy Bloomberg

Trump’s Dollar War Chest

The following section provides details on how the President can weaken the dollar and how effective such actions might be.

Currency Market Intervention

Intervening in the currency markets by actively selling US dollars would likely push the dollar lower. The problem, as Trump’s advisers note, is that any weakness achieved via direct intervention is likely to be short-lived.

The US economy is stronger than most other developed countries and has higher interest rates. Both are reasons that foreign investors are flocking to the dollar and adding to its recent appreciation. Assuming economic activity does not decline rapidly and interest rates do not plummet, a weaker dollar would further incentivize foreign flows into the dollar and partially or fully offset any intervention.

More importantly, there is a global dollar shortage to consider. It has been estimated by the Bank of International Settlements (BIS) that there is $12.8 trillion in dollar-denominated liabilities owed by foreign entities. A stronger dollar causes interest and principal payments on this debt to become more onerous for the borrowers. Dollar weakness would be an opportunity for some of these borrowers to buy dollars, pay down their debts and reduce dollar risk. Again, such buying would offset the Treasury’s actions to depress the dollar.  

Instead of direct intervention in the currency markets, Trump and Treasury Secretary Steve Mnuchin can use speeches and tweets to jawbone the dollar lower. Like direct intervention, we also think that indirect intervention via words would have a limited effect at best.

The economic and interest rate fundamentals driving the stronger dollar may be too much for direct or indirect intervention to overcome.

From a legal perspective intervening in the currency markets is allowed and does not require approval from Congress. Per the Wall Street Journal article, “The 1934 Gold Reserve Act gives the White House broad powers to intervene, and the Treasury maintains a fund, currently of around $95 billion, to carry out such operations.” The author states that the Treasury has not conducted any interventions since 2000. That is not entirely true as they conducted a massive amount of currency swaps with other nations during and after the financial crisis. By keeping these large market-moving trades off the currency markets, they very effectively manipulated the dollar and other currencies.

Hounding the Fed

The President aggressively chastised Fed Chairman Powell for not cutting interest rates or ending QT as quickly as he prefers. Lowering interest rates to levels that are closer to those of other large nations would potentially weaken the dollar. The only problem is that the Fed does not appear willing to move at the President’s pace as they deem such action is not warranted. We believe the Fed is very aware that taking unjustifiable actions at the behest of the President would damage the perception of their independence and, therefore, their integrity.

To solve this problem, Trump could take the controversial and unprecedented step of firing or demoting Fed Chairman Powell.  In Powell’s place he could put someone willing to lower rates aggressively and possibly reintroduce QE. These steps might push financial asset prices higher, weaken the dollar, and provide the economic pickup Trump seeks but it is also fraught with risks. We have written two articles on the topic of the President firing the Fed Chairman as follows: Chairman Powell You’re Fired and Market Implications for Removing Fed Chair Powell.

It is not clear whether the President can get away with firing or even demoting Chairman Powell. We guess that he understands this which may explain why he has not done it already. If he cannot change Fed leadership, he can continue to pressure the Fed with Tweets, speeches, and direct meetings. We do not think this strategy can be effective unless the Fed has ample reason to cut rates. Thus far, the Fed’s mandates of “maximum employment, stable prices, and moderate long-term interest rates” do not provide the Fed such justification.

Getting Help Abroad

One of the core topics in the U.S. – China trade talks has been the Chinese Yuan. In particular, Trump is negotiating to stop the Chinese from using their currency to promote their economic self-interests at our expense. As of writing this, the U.S. Treasury deemed China a currency manipulator. Per the Treasury: “As a result of this determination (currency manipulator), Secretary Mnuchin will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Said differently, the U.S. and other nations can now manipulate their currency versus the Chinese Yuan.

It is plausible that Trump might pressure other countries, including our allies in Europe and Japan as well as Mexico and Canada, to strengthen their respective currencies against the dollar. Trump can threaten nations with trade restrictions and tariffs if they do not comply. If tariffs are enacted, however, all bets are off due to the economic inefficiencies of tariffs or trade restrictions. To the President’s dismay, such action weaken the economy and scare investors as we are seeing with China. 

Threats of trade actions, trade-related actions, or trade agreements might work to weaken the dollar, but such tactics would require time and pinpoint diplomacy. Of all the options, this one requires longer-term patience in awaiting their effect and may not satisfy the President’s desire for short-term results.

Summary

Before summarizing we leave you with one important thought and certainly a topic for future writings. Globally coordinated monetary policy is morphing into globally competitive monetary policy. This may be the most significant Macro development since the Plaza Accord in 1985 when the Reagan administration, along with other developed nations (West Germany, France, Japan, the UK), coordinated to weaken the U.S. dollar.

With the Presidential election in about 15 months, we have no doubt that President Trump will do everything in his power to keep financial markets and the economy humming along. The problem facing the President is a Democrat-controlled House, a Fed that is dragging their feet in terms of rate cuts, weakening global growth, and a stronger U.S. dollar.

We believe the odds that the President tries to weaken the dollar will rise quickly if signs of further economic weakness emerge. Given the situation, investors need to understand what the President can and cannot do to spike economic growth and further how it might affect the prices of financial assets.

On the equity front, a weaker dollar bodes well for companies that are more global in nature. Most of the companies that have driven the equity indices higher are indeed multi-national. Conversely, it harms domestic companies that rely on imported goods and commodities to manufacture their products. The price of commodities and precious metals are likely to rise with a weaker dollar. A weaker dollar and any price pressures that result would likely push bond yields higher.

The relationships between the dollar and various asset classes are important to monitoring how intentional changes in the value of the dollar may impact all varieties of asset classes. The addendum below quantifies short and longer-term correlations.

Addendum – Short & Long-term Asset Correlations

The following tables present short term daily correlations and longer-term weekly correlations between the dollar and several asset classes and sub-asset classes. The correlation data for each asset quantifies how much the price of the asset is affected by the price of the dollar. A positive correlation means the dollar and the asset tend to move in similar directions. Conversely, a negative relationship means they move in opposite directions. We highlighted all relationships that are +/- .30. The closer the number is to 1 or -1, the stronger the relationship. CLICK TO ENLARGE

The Prospects of a Weaker Dollar Policy

“Let me be clear, what I said was, it’s not the beginning of a long series of rate cuts.”- Fed Chairman Jerome Powell -7/31/2019

“What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world….” – President Donald Trump – Twitter 7/31/2019

With the July 31, 2019, Fed meeting in the books, President Trump is up in arms that the Fed is not on a “lengthy and aggressive rate-cutting” path. Given his disappointment, we need to ask what else the President can do to stimulate economic growth and keep stock investors happy. History conveys that is the winning combination to win a reelection bid.

Traditionally, a President’s most effective tool to spur economic activity and boost stock prices is fiscal policy. With a hotly contested election in a little more than a year and the House firmly in Democratic control, the odds of meaningful fiscal stimulus before the election is low.

Without fiscal support, a weak dollar policy might be where Donald Trump goes next. A weaker dollar could stimulate export growth as goods and services produced in the U.S. become cheaper abroad. Further, a weaker dollar makes imports more expensive, which would increase prices and in turn push nominal GDP higher, giving the appearance, albeit false, of stronger economic growth.

In this article, we explore a few different ways that President Trump may try to weaken the dollar. 

Weaker Dollar Policy

The impetus to write this article came from the following Wall Street Journal article: Trump Rejected Proposal to Weaken Dollar through Market Intervention. In particular, the following two paragraphs contradict one another and lead us to believe that a weaker dollar policy is a possibility. 

On Friday, Mr. Kudlow said Mr. Trump “ruled out any currency intervention” after meeting with his economic team earlier this week. The comments led the dollar to rise slightly against other currencies, the WSJ Dollar index showed.

But on Friday afternoon, Mr. Trump held out the possibility that he could take action in the future by saying he hadn’t ruled anything out. “I could do that in two seconds if I wanted to,” he said when asked about a proposal to intervene. “I didn’t say I’m not going to do something.”

Based on the article, Trump’s advisers are against manipulating the dollar lower as they don’t believe they can succeed. That said, on numerous occasions, Trump has shared his anger over other countries that are “using exchange rates to seek short-term advantages.”

As shown below, two measures of the U.S. dollar highlight the substance of frustrations being expressed by Trump. The DXY dollar index has appreciated considerably from the early 2018 lows but is still well below levels at the beginning of the century. This index is inordinately influenced by the euro and therefore not 100% representative of the true effect that the dollar has on trade. The Trade-weighted dollar which is weighted by the amount of trade that actually takes place between the U.S. and other countries. That index has also bounced from early 2018 lows and, unlike DXY, has reached the highs of 2002.

Data Courtesy Bloomberg

Trump’s Dollar War Chest

The following section provides details on how the President can weaken the dollar and how effective such actions might be.

Currency Market Intervention

Intervening in the currency markets by actively selling US dollars would likely push the dollar lower. The problem, as Trump’s advisers note, is that any weakness achieved via direct intervention is likely to be short-lived.

The US economy is stronger than most other developed countries and has higher interest rates. Both are reasons that foreign investors are flocking to the dollar and adding to its recent appreciation. Assuming economic activity does not decline rapidly and interest rates do not plummet, a weaker dollar would further incentivize foreign flows into the dollar and partially or fully offset any intervention.

More importantly, there is a global dollar shortage to consider. It has been estimated by the Bank of International Settlements (BIS) that there is $12.8 trillion in dollar-denominated liabilities owed by foreign entities. A stronger dollar causes interest and principal payments on this debt to become more onerous for the borrowers. Dollar weakness would be an opportunity for some of these borrowers to buy dollars, pay down their debts and reduce dollar risk. Again, such buying would offset the Treasury’s actions to depress the dollar.  

Instead of direct intervention in the currency markets, Trump and Treasury Secretary Steve Mnuchin can use speeches and tweets to jawbone the dollar lower. Like direct intervention, we also think that indirect intervention via words would have a limited effect at best.

The economic and interest rate fundamentals driving the stronger dollar may be too much for direct or indirect intervention to overcome.

From a legal perspective intervening in the currency markets is allowed and does not require approval from Congress. Per the Wall Street Journal article, “The 1934 Gold Reserve Act gives the White House broad powers to intervene, and the Treasury maintains a fund, currently of around $95 billion, to carry out such operations.” The author states that the Treasury has not conducted any interventions since 2000. That is not entirely true as they conducted a massive amount of currency swaps with other nations during and after the financial crisis. By keeping these large market-moving trades off the currency markets, they very effectively manipulated the dollar and other currencies.

Hounding the Fed

The President aggressively chastised Fed Chairman Powell for not cutting interest rates or ending QT as quickly as he prefers. Lowering interest rates to levels that are closer to those of other large nations would potentially weaken the dollar. The only problem is that the Fed does not appear willing to move at the President’s pace as they deem such action is not warranted. We believe the Fed is very aware that taking unjustifiable actions at the behest of the President would damage the perception of their independence and, therefore, their integrity.

To solve this problem, Trump could take the controversial and unprecedented step of firing or demoting Fed Chairman Powell.  In Powell’s place he could put someone willing to lower rates aggressively and possibly reintroduce QE. These steps might push financial asset prices higher, weaken the dollar, and provide the economic pickup Trump seeks but it is also fraught with risks. We have written two articles on the topic of the President firing the Fed Chairman as follows: Chairman Powell You’re Fired and Market Implications for Removing Fed Chair Powell.

It is not clear whether the President can get away with firing or even demoting Chairman Powell. We guess that he understands this which may explain why he has not done it already. If he cannot change Fed leadership, he can continue to pressure the Fed with Tweets, speeches, and direct meetings. We do not think this strategy can be effective unless the Fed has ample reason to cut rates. Thus far, the Fed’s mandates of “maximum employment, stable prices, and moderate long-term interest rates” do not provide the Fed such justification.

Getting Help Abroad

One of the core topics in the U.S. – China trade talks has been the Chinese Yuan. In particular, Trump is negotiating to stop the Chinese from using their currency to promote their economic self-interests at our expense. As of writing this, the U.S. Treasury deemed China a currency manipulator. Per the Treasury: “As a result of this determination (currency manipulator), Secretary Mnuchin will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Said differently, the U.S. and other nations can now manipulate their currency versus the Chinese Yuan.

It is plausible that Trump might pressure other countries, including our allies in Europe and Japan as well as Mexico and Canada, to strengthen their respective currencies against the dollar. Trump can threaten nations with trade restrictions and tariffs if they do not comply. If tariffs are enacted, however, all bets are off due to the economic inefficiencies of tariffs or trade restrictions. To the President’s dismay, such action weaken the economy and scare investors as we are seeing with China. 

Threats of trade actions, trade-related actions, or trade agreements might work to weaken the dollar, but such tactics would require time and pinpoint diplomacy. Of all the options, this one requires longer-term patience in awaiting their effect and may not satisfy the President’s desire for short-term results.

Summary

Before summarizing we leave you with one important thought and certainly a topic for future writings. Globally coordinated monetary policy is morphing into globally competitive monetary policy. This may be the most significant Macro development since the Plaza Accord in 1985 when the Reagan administration, along with other developed nations (West Germany, France, Japan, the UK), coordinated to weaken the U.S. dollar.

With the Presidential election in about 15 months, we have no doubt that President Trump will do everything in his power to keep financial markets and the economy humming along. The problem facing the President is a Democrat-controlled House, a Fed that is dragging their feet in terms of rate cuts, weakening global growth, and a stronger U.S. dollar.

We believe the odds that the President tries to weaken the dollar will rise quickly if signs of further economic weakness emerge. Given the situation, investors need to understand what the President can and cannot do to spike economic growth and further how it might affect the prices of financial assets.

On the equity front, a weaker dollar bodes well for companies that are more global in nature. Most of the companies that have driven the equity indices higher are indeed multi-national. Conversely, it harms domestic companies that rely on imported goods and commodities to manufacture their products. The price of commodities and precious metals are likely to rise with a weaker dollar. A weaker dollar and any price pressures that result would likely push bond yields higher.

The statistical relationships between the dollar and other asset classes are important to quantify if in fact the dollar may become an economic tool for the President. A full spectrum of those relationships over various timeframes may be found in an addendum to this article for RIA Pro subscribers. Give us a try. All new subscribers receive a 30 day free trial to explore what we have to offer and view the addendum.   

The Fed’s Massive Debt for Equity Swap

All assets are priced where they are today because of central banks. That’s modern finance — it’s not about psychology or flows anymore, it’s about what the central banks are going to do next.” – Mark Spitznagel

Cause and Effect

Rene Descartes, a 17th-century mathematician, asked the fundamental question of how causal power functions. He was interested in how things relate to each other in terms of causality and how the thought of an action gets translated into a physical action. The theory he came up with, called “Interactionism,” affirms the relationship between thought and action. Importantly for our discussion, Descartes knew that any effect must have an antecedent cause.

When we are unclear about something, Descartes teaches us to search diligently for first principles, those things about which we are certain, and then explore what might have caused an event or observed the effect.

Warnings

In recent weeks, we have heard a variety of pundits, including a parade of Federal Reserve (Fed) officials speaking about mounting risks in the credit markets. Steve Eisman, who correctly pre-identified the magnitude of the sub-prime mortgage debacle, expressed confidence in commercial banks but worried that a U.S. recession would bring “massive” losses to the corporate bond market. The Fed published a report stating that there are meaningful risks in the corporate bond markets due to the amount of issuance that has occurred over the past decade and the weak credit quality of much of that issuance. As documented in many prior articles, we concur with those concerns and suggest the effect has a nasty way of sneaking up on central bankers. For our latest on the topic please read The Corporate Maginot Line.

The potential problems brewing in the credit markets are an effect. Corporations did not just decide to issue mountains of debt, much of which is low rated and of poor quality, for no reason at all. They did it, in large part, as a result of the economic and market environment created by the Fed through low interest rates and quantitative easing (QE).

The Fed removed over $4 trillion of the highest quality bonds out of the domestic market. In doing so, they pushed interest rates to historic lows. The combined effect all but forced investors to seek out higher-yielding, riskier instruments. As a result, the demand was ready and more than willing to absorb the on-coming wave of corporate supply and to do so at remarkably low yields and therefore very favorable terms for the issuers.

Cause

At the depths of the financial crisis, the Fed advertised QE as a means to boost asset prices, create a wealth effect, and fuel consumer borrowing and spending. It was sold as an economic growth booster that would benefit everyone. The ultimate objective was to staunch the crisis and foster an economic recovery.

Through QE, the Fed did this by acquiring mortgage and Treasury bonds from large banks and crediting those banks’ reserve accounts with digitally manufactured U.S. dollars. From September 2008 until January 2015, when the third round of QE was completed, the Fed balance sheet swelled by nearly $4 trillion while bank reserves grew from $2 billion (that’s $0.002 trillion) in July 2008 to almost $3.0 trillion.

As the Fed acquired vast amounts of high quality fixed-income securities from banks through QE, it created a vacuum in the bond market that had to be filled. The vanishing high-quality Treasuries and mortgages generated fresh demand for investments of lower-quality bonds.

Strong investor demand was met by corporations increasingly anxious to issue cheap debt to fund their activities. While those activities included capital expenditures, the debt increasingly was used to fund dividend payouts and share buybacks. Not coincidently, while the Fed’s balance sheet was expanding by $4 trillion, corporate debt outstanding exploded from $5 trillion to well over $9 trillion.

Debt-for-equity

As mentioned, the Fed removed high-quality securities from the market enabling corporate issuers to step in to fill the resulting gap. Since QE began, nearly 30% of the new corporate debt issued was used for stock buybacks. Putting the pieces of the mosaic together, it is fair to say the most intense corporate debt-for-equity swap in recorded history was enabled by the Fed via monetary policy and the federal government through tax-cuts.

This is symptomatic of a variety of issues that have been created by prolonged extraordinary monetary policy. In the same way that corporate behavior has been seriously altered as described above, every central bank in the developed world has undertaken even more extreme measures to foster growth, dictating that the behavior of market participants transform in some manner.

The chart below is a stark reminder of how the Fed has changed the natural order of the corporate debt market. Over the past 25 years, when corporate debt loads became onerous, investors required higher yields and wider spreads to compensate them for the added risks.

Today, despite the extreme amount of corporate leverage and the low quality of corporate credit, junk spreads remain near all-time lows. As shown below and highlighted by the red arrow, the long-standing correlation between leverage and high yield spreads is broken.

Data Courtesy: Bloomberg

This gross distortion and many others throughout the market offer clues and compelling evidence of a “cause.” Collectively, they point to a monetary policy that is manipulating the price of money and fostering irrational behaviors.

Effect

In his book, Economics in One Lesson, Henry Hazlitt states, “…the whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

The side-effects of extraordinary monetary policy, especially those that have been left in place for a decade, have scarcely been considered by the Federal Reserve. What was great (as in “get filthy rich” great) for the banks and the wealthy was not such a hot deal for the rest of the American public. The side effects are becoming more apparent and serious every day. As an aside, the rolling wave of populism did not emerge unprompted. It too is an effect. As Deep Throat said to Woodward and Bernstein, “Follow the money.”

Instead of investing in new property, plant, equipment, innovation, and employee training for the long-term benefit of their shareholders, employees, and the communities in which they operate, companies instead are taking advantage of ultra-low funding costs to buy back expensive stock. In a desire to prop up stock prices to enhance their compensation and satisfy short term investors, corporate executives have and continue to make poor capital allocation choices.

If the goal was to increase shareholder value via a temporarily higher share price, then corporations succeeded, albeit temporarily. The goal always should be to increase long-term shareholder value via stronger growth; a goal corporations have largely ignored. After ten years of poor decision making, many companies are left with inflated stock prices but dim prospects for future growth to fund their obese debt structures.

Summary

A weak post-crisis economic recovery that hurt low income wage earners alongside monetary policy that fueled steady gains in the cost of living meant many people were going to be left behind. The calculus did not anticipate that effect would extend so far up into the middle class. Struggling to maintain their previous standard of living, consumers borrow at the Fed’s new cheap rates. Quoting from the book, The Big Short, “If you want to make poor people feel rich, give them cheap loans.

That is exactly what the Fed did after the financial crisis for more than a decade and counting. That game has an unhappy effect as the economy loses productive capacity and has little fuel to spur organic growth and wage gains.

The series of events playing out right before us, like a pre-release movie trailer, reveals teasing fragments of information. The corporate debt market is today’s teaser. The set-up for that was the Fed-induced debt-for-equity swap. To anyone willing to pay attention to the data, it is again plain to see the excesses brewing in today’s environment which is eerily similar to those of 2005 and 2006. Even Dallas Fed President Kaplan has raised a warning flag by highlighting the amount and poor quality of corporate debt which could add to the burden on the economy in a downturn. He diplomatically understates the problem but at least he acknowledges it.

Monetary policies of the Fed are the cause. Those policies enable imprudent deficit-spending and accumulation of leverage at ultra-low interest rates.

Debt loads in the government, corporate and household sector, and various other hidden imbalances are the effect. What we know about circumstances is a concern, but what should be especially troubling are those things of which we are not even yet aware.

Turning back to Descartes, he offers this wisdom: “The senses deceive from time to time, and it is prudent never to trust wholly those who have deceived us even once.”

Federal Reserve Headlines – Fact or Fiction?

When it becomes serious, you have to lie.” – Jean-Claude Juncker, former President of the Eurogroup of Eurozone finance ministers

On July 16, 2019, Chicago Federal Reserve President Charles Evans made a series of comments that were blasted across the financial news wires. In the headlines taken from his speech on the 16th and other statements over the past few weeks, Mr. Evans argues for the need to cut interest rates at the July 31st meeting and future meetings.

In this article, we look at his rationale and provide you with supporting graphs and comments that question his logic supporting the rate cuts. We pick on Charles Evans in this piece, but quite honestly, he is reiterating similar themes discussed by many other Fed members.

The issues raised here are important because the Fed continues to play an outsized role in influencing asset valuations that are historically high. As such, it is incumbent upon investors to understand when the Fed may be on the precipice of making a policy error. If asset prices rest on confidence in the Fed, what will happen when said confidence erodes?

The Fed’s Mandate

Before comparing reality with his recent headlines, it is important to clarify the Fed’s Congressional mandate as stated in the Federal Reserve Act. The entire Federal Reserve act can be found HERE. For this article, we focus on Section 2A- Monetary Policy Objectives as follows:

The stock market is at all-time highs, bond yields are well below “moderate,” unemployment stands at 50-year lows, and prices are stable. Based on the Fed’s objectives, there is certainly no reason to cut rates.

Evans Thoughts versus Reality

All of the headlines below in red are courtesy of Bloomberg News and the data is sourced from Bloomberg and the St. Louis Federal Reserve

There are a lot of risks out there, citing BREXIT

BREXIT, the UK withdrawal from the European Union (EU), passed in a public referendum over three years ago. Since then, lawmakers on both sides of the Channel have tried unsuccessfully to fulfill voters’ wishes. The exit was supposed to occur by March 29, 2019 but was extended to October 31, 2019. BREXIT is not a new risk. In fact, there was a high likelihood of a hard BREXIT in late March before the extension, and the Fed never mentioned it then as a reason to take action.  Further, the Bank of England (BOE) and the European Central Bank (ECB), not the Fed, are the parties that should be first in line to mitigate any financial/monetary risks associated with Europe and any repercussions coming from BREXIT. At some point Fed action may be warranted if a hard BREXIT occurs and rattles global economies. However, acting in advance on what might or might not happen is not the Fed’s job.

There are other risks, such as the ongoing trade war with China, the coming debt cap, and Iran to name a few. We ask you though, has there ever been a period where numerous concerns and risks did not exist?

Fed should not generate excess stimulus

The first graph quantifies the level of Fed Funds and the amount of QE, allowing us to compare monetary stimulus over the last 40 years. Clearly, the last ten years, including the current period, is excessive and if anything means the Fed should be removing “excess stimulus.”

For more details on this graph and other measures of excessive stimulus, please read our article Why the Fed’s Monetary Policy is Still Very Accommodative.

Other evidence also indicates that current monetary policy is excessive. For instance, the graph below, courtesy of Mr. Evans own Chicago Federal Reserve, shows that national financial conditions are near the easiest of any period in the last 50 years. Of the 2,531 weekly data points in the graph, only 60 weekly periods (2.3%) had easier financial conditions than today. Again, conditions are easy because monetary policy is very accommodative. Excess is an appropriate term to describe the state of monetary policy and it may actually be an understatement.

We need to do everything we can to get to 2% inflation

The Federal Reserve Act clearly says the Fed should promote stable prices. Stable prices do not axiomatically mean 2% inflation as they have interpreted it. The Act also makes no mention of persistent inflation that compounds over time.

The following graph shows the level of prices since the Revolutionary War. From 1775 to 1971 prices were relatively stable, except during times of war. Since 1971, when Nixon revoked the gold standard and allowed the Fed carte blanche to manipulate the money supply, higher annual prices have accumulated, resulting in massive price inflation.

The Fed’s 2% inflation target is a far cry from the price stability mandate to which they are supposed to adhere.

Says path of U.S. economy is toward trend growth

Mr. Evans uses language that suggests U.S. GDP has been running below trend but making progress toward trend growth. Based upon data supplied by the St. Louis Fed, real GDP has been running above trend for the last eight quarters as shown below.

Inflation situation alone calls for two 25 basis point cuts by year’s end

The following graphs show various measures of inflation and inflation expectations. It is hard to point to any recent inflation trends in these graphs that have meaningfully changed from the trends of the last few years. Given this broad set of data, why does the current inflation “situation” warrant even more aggressive monetary policy action?

Economic fundamentals are solid / U.S. economy is really quite solid

Mr. Evans is right. GDP was a little soft in the second quarter, but it was running above trend for the prior eight quarters. With Fed Funds still at dangerously low levels, the Fed’s balance sheet swollen beyond any historical precedent, and the economy “really quite solid,” his call for rate cuts does not reconcile with his own assessment of the economy.

Says he forecasts 50 basis points of accommodation to lift inflation

Using data going back to 1990, the graph below shows that there is no statistical relationship between the Fed’s (current) preferred measure of inflation (PCE) and the Fed Funds rate they manage. PCE measured a year forward to the current Fed Funds rate demonstrates even less of a relationship.

Based on data provided by the Fed, the idea that the Fed possess a magical joystick which enables them to control prices is fallacious. Evan’s statement lacks any statistical backing and is a complete guess at best. At worst, it is an intentional effort to influence public sentiment improperly.

Summary

The conclusions here suggest that Evans logic is flawed and misleading. Based on his arguments, the Fed has no basis to cut interest rates. Fed speakers that modify their language daily, as they have been doing over the prior month or two, to conjure support for rate cuts put their integrity and investor confidence in the Fed at risk.

The primary objective of Fed policy should be geared toward imperceptible adjustments to foster a well-functioning market-based economy. On the contrary, what we increasingly see is a market-economy increasingly jostled and cajoled by hair-on-fire day-traders posing as a monetary authority. By employing well publicized micro-management tactics, the Fed naturally increases the chances of a policy error. Indeed, the proper characterization of that risk is that the Fed increases the likelihood of further policy errors compounding the legacy issues already in play thanks to Powell’s predecessors.

Given the reliance of equity prices on the so-called “Fed Put” and the excessive valuations in many asset markets, we advise paying close attention as a policy error could quickly cause assets to re-price to properly reflect their inherent risks, and then some. Seldom do those adjustments stop at fair value.

The Wisdom of Peter Fisher

“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President

In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.

Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.

In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.

Define “Normal”

Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”

For instance:

  • The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
  • The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.

The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.

In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.

As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.

Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.

Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?

The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.

Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.

Second-Order Effects

As Fisher stated in his remarks at the conference, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.

The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.

Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.

Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”

As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”

What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”

A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”

Linear Extrapolation

Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”

Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.

Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.

That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.

Summary

Fisher fittingly sums up by restating the point he made at the beginning:

“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”

The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.

Undoing Extraordinary Monetary Policy

INTERVIEW: Raoul Pal – The Coming Debt-Driven Crisis & Why The Fed Can’t Stop It.

I recently had the privilege to visit with Raoul Pal, the founder of Real Vision, to discuss a variety of topics including:

  • The risk of recession in the U.S.
  • What Trump’s nomination of Judy Shelton to the Fed means.
  • Can you have a gold standard AND zero interest rates.
  • The future of the ECB and monetary policy in Europe
  • The real value of gold.

After we stopped rolling tape on the interview Raoul and I kept going and discussed Facebook’s Libra, cypto currency, and how much you should own. The cameras kept rolling so we have a great bonus clip for you.

Check out the new FREE version of Real Vision at www.realvision.com/free

I hope you enjoy our interview with Raoul Pal.


RECESSION: Can The U.S. Have A Recession Without GDP Showing It?


The Future Of The Fed, Monetary Policy, Rates, Judy Shelton, IMF, and the ECB


The True Value Of Gold


BONUS TRACK: Crypto Currency, Facebook’s LIBRA, & How Much You Should Own.


A Fly in the Ointment

Many financial assets, especially those that are the riskiest, are priced well above their respective fundamental values. A thank you primarily belongs to unprecedented monetary policy conducted on a domestic and global scale. The vast financial rewards and temporary economic stability attributed to central bank actions appear to be blinding many investors to the longer-term consequences of these actions and the implications for their investments in an era of monetary policy normalization.

Accordingly, we discuss the proverbial fly in the ointment, or what might prevent central bankers from being able to successfully “manage” markets with their extraordinary policies.

The Fed Put

Many investors assume that, if the equity markets decline in a meaningful way, the Federal Reserve (Fed) will once again spring into action to halt the decline. The so-called “Fed Put” is not new; in fact, it was originally coined the “Greenspan Put” due to the actions of Fed Chairman Alan Greenspan following the 1987 stock market crash. At that time, the Fed led by Greenspan added liquidity to the financial system to comfort investors and make them willing to buy financial assets. Ever since the Fed has been increasingly active vocally and via monetary policy in attempting to stem sharp market declines.  

It is important to understand that the Fed does not stop stock market declines by purchasing stocks directly. They provide verbal influence and liquidity to banks which works its way through the financial plumbing to the markets.  Therefore, and of huge importance, the effectiveness of Fed actions is highly dependent on the trust and willingness of investors. To retain this trust, the Fed must remain vigilant of market conditions.

The Fed’s attentiveness has been on full display since the Financial Crisis of 2008. On numerous occasions since the Crisis, relatively minor equity index declines elicited speeches by Fed members to subtly, and not so subtly, remind the market of their money printing capabilities. In fact, even when markets rested at all-time highs, they have been quick to remind the public of their abilities. The following two examples serve as evidence:

  • On the morning of October 15, 2014, with the S&P 500 down over 3% on the day and nearly 10% since mid-September, Federal Reserve Bank of St. Louis President and FOMC voting member James Bullard stated that QE might be extended. This was curious, to say the least, considering that in the weeks prior he mentioned that it was time to reduce QE. Bullard’s simple reminder of QE spurred the bulls to actions. From the moment he mentioned QE, the S&P 500 rallied over 2% and closed the day down less than 1%. In the two weeks following, it rose another 10% and closed the month at record highs. That action was later deemed the “Bullard Stick Save.”
  • We were recently reminded of this in the fourth quarter of 2018. By Christmas Eve stock markets were down nearly 20% over the preceding three months. Within a month, Jerome Powell and the Fed all but put an end to further rate hikes and halted quantitative tightening (QT). These actions were ultimately made official in the months following and all with negligible economic evidence to support such a sharp reversal in monetary policy.  

Inflation and the U.S. Dollar

Over the last 30 years, the Fed’s primary weapon to support markets has been interest rate reductions using the Fed Funds target rate. Since 2008, money printing, technically known as quantitative easing (QE), was introduced as the zero bound on interest rates constrained the Fed from reducing the Fed Funds rate further. Lower interest rates and QE have proven to be an incredibly powerful driver of asset prices, but only as long as inflation is benign and the dollar is relatively stable.   

Inflation: Before the low and stable inflation environment of the last 20 years, inflation was much more of a concern. From 1972 to 1980, inflation, as measured by annual changes in the consumer price index (CPI), increased from 3% to nearly 15%. Under Chairman Paul Volcker (1978-1987) and Arthur Burns (1970-1978), the Fed aggressively increased the Fed Funds rate to put a lid on inflation and reinforce confidence in the U.S. dollar. These leaders prescribed the necessary medicine with little regard for the stock market.

The graph below compares Fed Funds and CPI to the S&P 500 in the 1970s.  Note that, in 1973 and 1974 under the chairmanship of Arthur Burns, the Fed aggressively removed liquidity from the financial system by raising the Fed Funds rate despite mounting losses in the S&P 500.

Data Courtesy: Bloomberg

Had the Fed sat on their hands out of concern for stock prices, it is quite likely inflation would have kept rising and the dollar may have been at risk of losing its status as the world’s reserve currency. That would have produced global turmoil along with massive repercussions for economic growth for years to come. The Fed prescribed medicine that would further aggravate current economic woes but with the promise of a healthier domestic and global economic environment in the future.

Currently, inflation hovers near the Fed’s target level and they characterize risks to growth as balanced. However, asset inflation resulting from the Fed’s easy money policies is soaring. Stock prices, as measured by prices and importantly valuations, and at or near record highs, largely due to excessive amounts of liquidity injected by global central banks to combat the financial crisis. Interest rates remain at historically low levels and credit spreads near some of the tightest levels of the last 50 years. Art, classic cars, high-end real-estate, and a host of other assets are engulfed in the same mania driving more traditional financial assets. 

Recently we have seen some data from corporate earnings reports and corporate surveys that suggests inflation is starting to form. Although still weak, wages have also turned higher. Price pressures are still benign, but if inflation were to suddenly rise beyond the Fed’s 2% target, the Fed would become more vigilant.

While the Fed believes some inflation is a sign of a healthy economy, they do not want rampant inflation and the associated economic consternation resulting from significantly higher interest rates. Given the enormous debt burden of the U.S. government, corporations, and households, the impact of higher inflation and higher interest rates, is much greater now than at any time in history.

Despite their recent posture of patience and gradualism, if traditional measures of inflation were to move abruptly higher, the Fed will likely react with a more hawkish tone and likely raise Fed Funds rate and resume plans to reduce their balance sheet. While the intention would be to reverse inflationary pressures, the result may be to stoke them further. Monetary velocity will become an important data point to follow to gain insight on how Fed actions might affect prices.

Given the financial market’s dependence on an accommodative Fed and low interest rates, such actions would likely reverse the asset price inflation witnessed since 2009 when the Fed began conducting such extraordinary monetary policy.  

U.S. Dollar

The other factor allowing the Fed to maintain such extraordinary monetary policy is the relative stability of the U.S. Dollar. Following the double-digit inflation of the 1970s and the Fed’s drastic actions to bring it down, the dollar index rose dramatically as shown below. Upon peaking in 1985, the dollar eventually traded back to the low levels seen during the high inflation era of the late 1970s. Since that time, the dollar has been relatively stable.

As illustrated in the graph, one can spot weakness leading up to the 2008 crisis, but the dollar has since recovered.  Somewhat counter-intuitively, the dollar has strengthened since 2011 despite the Fed printing money on an unprecedented scale.  The reason lies in the way the value of the dollar is portrayed. The dollar index is essentially a weighted index based on cross-currency exchange rates between many of our largest trade partners. While the U.S. printed money, many other countries were following suit and the dollar was able to maintain its relative value.

Some of the recent strength in the dollar lies in the fact that QE has ended in the U.S. while it continues aggressively in many other developed nations. Furthermore, the Fed has been gradually raising interest rates and reducing the size of its balance sheet. These actions are currently on hold, but nonetheless, the Fed still has a more hawkish stance than most other developed nations.

A weak dollar has two major effects. U.S. exports increase as dollar-based goods are cheaper outside of the U.S., and goods imported into the U.S. from other countries become more expensive. As a net importing country, the net effect in the U.S. of the two factors above should be higher inflation.  Additionally, a weak dollar bodes poorly for foreign investments in the U.S. Over 40% of publicly traded government bonds are held by foreigners, and a sizeable share of private lending/investment is done by foreign entities as well. When the dollar declines versus the domestic currency of the foreign entity, the value of these investments declines. This, in turn, makes further investment less likely and raises the possibility that current holdings might be liquidated.

For a country that is overly reliant on debt and needs to fund current consumption and the debts of years past, a weaker dollar is a big problem. Thus, it is likely the Fed would want to prop up the dollar in the event of significant weakness. In an inflationary environment, this would be accomplished through a higher Fed Funds rate, a reduced balance sheet and Fed rhetoric, all of which would likely be troubling for risk assets.

Summary

As we mentioned, the Fed Put is dependent upon an unspoken pact and high level of trust with investors. Investors will push markets higher and take on substantial risk in exchange for the implied protection of the Federal Reserve. Today, in the wake of the Fed’s most recent policy reversal based on weak stock prices, investor trust in the Fed is seemingly greater than ever. Although there has been a great deal of turnover among Fed members, there is currently little reason to suspect the Fed will change their methods or that investors will question the Fed’s intent.

In an economy transitioning from an ultra-easy policy stance to one less so, high inflation and/or pronounced dollar weakness can happen suddenly eliciting a more severe response from the Fed. If they are unable to effectively navigate the narrow path between accommodation and inflation vigilance, the trust in the Fed that is driving markets could disappear quickly.

With so many events converging to introduce new uncertainty into the economy, the stability of markets that investors have enjoyed and faith in the Fed seems very much in jeopardy.

Its The Economy Stupid

In the months leading up to the Presidential election of 1992, Bill Clinton advisor James Carville coined the phrase “It’s The Economy Stupid” as a rallying cry for his candidate. At the time the U.S. economy was mired in weak economic growth despite having recently emerged from a recession. Democratic hopeful Bill Clinton was quick to remind voters of the circumstance and place direct blame on his opponent, George H.W. Bush. The strategy James Carville and Bill Clinton employed focused on the fact that presidential incumbents fare poorly when the economy is suffering.

“Long in the tooth” and “bottom of the ninth inning” are phrases we have recently used to describe the current economic cycle. In just a matter of days, this economic expansion will tie the period spanning 1991-2001 as the longest era of uninterrupted growth since at least 1857.  

Whether the current expansion ends with a recession starting next week, next month or next year is unknown. What is known is that the odds of a recession occurring before the presidential election in a year and a half are reasonably high. As evidenced by public Fed-bashing for raising interest rates, this point is clearly understood by President Trump. 

Boosting Growth Beyond Its Natural Bounds

Donald Trump can certainly win reelection, but his chances are greatly improved if he avoids a recession and keeps the stock market humming along. Accomplishing this is not an easy task for several reasons as we expand on.

Trend Economic Growth

The natural growth rate of the economy is about 2% per annum and declining. The graph below shows the ten-year average growth rate and its trend over the last 60 years.

Data Courtesy: St. Louis Federal Reserve

The slope of the trend line is -0.0336x, meaning that trend growth is expected to decline further by 0.0336% per year or approximately 0.34% per decade.

Fiscal Stimulus

During Trump’s term, economic growth has run 0.50-0.75% above trend in large part due to various forms of fiscal stimulus, including tax reform, hurricane/fire relief, and increased deficit spending. In 2018 for example, Treasury debt outstanding increased by $1.48 trillion as compared to an increase of $515 billion in the prior year. The difference of nearly $1 trillion directly boosted GDP for 2018 by approximately 1.30%.

Even if the Treasury’s net spending were to increase by another $1.48 trillion this year, the incremental contribution to GDP growth for 2019 would be zero. Any decline in Treasury spending from prior year levels will reduce economic growth.  It is a story for another day, but most economic measures are centered on percentage growth rates and not absolute dollars, meaning what matters most is the rate and direction of change.  

Given that control of the House of Representatives is in Democratic control we find it unlikely that deficits can increase markedly from current levels. Simply, the Democrats will not do anything to boost the economy and help Trump’s election chances.

Monetary Stimulus

Without the help of fiscal stimulus and a low rate of natural economic growth, Trump’s best hope to sustain 3-4% economic growth and avoid a recession by 2020 is for the Fed to lower interest rates and quite possibly re-introduce QE. Trump and his economic team have been publically insistent that the Fed does just that. Consider the following clips from the media:

3/29/2019 – White House economic advisor Larry Kudlow says he wants the Fed to cut its overnight lending rate by 50 basis points “immediately.”

4/5/2019 – (Reuters) – “I think they should drop rates,” Trump told reporters. “I think they really slowed us down. There’s no inflation.”  The U.S. president also suggested that the central bank pursue an unconventional monetary policy called “quantitative easing” that was used to nurse the economy back after the global financial crisis. “It should actually now be quantitative easing,” Trump said.

3/26/2019 – Stephen Moore, Donald Trump’s nominee for a seat on the Federal Reserve Board, told the New York Times that the central bank should immediately reverse course and lower interest rates by half a percentage point.

4/14/2019

The Fed has partially acquiesced to Trump’s public demands. Over the last three months, the Fed has gone from a steadfast policy of further rate hikes and QT on “autopilot,” to ending the prospect of interest rate increases this year and halting QT by the end of the third quarter.

As far as the next step, reducing rates and possibly reengaging in QE, the Fed does not seem willing to do anything further. Consider the following clips from the media:

3/27/2019 – “I doubt we’re accommodative, but I also doubt we’re restrictive,” said Dallas Fed President Robert Kaplan. “If we’re restrictive, it is very modest.”

4/12/2019 – Minneapolis Fed President Neel Kashkari says it isn’t time to cut rates.

3/20/2019 – Per the FOMC statement from the most recent meeting- The Fed expects the benchmark rate to stay near 2.4 percent by the end of 2019.

4/11/2019 – “We’re strictly nonpartisan” “We check our political identification at the door” -Jerome Powell

4/12/2019 – Per Bond Buyer: Powell said to tell Democrats Fed won’t bend to pressure.

Based on the statements above and others, the Fed appears comfortable that their current policy is appropriate. It does not seem likely at this time that they will “bend to pressure” to get Trump and his team off their backs. 

Summary

Given that fiscal stimulus and the anemic growth trend will do little to help Donald Trump win reelection, all eyes should focus on the Fed. Pressure on the Fed to lower rates and start back up QE will become much stronger if the economy slows further and/or the stock market declines.

We believe the Fed will try to protect its perceived independence and keep policy tighter than the President and his team prefers. This dynamic between the President wanting a stronger economy to help his election chances and a Fed focused on maintaining their independence is likely to fuel fireworks on a scale rarely if ever seen in public. The market implications of such a publically waged battle should not be ignored.

This article is a prelude to another following soon which discusses the investment implications and consequences if Donald Trump were to fire or replace Chairman Powell.

Just in case you are wondering we believe the President can fire the Chairman despite no historical precedence for such an action. The paragraph below is from the Federal Reserve Act.

The Fed’s Body Count

The problem with the war (Vietnam), as it often is, are the metrics. It is a situation where if you can’t count what’s important, you make what you can count important. So, in this particular case what you could count was dead enemy bodies.” – James Willbanks, Army Advisor, General of the Army George C. Marshall Chair of Military History for the Command and General Staff College

If body count is the measure of success, then there’s a tendency to count every enemy body as a soldier. There’s a tendency to want to pile up dead bodies and perhaps to use less discriminate firepower than you otherwise might in order to achieve the result that you’re charged with trying to obtain.” – Lieutenant Colonel Robert Gard, Army and military assistant to Secretary of Defense Robert McNamara

Verbal Jenga

In recent press conferences, speeches, and testimony to Congress, Federal Reserve (Fed) Chairman Jerome Powell emphasized the Fed’s plan to be “patient” regarding further adjustments to interest rates. He also implied it is likely the Fed’s balance sheet reductions (QT) will be halted by the end of the year.

The support for this sudden shift in policy is obtuse considering his continuing glowing reports about the U.S. economy. For example, the labor market is “strong with the unemployment rate near historic lows and with strong wage gains. Inflation remains near our 2% goal. We continue to expect the American economy will grow at a solid pace in 2019…” The caveats, according to Powell, are that “growth has slowed in some major foreign economies” and “there is elevated uncertainty around several unresolved government policy issues including Brexit, ongoing trade negotiations and the effect from the partial government shutdown.

Powell’s juggling of monetary policy and economic projections is a form of verbal Jenga with the blocks delicately stacked. Powell hopes to avoid saying anything to disrupt the structure without regard for veracity. To read more on our perception of his authenticity, read our latest article: Jerome Powell on 60 Minutes: Fact Check.

Jerome Powell’s policy rationale and politics is not entirely logical. Does it make sense to manage U.S. monetary policy to the self-inflicted BREXIT risks associated with the U.K., a country with a productive output about one-tenth that of the United States? Or with concerns about growth in China, which has never produced reliable public economic data? Or the residual effects of the U.S. government shutdown, which had an impact of less than 0.1% of GDP?

The Fed’s mandate, as legislated by Congress, is to manage the economy to full employment and stable inflation. Nothing about Powell’s recent comments justify policy change based on those guidelines. The change in policy is primarily speculative conjecture. It was also speculative conjecture that was behind Bernanke’s speech in January of 2008, where he confidently stated that a recession was not in the cards and his earlier comments that a national housing recession was implausible.

Mandates that Matter

What if the Fed had goals that really mattered like productivity and prosperity metrics that offer a genuine gauge of the health of the nation? What if they focused on the long-term cause and effect of their actions as opposed to becoming the day-traders they are, with a focus predominately on the markets and the wealthy?

The tiny world the Fed currently occupies is hyper-focused on “inflation” (which they cannot measure), unemployment (which is backward looking) and “financial stability” which is a catch-all for rationalizing whatever they choose to do at any given moment, namely propping up the stock market. These are undefinable goals which allow the Fed to move the goalposts as frequently as necessary to accommodate whichever constituent is least satisfied at the moment (President Trump, the stock market, the banks, etc.).

Markets and economies, like nature itself, are beholden to a cycle, and part of the cycle involves a cleansing that allows for healthy growth in the future. Does it really make sense to prop up dead “trees” in the economy rather than allow them to fall and be used as a resource making way for new growth?

The Fed’s War

The Fed’s version of economic assessment is like the metrics used to justify military action in Vietnam. Footage of Huey helicopters lifting nets full of dead “enemy soldiers” supported the optics of an American military campaign making progress in the war against Soviet-style communism. The “kill ratio”, calculated as the ratio of dead “gooks” divided by the number of dead American boys, was an important measure of success (The highly offensive term “gooks” was an all-encompassing, common slang term used by U.S. military forces to make soldiers think of all Vietnamese as sub-human and therefore easier to kill men, women, and children). 

The problem was that the government and military manufactured numbers that made it look as though they were making progress in the war. They did not actually “manufacture” numbers so much as improperly include dead Vietnamese civilians in with the count of actual North Vietnamese soldiers and Viet Cong militia. These metrics were a guise for a true measure of success or failure. Need more enemy dead to boost the kill ratio? Use less discriminating firepower to get a broader sweep of destruction to boost the number.

The Fed, however, cannot even pretend to count what is important – productivity and inflation – so they make it up as they go along. They use pieces of economic data that tell whatever tale they need to retain the confidence of leadership, banks, and citizens. They give speeches, hold press conferences and even go on 60 Minutes to advance the spin. It is the current-day equivalent of “counting corpses” to get the numbers needed.

As with the Vietnam War, the game-theory of monetary policy being applied today is intended to obfuscate and demoralize those who argue against it. Unlike Vietnam, however, where body count became the important metric, the Fed concocts metrics and analysis such as r-star, fabricated inflation statistics, and questionable labor composites.

They have, as firepower, the support of the established government, which depends on the Fed to serve its complicit role in support of government spending and rampant national debt accumulation. As the graph below reflects, the trajectory of U.S debt outstanding is the pure mathematical definition of a parabolic curve. Having greatly reduced any possibility of true organic growth, debt has become the backbone of economic growth.

Data: Flow of Funds – Domestic Non-financial

In coordination with the U.S. Treasury Department, the Fed acts in a manner that incentivizes the very behavior they should discourage. The Fed punishes savers by manufacturing lower interest rates to spur consumer and corporate borrowing and spending at a time when both are heavily burdened by existing debt. As a result, savings are diminished and investment suffers. When investment is reduced, productivity, the main source of economic dynamism and advancing standards of living, suffers.

Fed policy advances debt-driven consumption and spending before savings and investment, which puts the economic cart before the horse. Eventually, as we are now seeing, this destructive cycle causes prosperity to deteriorate. Citizens become fed up with the establishment rule and begin to elect radical politicians with radical ideas about how to fix the system.

Reactionaries

The Fed has shown themselves to be more worried about the stock market than the long-term well-being of the populace. Unlike Paul Volcker, who took on enormous career risk in his handling of monetary policy in the late 1970s and early 1980s, it appears there is no one with a similar level of character or integrity at the Fed today. There is no one willing to sacrifice in the short run for the long run health of the nation. Volcker was, at the time, vilified for making difficult and painful decisions in his time at the helm of the Fed, but ultimately, he set the stage for one of the greatest periods of growth and innovation in American history. Today, the Fed is held hostage by the fluctuations of the stock market and the protestations of the President.

We would do better if we would show ourselves a little more relaxed and less terrified of what happens in… certainly the smaller countries of Asia and Africa, and not jump around like an elephant frightened by a mouse every time these things occur. This is not only not our business, but I don’t think we can do it successfully… I have a fear that our whole thinking about this problem is still affected by some sort of illusions about invincibility on our part.” – George Kennan

George Kennan was an academic who advanced the U.S. policy of pacification during the first 20 years of the cold war. His doctrines were frequently misused in the justification of U.S. foreign policy in Southeast Asia in the 1950s and 1960s. As troop buildup in Vietnam continued in the mid-1960s, Kennan was called to testify before Congress. Despite his warnings of an unwinnable war, politicians seeking re-election could not bring such a message to the American public. Better to sacrifice the lives of less-privileged 19-year-old boys than admit a flaw in the U.S. foreign and the military policy machine. Besides that, building bombs to be blown up in a foreign country boosted economic output even though there was nothing productive or beneficial about it.

Today, Kennan’s comments can easily be mapped to the proclivity of central bankers’ actions and the stock market “mouse.”

Complex System

The United States economy is an extremely complex and dynamic system. Trying to measure the level and pace of economic growth, employment, inflation, and productivity are very difficult, if not impossible tasks. The various government and private agencies bearing the responsibility for such measurement do their best in what must be acknowledged as a highly imperfect effort. Initial readings are always revised, sometimes heavily, especially at key turning points in the economy.

Of greater concern, we are led to assume the methodology used to assess the quality of economic growth is not only proper but precise. However, one glance at the components of GDP shows the inclusion of activities that are questionable and excludes other things that clearly should be included. As a result, economic policy-making focuses on those things which are measured according to their preferences without regard for accuracy or importance. Emphasis is placed on “body count” without proper discernment. For more on this read our article The Fallacy of Macroeconomics.

Summary

In the Vietnam War, General William Westmoreland maintained a strategic emphasis on attacking North Vietnamese troops which supported the Viet Cong guerillas in South Vietnam. Westmoreland referred to something he called “the crossover point.” This was defined as the point at which U.S. military forces were killing more of the North Vietnamese enemy troops than could be replaced. It was truly a strategy of attrition. As a result of this concept, as discussed above, what became important as a grisly gauge of success was “body count.” Since body count was all that mattered, everyone became an enemy soldier whether innocent civilian or North Vietnamese military officer.

You don’t get details with a body count. You get numbers. And the numbers are lies, most of them. If body count is your success mark, then you are pushing otherwise honorable men to become liars. – Joe Galloway, News Correspondent, and Journalist

In the same way that Westmoreland’s approach to executing the Vietnam War failed to produce results, served as a false justification for actions taken, and cost countless young American and Vietnamese lives, the U.S. government and the Fed are engaged in misreading the optics of a series of measures in the economy to justify their actions as evidenced by the following:

  1. Fed policy is influenced by the constituents of the Central Bank which includes the federal government, major global banking institutions, and the wealthiest 1%
  2. U.S. interest rates, the global benchmark for the price of money, are manipulated by Fed policy
  3. Stock market valuations are heavily influenced by manipulated interest rates and currencies
  4. Stock market prices are manipulated higher by share buybacks facilitated by low-interest rates
  5. The federal government, through advocacy of the Securities Exchange Commission’s (SEC) share buyback Rule 10b-18, endorses stock price manipulation policies

“We tend to fight the next war in the same way we fought the last one. We are prisoners of our own experience. It was a kind of oversimplification of the problem combined with our overconfidence that caused us, I think, to be arrogant. And it’s very, very difficult to dispel ignorance if you retain arrogance.” – Lieutenant General Sam Wilson, Army

Federal Reserve actions and the Vietnam War are worlds apart, but the thinking in the mind of the bureaucrat is very similar. Misleading tactics are often used as a tool for those that need to justify something that makes little to no sense and violates moral code.

Jerome Powell on 60 Minutes: Fact Check

On Sunday, March 11, 2019, Federal Reserve Chairman Jerome Powell was interviewed by Scott Pelley on 60 Minutes. We thought it would be helpful to cite a few sections of their conversation and provide you with prior articles in which we addressed the topics discussed.

We have been outspoken about the role of the Fed, their mission and policy actions over the last ten years. We are quick to point out flaws in Fed policy for a couple of reasons. First, is simply due to the enormous effect that Fed policy actions and words have on the markets. Second, many in the media seem to regurgitate the Fed’s actions and words without providing much context or critique of them. The combination of the Fed’s power over the market coupled with poor media analysis of their words and actions might expose investors to improper conclusions and therefore sub-optimal investment decision-making.

With that, we review various parts of the 60 Minutes interview and offer links to prior articles to help provide alternative views and insight as well as a more thorough context of Chairman Powell’s answers.  

Click the following links for the interview TRANSCRIPT and VIDEO.

Can the Fed Chairman be fired?

PELLEY: Do you listen to the president?

POWELL: I don’t comment on the president or any elected official.

PELLEY: Can the president fire you?

POWELL: Well, the law is clear that I have a four-year term. And I fully intend to serve it.

PELLEY: So no, in your view?

POWELL: No.

Our Take: Yes, the Federal Reserve Act which governs the Fed makes it clear that he can be fired “for cause.”- Chairman Powell You’re Fired

Does the Fed play a role in driving the growing income and wealth inequality gaps?

PELLEY: According to federal statistics, the upper half of the American people take home 90% of income, leaving about 10% for the lower half of Americans. Where are we headed in this country in terms of income disparity?

POWELL: Well, the Fed doesn’t have direct responsibility for these issues. But nonetheless, they’re important.

Our Take:  Inflation hurts the poor and benefits of the wealthy. The Fed has an inflation target and therefore takes direct policy action that fuels the wealth divide. – Two Percent for the One Percent

Will Chairman Powell know when a recession is upon us?

PELLEY: This is the longest expansion in American history. How long can it last?

POWELL: It will be the longest in a few months if it continues. I would just say there’s no reason why it can’t continue.

PELLEY: For years?

Our Take: In January of 2008 Chairman Bernanke said a recession was not in the cards. It turns out the official recession started a month earlier.– Recession Risks Are Likely Higher Than You Think

How healthy is the labor market?

POWELL: So, the U.S. economy right now is in a pretty good place. Unemployment is at a 50-year low.

Our Take: We continually hear about the strength of the labor market. While that may seem to be the case, wages and the labor participation rate paint a different picture. – Quick Take: Unemployment Anomaly (RIA Pro – Unlocked)

Do record high stock valuations represent healthy financial conditions?

PELLEY: We have seen big swings in the stock markets in the United States. And I wonder, do you think the markets today are overvalued?

POWELL: We don’t comment on the valuation of the stock market particularly. And we do though, we monitor financial conditions carefully. Our interest rate policy works through financial conditions. So we look at a very broad range of financial conditions. That includes interest rates, the level of the dollar, the availability of credit and also the stock market. So we look at a range of things. And I think we feel that conditions are generally healthy today.

Our Take: We beg to differ with over 100 years of history on our side. – Allocating on Blind Faith (RIA Pro – Unlocked)

Is the Fed Chairman aware of the burden of debt and its economic consequences?

PELLEY: But the overarching question is are we headed to a recession?

POWELL: The outlook for our economy, in my view, is a favorable one. It’s a positive one. I think growth this year will be slower than last year. Last year was the highest growth that we’ve experienced since the financial crisis, really in more than ten years. This year, I expect that growth will continue to be positive and continue to be at a healthy rate.

Our Take: The record amount of debt on an absolute basis and relative to economic activity is a burden on the economy. Expectations should be greatly tempered. – The Economic Consequences of Debt and Economic Theories – Debt Driven Realities

Does Chairman Powell bow at the altar of the President and Congress?

On December 17 & 18 of 2019 President Trump tweeted the following: 

“It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering yet another interest rate hike. Take the Victory!”

I hope the people over at the Fed will read today’s Wall Street Journal Editorial before they make yet another mistake. Also, don’t let the market become any more illiquid than it already is. Stop with the 50 B’s. Feel the market, don’t just go by meaningless numbers. Good luck!”

PELLEY: Your Fed is apolitical?

POWELL: Strictly non-political.

Considering the Fed made an abrupt U-Turn of policy following the Tweets above, a sharp market decline and very little change in the data to justify it, we think otherwise. – The Fed Doesn’t Target The Market

Summary

The Fed has a long history of talking out of both sides of their mouths. They make a habit of avoiding candor about policy uncertainties in what appears to be an effort to retain credibility and give an appearance of confidence. The Fed’s defense of their extraordinary actions over the past ten years and reluctance to normalize policy is awkward, to say the least and certainly not confidence inspiring. As evidenced by his responses to Scott Pelley on 60 Minutes, Jerome Powell is picking up where Bernanke and Yellen left off.

This article aims to contrast the inconsistencies of the most current words of the Fed Chairman with truths and reality. Thinking for oneself and taking nothing for granted remains the most powerful way to protect and compound wealth and avoid large losses.

Navigating With The R Star

“It’s difficult to make predictions, especially about the future.” – Niels Bohr

On November 28, 2018, Federal Reserve (Fed) Chairman Jerome Powell gave a speech at the Economics Club of New York that sent the stock market soaring by over 2%. The reason cited by market pundits was the reversal of language he used a few weeks earlier suggesting that the Fed still had several more rate hikes ahead. In other words, he softened that tone and seemed to imply that the Fed was close to pausing.

By most accounts, Fed policy remains very accommodative but the “Powell Pivot”, which began in late November and continues to this day, hinges on an obscure metric called R-Star (r*).  Even though interest rates have been held low and vast amounts of liquidity force fed into markets through quantitative easing, the idea that interest rates should not rise much further presents a unique dilemma for the Fed. Rationalizations for their guidance hinges on r*. Before going in to details about this important measure, let us reflect on history.

Doomed To Repeat It

“Well, we currently see the economy as continuing to grow, but growing at a relatively slow pace, particularly in the first half of this year. As the housing contraction begins to wane, as it should sometime during this fiscal year, the economy should pick up a bit later in the year. –Federal Reserve Chairman Ben Bernanke on January 17, 2008 in response to Congressman John Spratt ranking member of the House Budget Committee

The table below was a document used on an unscheduled Fed conference call on January 9, 2008 to discuss deteriorating credit conditions in the U.S. economy. At that time and unbeknownst to the Fed, the economy slipped into recession the prior month, yet the Fed’s commentary and one- and two-year outlook for growth remained positive. The point is not to deride Bernanke and the Fed, but show that even the most well-informed PhD economists struggle to forecast economic activity or assess current economic conditions properly.

The challenge in assessing the outlook for a highly complex system like the U.S. economy cannot be overstated. Yet, what we saw in the past and still see currently, is a small group of people with enormous influence over the economy failing to grasp the natural mechanisms of a market economy. To put it another way, the Fed continues to believe that they know things they simply cannot know, and most concerningly, they set monetary policy on the basis of that fallacy.

An Abstract Barometer

Over the past several years, Fed economists invented a concept that purportedly identifies the point at which monetary policy is “neutral” or in equilibrium with economic activity. This number, called r* (r-star), is abstract and imprecise as it requires a variety of assumptions about the level of interest rates and economic activity. R* is formally defined as the “inflation-adjusted, short-term interest rate that is consistent with the full use of economic resources and steady inflation at or near the Fed’s target level.

As discussed in Clues from the Fed II – A Review of Jerome Powell’s Speech 11/27/18, his exact language was the following:

“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.”

The current “target level” for the Fed Funds rate, the primary interest rate lever used to impact the economy by altering interest rates, is currently in a range of 2.25-2.50%. What Powell seems to have implied, or what the market gleaned from the comment above, is that the Fed may only increase the target rate by another 0.25-0.50% as opposed to the 1.00-1.50% forecast by the very same Fed just two months prior. The extent to which the Fed is willing to tighten monetary policy by raising interest rates has a dramatic impact on the amount of risk investors are willing to take. Thus, with the dovish change in Powell’s language, the stock market took off.

Just The Facts

The data on the economy remains robust. Annualized GDP growth through the 3rd quarter of 2018 was 3.3% and the unemployment rate sat near a historic low at 3.9%. The regional surveys from the Fed consistently reflect that companies are having difficulty finding qualified workers, which implies that demand is good and wage growth, a key determinant of inflation, is likely to move higher. The index of Leading Economic Indicators remains solidly positive and consumer and business sentiment surveys nationally, while weakening, continue to point towards expansion.  

Data Courtesy: St. Louis Federal Reserve

Examining charts of various measures of inflation also offers insight into current circumstances. The traditional measures of inflation, Consumer Price Inflation (CPI) and Core (ex-food & Energy) CPI seem benign with core levels at roughly 2.2% although those indicators have declined modestly in recent months.

Data Courtesy: St. Louis Federal Reserve

Alternative inflation indicators like the Employment Cost Index (ECI) wages and average hourly earnings reflect a steady trend of rising wage pressures as shown in the chart below.

Data Courtesy: St. Louis Federal Reserve

The chart below uses the ECI Wages and Salaries data from above and compares it with two components of compensation from the NFIB small business survey. As shown, both metrics demonstrate mounting wage pressures. The NFIB survey shows that companies planning to raise worker compensation is trending higher. Additionally, the survey shows that the single biggest problem for small business is availability of quality labor (correlation using 9-month lead is over 76%) and that measure is also trending higher.

Data Courtesy: St. Louis Federal Reserve

Manufacturing activity captured via the Purchasing Managers Index (PMI) appears to lead CPI with some durability. The correlation is 52% since 2000 and 76% since 2006. Given the current level of manufacturing activity, it suggests that Core CPI should remain above 2.0% over the next several months.

Data Courtesy: St. Louis Federal Reserve

Economies Are Hard To Forecast

Economic systems are complex with many hidden, unobservable and non-linear relationships making economic activity very difficult to forecast. However, by applying simple logic about possible outcomes, we can better frame the risks of higher inflation due to wage pressures. If, as is currently forecast, GDP growth begins to gradually decline as the effects of tax reform and fiscal stimulus diminish, then we should expect gains in employment to moderate. That scenario does not necessarily argue for unemployment to rise which leaves the current labor market situation tight. The effects described above would remain well in place and higher labor costs could reasonably push inflation higher. Higher inflation would put upward pressure on long-term interest rates while creating a headwind for corporate profits, margins and stock prices. That would not be good for most investors.

Another scenario, again given the difficulties associated with forecasting GDP, is that economic growth does not moderate as much as expected and remains somewhat above the post-crisis trend. Labor costs, in that case, would accelerate and could cause wage inflation to move meaningfully higher. Clearly, the risks emanating from that scenario would be very bad for both stocks and bonds and thus a world enamored with passive investing and awash in 60/40 portfolios.

Other Info

A cursory review of other economic data provides even more evidence that the level of interest rates is well below what it should be. Household net worth, industrial production and retail sales are all more than fully recovered from the crisis and have been for some time. Furthermore, the U.S. never experienced deflation, and thus the common point of comparison and rationalization for gradual policy adjustments – that the U.S. could end up in a situation akin to what Japan has been experiencing and combatting for decades – rings hollow. The counter-factual argument is that Fed actions prevented a “Japan-like” outcome, but there is no evidence to support that claim. All this strongly argues that the Fed Funds target rate remains not just slightly accommodative as Powell acknowledges but extremely accommodative.

The following graph, from our article Why Fed’s Monetary Policy Is Still Very Accommodative, shows that the current level of monetary policy is accommodative and unprecedented over the last four decades.

Fortunetellers

Since the financial crisis, the Fed has exerted ever more influence over the economy through extraordinary policy measures. Importantly, their financial crisis and post-crisis involvement came partially as a result of their prior involvement in stoking a housing and stock market bubble that in part led to the crisis.

Now, as they seek to reverse out of those policies, their job is proving more difficult than anticipated and contrary to what Bernanke, Yellen and Dudley told us as they were enacting said policy. That circumstance does not appear to have imposed much humility on the Fed. Despite all their innovations, such as r*, complex labor market indicators, data dependency and forward guidance, Jerome Powell is flying just as blind as Bernanke was in the early innings of the financial crisis. He confirmed this by reasserting and then reversing prior language around his assessment of the economy four times since October 3, 2018. This is not the most confidence-inspiring tactic for a Fed Chairman.

A more reliable approach to monetary policy would be to allow markets to dictate prices. Billions of buyers and sellers, borrowers and lenders, who transact every day are collectively better informed than the small group of unelected and unaccountable figureheads at the Fed. Should the Fed find the urge to become engaged, and it would be a rare occasion indeed, they should respond to market forces and stay out of the way of the robust pricing mechanisms of markets.

Summary

The analogy for the Fed and its approach to monetary policy is one of a driver on a curvy country road. A licensed driver obeying the law who pays attention to the speed limit and other important road signs indicating warnings should be able to successfully navigate to a destination. If, however, the driver decides to navigate by anticipating the contours of the road and confidently driving above the speed limit, he will eventually end up off the road, through a fence or over a cliff. Unfortunately, we are all passengers along for the Fed’s ride currently.

Most of us are willing passengers, having been convinced that the Fed knows what they are doing. That is understandable given the influence on markets from the trillions in liquidity they supplied, but it is not true. The consequences of years of excessive policy will eventually begin to reveal themselves, and we posit they already are. The intersection of manipulated economic forces and societal outrage are exhibit A. What is so confounding, is the misplaced trust in the entities and leaders that are causing the problems described.

R* and all the other economic terms that supposedly guide policy-makers are conjured from the realm of scientific economic analysis but human beings and their behavior cannot be modeled in a spreadsheet. The problem is the failure to apply proper humility or even common sense when crafting the formulas on which policies rest and livelihoods depend.

Normal Is In The Eye Of The Beholder – RIA PRO

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester, and discussed HERE, it turns out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence:

Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.”

The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

This article was made exclusive to RIA Pro subscribers on February 25th. We share it with you to demonstrate one of the many benefits of subscribing to RIA Pro. If you would like to take us for a test ride, use the coupon code PRO30 for a 30-day free trial. To learn more please click here.

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

Normal is in the Eye of the Beholder

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester and discussed HERE, it turs out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence: “Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.” The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

The Coming Age of Real Assets

What do these four periods have in common?

  • 1861-1865
  • 1916-1920
  • 1941-1950
  • 2010-2018

On close inspection, the first three eras are periods of major U.S. military conflicts (The Civil War, World War I, and World War II), but you may be wondering why we included the recent, post financial crisis era. The reason is that these four instances are periods of excessive monetary stimulus. The chart below, recently published by JP Morgan Asset Management, illustrates average real yields in 5-year periods since 1830.

As shown, historical periods of negative real yields (market interest rates below the rate of inflation) developed out of the dire need to fund deficit-spending associated with the massive cost of those wars.

In stark contrast with those major events, that is not what is happening today. The current period is a remarkable anomaly as it stems not from war but from years of financial chicanery and monetary policy experimentation. This period is something altogether different and will certainly have consequences that many fail to anticipate.

We have been frequent critics of the Federal Reserve (Fed) and the other major central banks for all their various forms of so-called sound central banking policies. The manufactured stimulus resulting from interest rate manipulation and money printing aimed at forcing stock prices higher has wide ranging effects. Some are easily noticeable in the short term and other distortions and consequences will only be observable over longer periods of time. This article discusses one such distortion that presents an investment opportunity in the making.

As discussed in Wicksell’s Elegant Model, when the market rate of interest is held below the natural rate of interest (a proxy for economic growth) as has been the case since the financial crisis, capital tends to get misallocated on a vast scale. Companies and investors that can borrow at ultra-low cost are more incentivized to re-invest in existing assets. They do not need or want to take on the risk and time demands of deploying capital into new long-term projects. This is even truer today as executive compensation packages, laden with stock options, reward such behavior.

The result is a price boom in existing financial assets such as stocks and bonds. Because capital is largely directed to financial assets, commerce increasingly shuns investment in new property, plant and equipment and gravitates toward takeover bids for existing competitors, share buybacks and larger dividends.

Financial asset transactions, however, do not lead to an expansion of the capital stock. They are only a transfer in the ownership of assets which primarily results in a net increase of total debt. Economic growth during such environments has little organic sponsorship. Instead, the growth realized is largely, superficially fueled by debt and, as a result, temporary.

Money Message

Part of the reason financial engineering and speculation has taken precedence over real capital investment is that investors lack a sound basis for making long-term investment and project decisions. Exchange rates and interest rates are a reflection of money as a store of value and therefore a vital conduit of information. When policymakers tamper with either or both, they distort that flow of information, thus handicapping investors in their ability to properly assess the current and future value of goods and services. Under those circumstances, few business managers are willing to take on the risk of investing in new plant and equipment especially after adjusting for the probability of failure. The easiest solution to that problem is to borrow heavily at low interest rates and reinvest in assets offering an existing stream of income. This produces a reasonable return on investment with much better visibility.  

One of the more compelling charts we have seen in the last year is the long-term relationship between the S&P 500 and the Goldman Sachs Commodities Index (GSCI). No chart better illustrates the distortion of uses of capital as described above. The following chart highlights the divergence between financial assets, using the S&P 500 as a proxy, which have exploded in price and real assets such as those found in the commodities complex.

To offer a more detailed perspective, the next chart highlights the contrast in price returns between the S&P 500 and the Commodities Research Bureau (CRB) commodities index along with the ratio between the two gauges.

If the negative real interest rate regime of the post-crisis era has indeed obscured the pricing mechanism of money and reinforced the preference for financial assets, it should also be negatively reflected in real assets. Using the CRB index as a proxy as shown below, we notice that commodity prices are at levels seen over 20 years ago.

Despite negative real rates and rising marginal costs of production, two factors that have historically supported commodity prices, they continue to remain under pressure. Additionally, while China’s appetite for raw materials has diminished somewhat, plans for the massive One-Belt, One-Road (OBOR), the new silk road, continue to advance as do the commodity requirements for that project.

Opportunities in Commodities

If as we suspect, the low interest rate environment has been an important dynamic in financial asset price inflation, then normalizing interest rates may also bring gradual normalization of investor preferences.

Such an adjustment could be an impetus towards more investment in durable cash flow projects and less in speculative financial assets. Over time this would be disruptive to stock prices and beneficial for commodities.

From a value perspective, commodities are relatively cheap as an asset class and some specific components in particular have been depressed for quite some time. Since 2017, sugar is down -35%, coffee is down -45% and natural gas is down -28%.

Taking a longer view, since 2014 corn and soybeans are down -11% and -28% respectively while lean hogs are down -44% and sugar is down -22%. Last we checked, the global population is not shrinking and the likelihood that demand for these basic necessities will fall seems low.

Add to the equation the supply restraints of harvesting or mining resulting from environmental disruptions and this out of favor asset class could begin to surprise to the upside. In a world where everyone seems inclined to pay top dollar for the latest fad, these staples of global society certainly warrant close monitoring.

Summary

Low interest rates have disrupted the normal functioning transmission mechanism of the price of money and prudent decision-making has been obscured as a result of these extensive price controls. This has led investors, corporate managers and entrepreneurs to take evasive actions, avoid risks, and lever up cheap money to go for the sure thing. The irony is that although this produces favorable short-term results, it impairs the intermediate and long-run growth potential of the economy.

Given the slow and methodical process promised by the Fed, any normalization may take time. Then again, if concerns around inflation begin to emerge, the normalization of interest rates may be forced to accelerate. Commodities have been a big underperformer since 2011 as investors shunned real assets over financially engineered options. Although the turn may not be here quite yet, the commodity sector stands to eventually benefit and is one place with a lot of options to look for value.

Those who see that the last 10-years of experimental stimulus has been on par with, or arguably exceeded, policies historically reserved for major wars gain a unique and valuable perspective of the current monetary mirage. The demise of those policies, as they are bound to unravel, will reveal a multitude of investment opportunities left behind in the ill-advised euphoria of anti-capitalism.

Quick Take: Mester Signals Panic at the Fed

Last night the following Reuters headlines hit the wires. The report is from a speech given by Cleveland Federal Reserve Governor Loretta Mester.

Mester’s comments and similar remarks from other Fed Governors occur within two weeks of a very strong BLS employment report. Over the last two months payrolls have increased by 526,000 jobs, a pace greater than any two month period since July of 2016. Providing further evidence of a strong jobs market, yesterday the BLS released the JOLTS (Job Openings and Labor Turnover Summary) report which confirmed the labor situation is not only healthy but at some of the strongest levels in recent history.

Here are the facts:

  • The unemployment rate is only 0.3% above the lowest level in nearly 50 years
  • Jobless claims are at levels last seen in 1969
  • JOLTS just reported the highest number of job openings since they began reporting on the data in 2000. 

These and other signs of a strong labor market point to the growing possibility that wages, and with it inflation, will rise in the coming months.

Maximizing employment is one of  two Federal Reserve congressionally chartered mandates. The second is stable prices and moderate long term interest rates. Inflation is stable and interest rates are among the lowest in recorded history. The BLS reported this morning that the Fed’s preferred measure of CPI inflation, Core CPI (CPI less food and energy) is running at a 2.2% annual rate. The Fed considers stable inflation to be 2.0%.

To be fair, not everything is rosy. Slowing global growth, further dollar strength, and the ongoing trade debate pose the potential to hamper US economic growth.

Bottom line: there are some clouds gathering on the global economic horizon, but the sun is still shining brightly in the U.S.

With that backdrop, we come back to the question we asked in two articles published two weeks ago. On January 30th and February 1st, we summarized and commented on the recent Federal Reserve FOMC policy meeting. Of importance, we were trying to figure out why the Fed made such an abrupt policy U-turn from the prior meeting on December 19, 2018. Here are the articles.

Quick Take: January 30, 2019 Fed Meeting

Additional Thoughts: Quick Take January 30, 2019 Fed Meeting

Our initial take was that the 20% stock market decline was to blame for the change in policy. It didn’t help that President Trump was calling for Fed action and at the time Powell’s head seemingly daily. In the “Additional Thoughts” article we posited the following:

What Does the Fed Know?

During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore. In response, Powell stated “We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.” As we discussed in the original article, Powell’s response was incomplete and failed to address the question directly. Given his weak answer, we wonder if Powell knows something we don’t. Could China’s economy be rolling over at a much more concerning pace than anyone thinks? Are trade discussions with China a no-go, therefore resulting in eminent tariffs? Is a bank in trouble?

The possibilities are endless, but given Powell’s awkward response and unsatisfactory rationale to a simple and obvious question, it is possible that he is hiding something that accounts for the policy U-turn.

Our Current Take

The market has largely recovered from the fourth quarter swoon, as such the Fed should be resting more comfortably. Economic data remains strong, and if anything it is slightly better than December when the Fed was ready to raise rates three times and put balance sheet reduction on “autopilot.”

Today the Fed has all but put the kibosh on further rate hikes and, per Mester’s comments, will end balance sheet reduction (QT) in the months ahead.

It is becoming more suspect that the Fed knows something the market does not. What this is, one can only guess. Recent Fed comments are not “measured” nor commensurate with economic data. They fly in the face of their claim that policy will be “data dependent.”

The stock market may continue to march higher on dovish Fed-speak. In doing so, it will ignore the elephant in the room, and that is why the Fed is battening down the hatches on such a calm and sunny day.

When the market discovers the reason for the pivot, volatility may suddenly pick up and the gains resting on the back of a dovish Fed tilt may quickly be erased. Until then enjoy the rally but keep both eyes on the horizon.

 

 

 

 

Fables, Fairy Tales and the Gold Standard

President Trump often tweets about the strength and health of the U.S. economy, and two weeks ago, he tweeted that the U.S. economy was the Gold Standard throughout the World.

The fact that Trump capitalized the words “Gold Standard” may have piqued the interest of those who believe in sound money principles.  Trump has in fact spoken in the past about a return to the Gold Standard, and some of the issues surrounding this are summarized in an October 2018 article: Trump Puts Gold Standard On The Table.

A simple interpretation of Trump’s tweet means that the U.S. economy is the envy of the world, the benchmark by which other economies measure themselves.

Nevertheless, Trump’s tweet can be viewed as valid in another way, whether this interpretation was intended or not.  When the U.S. dollar was de-linked from the value of gold in 1971, the U.S. dollar and its economy became the Gold Standard.  The U.S. dollar is the primary reserve currency throughout the world, and therefore almost everything bought or sold in the world has a reference point to the value of the dollar.

The value of the dollar is related to the health of the U.S. economy, and the U.S. economy, absent a “real” gold standard, IS the monetary standard throughout the world.

We are not suggesting that Trump will help navigate the world back to a Gold Standard, and any political, strategic or tactical discussions on that point are above our pay grade.  In fact, we prefer to summarize our understanding of the gold market by way of two children’s stories.

Fables and Fairy Tales

Everyone loves a good story.  Good stories can give us hope and fill us with courage.  Good stories can teach us what is “good” and what is “evil.”  Good stories give us examples to follow and mistakes to avoid.   Good stories resonate with us and even help frame our understanding of reality.

Simple stories can the most entertaining ones, and great stories are replayed again and again in many different ways.  A common, mistreated and honorable girl falls in love and marries the prince (i.e. Cinderella).  The swashbuckling hero takes from the rich and gives to the poor (i.e. Robin Hood).  The wayward and shame-stricken son finds his way to become the king of the jungle (i.e. The Lion King).

Two well-known fables that summarize our understanding the gold market: Rumpelstiltskin and The Boy Who Cried Wolf.

Rumpelstiltskin

In the story of Rumpelstiltskin, a goblin-like creature appears to help a girl turn straw into gold for a king.  The girl’s father had promised the king that the girl herself could accomplish this task.  Her ultimate reward is marriage, but her punishment is death if she cannot.  Rumpelstiltskin has increasing demands for the girl in exchange for his magical feat of doing what she could not – turning straw into gold.

Without getting into the finer details, let’s take a step back and consider the power that someone would have if they could turn common straw into gold, whether they are a king, a girl or a goblin.  If you could turn paper into gold, then money would literally grow on trees, just for you.

It is not a stretch of the imagination to see that the turning-straw-into-gold ability exists for those who sell paper derivative gold of all kinds.  A large amount of investors demand for gold exists primarily in paper or electronic forms – whether such demand is for gold-backed ETFs or gold futures contracts.  The banks and brokers who satisfy this demand have a license to create “gold” from paper (or electronic promissory notes).

Gold selling banks and brokers usually sell paper “gold” without necessarily acquiring more physical gold reserves.  Spoken plainly – they often sell gold they do not have.  It is easy to imagine how this scheme can distort price discovery in the gold market.

The paper-derivative gold supply scheme is an accomplishment that should make even Rumpelstiltskin proud.

The Boy Who Cried Wolf

This story is about a shepherd boy who repeatedly issues a false alarm to nearby villagers, claiming that wolves are attacking his flock. When a wolf actually does appear and the boy again calls for help, the villagers believe that it is another false alarm and the sheep are eaten by the wolf.

There are many well-intentioned shepherd boys in the gold market (and some not so well-intentioned), who on regularly highlight problems with the worldwide monetary system.  The “wolf” in this case might be characterized as a form of worldwide monetary reset, perhaps with physical gold as a benchmark, rather than the U.S. dollar.

There is burgeoning and unsustainable debt creation worldwide.  The U.S. dollar is losing ground as the benchmark reserve currency.  There is increasing accumulation of physical gold reserves by central banks worldwide.   The BRIC nations are creating payment systems to rival the U.S. dollar-based SWIFT payment system.  There is indeed evidence that the wolf is on the prowl, and investors should consider how to protect their savings and long-term purchasing power.

On the other hand, shepherd boys have been crying, “WOLF!” for over a decade since the 2008 financial crisis, and many investors have been misled – especially those who have bought paper-derivative gold on a DATE-CERTAIN-THIS-IS-THE-BIG-ONE panic.

We believe that investors should seriously consider buying precious metals.  But investors should also prudently assess whether they MUST ACT NOW when they do so.

Here is the bottom line for the long-term: every major economy is printing more and more paper currency. The value of money, like any other commodity, rises and falls as the supply changes.  As the money supply continues to increase over time, the value of gold relative to those currencies will increase over time.  It is that simple.

Here’s why we believe The Boy Who Cried Wolf metaphor is so appropriate.  The wolf is coming.  We don’t know when, why or how, but he is coming. It could be next month, or it could be many years from now.  When he does come, it won’t matter whether you purchased gold at $1,200 or $1,500 per ounce.  Either way, your purchasing power should be protected over the long run.

Until the wolf does come – and even after he does – it might be prudent to purchase physical gold (or other precious metals) on a routine, dollar-cost-averaging basis, regardless of the headlines and whatever the shepherd boys are calling out this week.

Bears Getting Bullish On Boxing Day

On the day after Christmas when investors were sad with the coal they found in their stockings, Santa provided some Boxing Day cheer. The S&P 500 posted a 5% gain, in a rally that was widely expected. We along, with many market technicians, had been highlighting the extremely oversold conditions and thought a relief rally was inevitable. The question was just a matter of when.

Of note, the most vocal about the potential for a short term rally appeared to be those with longer term bearish outlooks. In particular, John Hussman who over the past few years, has repeatedly made a strong and compelling case for the market dropping 50% or more. On Wednesday morning with the market barely green, he posted the following bullish statement on his Twitter account:

ICYMI: “While we don’t observe conditions to indicate a ‘bottom’ from a full-cycle standpoint, we do observe conditions permissive of a scorching market rebound. Yes, that means one or more daily moves of ~100-150 points on SPX and 900-1300 on the Dow. You think I’m kidding.”

Make no mistake, Mr. Hussman makes it clear that the 100-150 point “scorching market rebound” rally which he correctly called is a temporary surge within a bear market. Providing support for his Tweet is the graph below which shows that market surges of Wednesday’s magnitude occur during bear markets, not bull markets.

The important question we are grappling with is whether Wednesday was the peak before another leg lower or will the market continue higher over the next week or two.

Technically we think a run higher of 5% or even 10% to firm resistance levels is possible. However, we are very cautious to try to take advantage of the situation because everyone, bulls and bears, seem to be on the same page. There is an old Wall Street saying that states the market will do that which inflicts the most pain. Said differently, the boat tips over when everyone is standing on one side.

Our concern here is that a rally seems so obvious from a technical viewpoint and seasonal perspective that the market will do the opposite of what everyone is expecting. Our advice as we have said on numerous occasions, short term traders should stay disciplined with stop loss orders and longer term investors should use market relief rallies to bring your stock exposure to levels that are commensurate with the amount of risk you are willing and able to endure.

Greetings From Stiltsville : Deficit Spending is not a Free Lunch

A special thank you to Peter Cook, CFA for co-authoring this article with us.

Imagine an island called Stiltsville, where a person’s value is based solely on their height. In order to increase their value, people living on the island used to wear platform shoes. A person wearing six-inch platform shoes would suddenly be more valuable than a person of similar height who wore normal footwear. Eventually, platform shoes were replaced by stilts, three-foot stilts were be replaced by six-foot stilts, and so on. People eventually rose to be the height of giraffes. The main point is that, on an island where height is valued above all else, people will try to game the situation to their advantage by increasing their height by any means available.

People from other lands would look at the people of Stiltsville and recognize their obsession with height greatly distorts their perception of value.  They would also likely conclude that distorted perceptions result in actual distortions in productivity, because:

  • People waste time and money thinking about how to increase their height, and
  • Walking around in platform shoes or stilts does not necessarily increase a person’s productivity, and instead most likely impairs it

Now imagine a world in which the health of an economy is perceived to be based on one metric; Gross Domestic Product (GDP). GDP is simply the total amount of spending in an economy. GDP, as currently measured, does not distinguish between “good” spending and “bad” spending. GDP does not distinguish between consumption spending and investment spending. GDP also does not distinguish whether spending is generated by existing wealth, by going into debt temporarily, or by going into debt permanently. In this world, every dollar spent on education or new means of production, is counted the same as every dollar spent on epic bachelor parties and video games. 

This world, the world of GDP accounting, is the world we live in. More spending today than occurred yesterday is considered economic growth. Growth, regardless of how it happened or at what cost, is highly sought after by politicians, economists and central bankers.

Gaming the System

Like the island where height is valued above all else, the world in which GDP is valued above all else can easily be gamed, making an economy appear healthier and larger than it really is. Instead of wearing platform shoes or stilts, politicians game GDP by increasing the amount of government spending without necessarily increasing the productivity of the economy. Politicians also tinker with the tax code and provide incentives for the private sector to increase consumption and/or to favor one type of spending over another. Central bankers, who should know better, sit idly by adjusting interest rates, which allows the government’s poor fiscal habits to persist and grow. Neither politicians, economists, nor central bankers have any regard for the quality of spending.

When such irresponsible behavior continues unabated over time, the divergence between the reported GDP and the actual health of an economy grow larger and larger.

Exploring Fiscal Spending

A book could easily be written, and probably has been, on the flaws of GDP and the errors of using GDP as an economic benchmark. To keep this short and get our point across, we will focus solely on the fiscal spending component of GDP. However, make no mistake, a rash of consumer materialism toward bigger houses, more expensive cars and a host of other non-productive spending has led to hollow GDP growth as well.

Because GDP measures all spending in an economy, government spending financed by budget deficits increases the level of GDP. Since much of government spending is not productive as it does not produce a return as large as the initial expenditure, this spending is a shell game which only shifts the timing of spending to ostensibly “produce growth.” Debt-financed spending today pulls consumption forward from tomorrow, but in doing so creates less spending in the future as the obligations to service existing debt grow. If new debt does not provide a revenue stream sufficient to cover the interest cost, then it is non-productive and results in a drag on economic growth. This does not mean all government spending needs to be productive, but non-productive expenses should be paid for with current tax revenue and not debt.

Rational observers understand that politicians elected today seek to deliver benefits to their constituents today.  Due to the current nature of politics and the strong motivations to be re-elected, very few politicians seem to care about anything beyond the next election. Since 1960, as shown below, fiscal spending inflated the GDP calculation in all but five years.

Data Courtesy St. Louis Federal Reserve

The era of consistent deficits began in the 1960’s during President Lyndon Johnson’s “guns and butter” policies. Johnson’s spending habits, while large at the time, pale in comparison to deficit spending since. Politicians have seemingly become addicted to making GDP appear larger than it is by spending more than is received in taxes each year, and by an increasing amount. The result is a charade which values the optics of economic growth over economic prosperity.

The cumulative effect of the obsession to increase GDP with deficit spending is shown below.  As a percentage of GDP, federal debt has tripled over the past 40 years.  More recently, deficit spending exploded higher in the wake of the Great Recession of 2008-09. Today, total federal debt outstanding is over $21.5 trillion, exceeding annual GDP of roughly $20.6 trillion. The ratio of debt-to-GDP is currently 104%. Before the 2008/09 recession federal debt was only 60% of GDP.

Data Courtesy St. Louis Federal Reserve

Summary

In our make-believe island of Stiltsville, where height matters above all else, it will eventually be obvious that 17-foot tall people who cannot easily navigate stairs and doorways are not as valuable as those on bare feet. In time, our world will face the harsh reality that an economy artificially boosted on non-productive spending and over-materialism may temporarily portray greatness in a warped sense, but will be increasingly beset with inevitable economic hardship.

Is deficit spending consequence-free as politicians and central bankers would have us believe?  Not if you believe the conclusions of Reinhart and Rogoff, who published “This Time is Different: Eight Centuries of Financial Folly” in 2009. Their exhaustive study of the history of government spending demonstrates that when the ratio of government debt-to-GDP exceeds 90%, economic growth slows and economic problems multiply eventually leading to a financial crisis. Having rejected all forms of fiscal and monetary prudence, U.S. debt-to-GDP far exceeds that level. Either an economic problem lies ahead, or this time really is different.

Finally, consider the following scenario:

Imagine the “GDP” of your family is equal to your family’s spending. Would your financial situation be “better” if:

  1. It maximizes spending every year, even if it must borrow to do so, or
  2. It limits spending, and tries to save and invest, subject to what it earns?

Most people would pick #2 understanding the dire consequences that would eventually emerge with option #1.  But using the consensus definition of GDP and a “growth at all costs” mentality, economists and politicians have chosen #1. Despite that unpleasant reality, we will all eventually deal with the consequences and share in the responsibility for putting our economic house back in order.

Preview: Federal Reserve Meeting 12/19/2018

In our article, Everyone Hears the Fed But Few Listen we showed the divergence between the market (Fed Funds Futures) and Federal Reserve members in regards to the future path of the Fed Funds rate. We believed at the time we wrote the article, and still do, that the differing views could be setting the stock market up for extreme volatility. This opinion does not necessarily mean an extreme sell-off but the potential for large movements up or down.

In July, when the article was published and Fed Funds stood at 2.00%, market levels implied that Fed Funds would average 2.50% in 2019 and 2.625% in 2020. In September, with the stock market on firm footing, approaching record highs, and the economy humming along, the market’s estimates rose by 0.125% for both years. At that time, the market implied levels were 0.32% and 0.44% lower than current average forecasts from the members of the Federal Reserve. Said differently, the market thought the Fed would raise rates twice in quarter point increments while the Fed was leaning to between three and four more hikes.

On September 20, 2018, the stock market peaked and has since declined over 10%. Further, global economic growth has weakened measurably with Germany, Italy, Japan, and Switzerland all reporting a negative rate of economic growth in the last quarter. Possibly more important, China, has reported a sharp slowdown in economic activity. While the U.S. economy has only shown vague signs of economic weakness, the number of economists issuing growth warnings has increased.

The clouding of the economic skies along with trade concerns and a host of geopolitical issues has certainly affected the market’s Fed Funds expectations. Before the Fed meeting on Wednesday December 19, 2018, the market is expecting a 0.25% increase and a tiny chance of another 0.25% hike by summer of next year. In other words, over the last two months, the market has taken a 0.25% hike off the table. More interesting, the market is also implying that the Fed starts lowering rates in 2020. The graph below charts the changes in the Fed Funds implied curve today versus September 2018. The orange dot on the orange line shows when the market implied levels begin declining and Fed rate cuts become more probable.

Given the decline in the market-based implied Fed Funds rate, the difference between market opinion and the Fed’s forecast has widened to 0.43% in 2019 and 0.76% in 2020. When we wrote the article in July the gap between the market and the Fed members was concerning. Our concern is only heightened given the stark increase in the gap.

What to Expect

If the Fed does not change their hawkish tone at Wednesday’s meeting it is likely the stock market will continue to head lower and possibly in a disorderly fashion. The yield curve would likely continue to flatten in this scenario as the Fed continues to signal rising rates despite growing signs of economic weakness. Therefore, short-term interest rates would track Fed rate hikes higher while longer term interest rates would decline on recession concerns.

Alternatively, if the Fed relents and uses more dovish language, short-term interest rates may rally as they reverse out prior expected rate hikes. While we do not expect a surge in equity prices to new highs, we do think, given the oversold conditions, stocks could rally on the order of 3-5%. As we have said, such a scenario is likely an opportunity to reduce equity exposure. Our chief concern in this short-term bullish situation is that the market begins to worry about the sudden change in the Fed’s language and the rising implications for a recession.

What Caused Chairman Powell To Flinch

Clues from the Fed II, an RIA Pro article from November 28, 2018, provided important insight into one of Jerome Powell’s most important speeches as the Federal Reserve Chairman. We share the article to provide context to this article as well as to demonstrate the benefits of subscribing to RIA Pro.

Since the latter stages of Chairwoman Janet Yellen’s term and including the beginning of Powell’s term, the Fed has been on monetary policy autopilot. As a result of policy actions taken following the financial crisis, the fed funds rate was so far below the rate of inflation and economic growth that they felt comfortable raising rates on a steady basis without much regard for economic, inflationary and financial market dynamics. In Fed parlance, they were not “data dependent.”

Based on Powell’s most recent speech and policy trial balloons floated in the media, the fed funds rate is now much closer to the expected rate of economic growth, therefore it is much closer to what is known as the neutral fed funds rate. As a result, future Fed rate moves are expected to be increasingly influenced by incoming economic data. If true, this change in monetary policy posture is one to which the market is far less accustomed.

Powell’s Abrupt Change

On October 3, 2018, Jerome Powell stated the following: “We may go past neutral. But we’re a long way from neutral at this point, probably”

On November 28, 2018, he said: “Funds rate is just below the broad range of estimates of the level that would be neutral for the economy.”

In less than two months, the Fed Chairman’s perspective about the proximity of the fed funds rate to neutral shifted from a “long way” to “just below.” Clearly, something in Mr. Powell’s assessment shifted radically. We have some thoughts about what it might be, but we decided to canvas the opinions of others first.

We created a Twitter poll to gauge our follower’s thoughts on Powell’s pivot, which came despite very little evidence that economic conditions have meaningfully changed in the interim.

The poll results from over 1,400 respondents are telling. Accordingly, we provide a brief discussion of the respective implications for monetary policy and the stock market.

“Trump persuaded Powell”

President Donald Trump, a self-described “low-interest rate guy”, has been openly displeased with Jerome Powell and the Federal Reserve for raising rates. To wit:

  • CNBC 11/27/2018– Trump told the Post, “So far, I’m not even a little bit happy with my selection of Jay,” whom he appointed earlier this year. The president told the newspaper that he thinks the U.S. central bank is “way off-base with what they’re doing.” — “I’m doing deals and I’m not being accommodated by the Fed,” Trump told the Post. “They’re making a mistake because I have a gut and my gut tells me more sometimes than anybody else’s brain can ever tell me.”
  • WSJ 10/23/2018– “Every time we do something great, he raises the interest rates,” Mr. Trump said, adding that Mr. Powell “almost looks like he’s happy raising interest rates.” The president declined to elaborate, and a spokeswoman for the Fed declined to comment. — Asked an open-ended question about what he viewed as the biggest risks to the economy, Mr. Trump gave a single answer: the Fed.
  • NBC 10/16/2018– “I’m not happy with what he’s doing because it’s going too fast,” Trump said of Powell. “You look at the last inflation numbers, they’re very low.”
  • AP News 10/16/2018 – Stepping up his attacks on the Federal Reserve, President Donald Trump declared Tuesday that the Fed is “my biggest threat” because he thinks it’s raising interest rates too quickly.– Last week, in a series of comments, Trump called the Fed “out of control,”

The Fed is under increasing pressure from the White House to halt interest rate hikes. While we like to think Fed independence means something and the President’s pressure is therefore futile, there is a long history of Presidents taking explicit steps to influence the Fed and alter their actions.

29% of poll respondents believe that Trump’s comments made in the open, and those we are not privy to, are the cause for Powell’s change in tone. If this is the case, it likely means that Powell will shift towards a more dovish monetary policy going forward. This would entail fewer rate hikes and a reduced pace of Fed balance sheet normalization. Since the financial crisis, the precise combination of low interest rates and expanded balance sheet (QE) has proven extremely beneficial for stocks. Looking forward, excessive monetary policy amid a smoothly running economy is a recipe for inflation or other excesses which would not bode well for stocks.

We think this scenario is short-term bullish, but it could easily be diminished by higher interest rates or growing inflationary pressures.

Before moving on, it is important to note that Trump’s remarks above (and many other of his comments) are a first of their kind. This isn’t, because other Presidents haven’t said similar things but because Trump’s comments are in the public for all to see.

Economy Slowing Quickly

Votes that a quickly slowing economy produced Powell’s shift represented 42% of all responses. If correct, this is the worst case scenario for the stock market. Global economic growth is already decelerating as witnessed by the declining GDP growth posted by Germany, Canada, Italy, Japan and Switzerland in the most recent quarter. Further, China, the main engine for global economic growth since the financial crisis, is sputtering.

In addition to the global forces affecting the economy, the growth benefits seen over the last year from a massive surge in fiscal spending and corporate tax cuts are waning. Lastly, higher interest rates are indeed taking their toll on our debt-burdened economy.

It goes without saying that stocks tend to do very poorly during recessions, regardless of whether the Fed is dovish and lowering rates. During the past two recessions, the S&P 500 dropped over 50% despite aggressive interest rate cuts.

We think this scenario is decidedly bearish.

Stock market woke him up

The “Greenspan Put” is a phrase that was used to describe Fed Chairman Alan Greenspan’s preemptive policy moves to save the stock market when it was headed lower. While Greenspan’s name is on the term, it goes back even further. Following the crash of 1929, for instance, the Fed made enormous efforts to halt stock market declines to no avail. In recent years, the Greenspan Put has taken on more significance as Ben Bernanke and Janet Yellen followed in his footsteps and spoken repeatedly about a beneficial wealth effect caused by higher share prices.

In the past, Powell has expressed reservations about the policy measures taken by his predecessors and has openly worried about the risk of high stock valuations and other potential imbalances. He has generally demonstrated less concern for protecting the stock market. With the market falling and the proverbial rubber hitting the road, we are about to find out if a 10% decline from record highs is enough to scare Powell into a dovish stance. If so the Greenspan, Bernanke, Yellen, Powell put is alive and well.

As previously mentioned, there have been several occasions in years past when the market suffered steep declines despite the presence of the Fed Put.

We think this scenario is bullish on the margin, but it may not be enough to save the market.

Summary

As judged by the voting, the most likely explanation accounting for Powell’s sudden and aggressive change in tone involves some combination of all three factors. Like most central bankers, he probably believes that he can engineer a “soft landing.” In other words, he can allow the current global and domestic economic pressures to reduce economic growth without causing a recession.

While such a plan sounds ideal, the ability to execute a soft landing has eluded central bankers for decades. Some will say the Fed, by delaying plans for rate hikes and reducing their balance sheet, avoided a hard landing in 2015 and 2016. They may have, but since then global economic and political instabilities have risen markedly. This makes a repeat execution of a soft landing much more difficult. A second concern is that the Fed, with rates still historically very low, does not have enough fire power to engineer a soft landing.

We will continue to pay close attention to the Fed for their reaction to what increasingly looks like a changing economic environment. We also leave you with a reminder that, while the Fed is powerful in igniting or extinguishing economic activity, they are simply one of many factors and quite often throughout their 105-year history they have fallen well short of their goals.

The market is a highly complex global system influenced more by the unseen than by the obvious. Jay Powell, like most of his predecessors who thought they could control market outcomes, apparently suffers from this same critical handicap. Of all the moral hazards the Fed sponsors, their hubris is certainly the most destructive. The stability of the last ten years and the shared perception of Fed control will lead many to forget the sheer panic that occurred only a decade ago.

Clues from the Fed II – A Review of Jerome Powell’s Speech 11/28/2018

The following speech by Jerome Powell, Chairman of the Federal Reserve, was given on November 28, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below. If you have not read our review of Vice-Chairman Richard Clarida’s speech from yesterday you can find it HERE.


The Federal Reserve’s Framework for Monitoring Financial Stability

Chairman Jerome H. Powell

At The Economic Club of New York, New York

It is a pleasure to be back at the Economic Club of New York. I will begin by briefly reviewing the outlook for the economy, and then turn to a discussion of financial stability. My main subject today will be the profound transformation since the Global Financial Crisis in the Federal Reserve’s approach to monitoring and addressing financial stability. Today marks the publication of the Board of Governors’ first Financial Stability Report. Earlier this month, we published our first Supervision and Regulation Report. Together, these reports contain a wealth of information on our approach to financial stability and to financial regulation more broadly. By clearly and transparently explaining our policies, we aim to strengthen the foundation of democratic legitimacy that enables the Fed to serve the needs of the American public.

Outlook and Monetary Policy
Congress assigned the Federal Reserve the job of promoting maximum employment and price stability. I am pleased to say that our economy is now close to both of those objectives. The unemployment rate is 3.7 percent, a 49-year low, and many other measures of labor market strength are at or near historic bests. Inflation is near our 2 percent target. The economy is growing at an annual rate of about 3 percent, well above most estimates of its longer-run trend.

For seven years during the crisis and its painful aftermath, the Federal Open Market Committee (FOMC) kept our policy interest rate unprecedentedly low–in fact, near zero–to support the economy as it struggled to recover. The health of the economy gradually but steadily improved, and about three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. 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. My FOMC colleagues and I, as well as many private-sector economists, are forecasting continued solid growth, low unemployment, and inflation near 2 percent.


RIA Pro commentIn these first two paragraphs Jerome Powell points out that the economy is running above its longer-term trend in large part due to the support of “near zero” interest rates (Fed monetary policy). Given recent above-trend economic growth and a sustained recovery from the financial crisis, the Fed raised rates to get to a less simulative level.

He states that “interest rates are still low by historical standards” and “remain just below” what they would consider neutral for the economy. The phrasing “remain just below” is the key line from the speech as it was only a month ago, on October 3rd, when he said they were a “long way” from neutral. In no uncertain terms, this abrupt change in posture is a clear signal to the market that the Fed may be close to ending their hiking cycle.

There are two other important points regarding the neutral rate worth discussing. First, the Federal Reserve does not know with any real precision what the “neutral” rate of interest for the economy is or should be. This is best left to un-manipulated markets and the independent buyers and sellers that drive them. Second, if indeed Powell and the Fed did know with certainty where the neutral rate should be, it likely would not be at a real rate near zero, with economic growth running above 3% and the unemployment rate at 50 year lows as is currently the case.


There is a great deal to like about this outlook. But we know that things often turn out to be quite different from even the most careful forecasts. For this reason, sound policymaking is as much about managing risks as it is about responding to the baseline forecast. Our gradual pace of raising interest rates has been an exercise in balancing risks. We know that moving too fast would risk shortening the expansion. We also know that moving too slowly–keeping interest rates too low for too long–could risk other distortions in the form of higher inflation or destabilizing financial imbalances. Our path of gradual increases has been designed to balance these two risks, both of which we must take seriously.

We also know that the economic effects of our gradual rate increases are uncertain, and may take a year or more to be fully realized. While FOMC participants’ projections are based on our best assessments of the outlook, there is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us. As always, our decisions on monetary policy will be designed to keep the economy on track in light of the changing outlook for jobs and inflation.


RIA Pro comment- Powell is parroting the substance of Clarida’s speech yesterday essentially saying that the Fed is no longer on rate-hiking auto-pilot. They will raise rates or abstain from raising rates based on what economic and financial data tell them (data dependency). As we mentioned yesterday, the increased emphasis on data dependency by definition reduces their reliance on forward guidance which will introduce more volatility to the markets. Prior reliance on forward guidance helped suppress volatility, so it follows that less reliance on it will make them less predictable and naturally raises the level of uncertainty for investors.


Under the dual mandate, jobs and inflation are the Fed’s meat and potatoes. In the rest of my comments, I will focus on financial stability–a topic that has always been on the menu, but that, since the crisis, has become a more integral part of the meal.

We omitted the rest of the speech as its focus is a historical perspective of financial stability and less relevant to current monetary policy. The entire speech can be found HERE

RIA Pro Summary

It is clear from this speech, as well as recent trial balloons put out by the Fed, that they are taking a more dovish stance. This does not mean they will halt their rate hikes, but in our opinion it is clear that once we move beyond the scheduled hike in December, all bets are off the table. Barring signs of wage growth, stronger inflation or sustained economic growth above 3%, they are unlikely to raise rates further.

The stock market rocketed higher on what is perceived as a dovish speech with the strong possibility that Fed hikes will be halted come 2019. Time will tell if the gains are sustainable and if the market is interpreting his speech correctly. It is worth mentioning however that a recession followed the last three times that the Fed Funds rate hit a cycle high. 

 

 

 

 

Clues from the Fed – A Review of Richard Clarida’s Speech 11/27/2018

The Following Speech by Richard Clarida, Vice Chairman of the Federal Reserve, was given on November 27, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. More specifically, given Clarida’s role as the Vice Chairman, he is one of the main sources of communicating whether the Fed is indeed considering reversing to a more dovish stance in the months ahead. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below.


Data Dependence and U.S. Monetary Policy

Vice Chairman Richard H. Clarida

At The Clearing House and The Bank Policy Institute Annual Conference, New York, New York

I am delighted to be speaking at this annual conference of the Clearing House and the Bank Policy Institute. Today I will discuss recent economic developments and the economic outlook before going on to outline my thinking about the connections between data dependence and monetary policy. I will close with some observations on the implications for U.S. monetary policy that flow from this perspective.

Recent Economic Developments and the Economic Outlook
U.S. economic fundamentals are robust, as indicated by strong growth in gross domestic product (GDP) and a job market that has been surprising on the upside for nearly two years. Smoothing across the first three quarters of this year, real, or inflation-adjusted, GDP growth is averaging an annual rate of 3.3 percent. Private-sector forecasts for the full year–that is, on a fourth-quarter-over-fourth-quarter basis–suggest that growth is likely to equal, or perhaps slightly exceed, 3 percent. If this occurs, GDP growth in 2018 will be the fastest recorded so far during the current expansion, which in July entered its 10th year. If, as I expect, the economic expansion continues in 2019, this will become the longest U.S. expansion in recorded history.

Likewise, the labor market remains healthy. Average monthly job gains continue to outpace the increase needed to provide jobs for new entrants to the labor force over the longer run, with payrolls rising by 250,000 in October. And, at 3.7 percent, the unemployment rate is the lowest it has been since 1969. In addition, after remaining stubbornly sluggish throughout much of the expansion, nominal wage growth is picking up, with various measures now running in the neighborhood of 3 percent on an annual basis. 

The inflation data in the year to date for the price index for personal consumption expenditures (PCE) have been running at or close to our 2 percent objective, including on a core basis‑‑that is, excluding volatile food and energy prices. While my base case is for this pattern to continue, it is important to monitor measures of inflation expectations to confirm that households and businesses expect price stability to be maintained. The median of expected inflation 5-to-10 years in the future from the University of Michigan Surveys of Consumers is within–but I believe at the lower end of–the range consistent with price stability. Likewise, inflation readings from the TIPS (Treasury Inflation-Protected Securities) market indicate to me that financial markets expect consumer price index (CPI) inflation of about 2 percent to be maintained. That said, historically, PCE inflation has averaged about 0.3 percent less than CPI inflation, and if this were to continue, the readings from the TIPS market would indicate that expected PCE inflation is running at somewhat less than 2 percent.


RIA Pro commentClarida believes the economy is growing at a healthy clip and wage growth is relatively strong in the 3% range. These statements by themselves argue that the Fed is woefully behind the curve in raising rates. Based on historical precedence, one would expect Fed Funds to currently reside in the 3.50-5.00% range versus the current 2.25%. One explanation for the low Fed Funds rate, as Clarida implies, is that inflation and inflation expectations remain low. In the next two paragraphs, he goes on to explain why inflation may remain low and not rise to levels that would overly concern the Fed.


What might explain why inflation is running at or close to the Federal Reserve’s long-run objective of 2 percent, and not well above it, when growth is strong and the labor market robust? According to the Bureau of Labor Statistics, productivity growth in the business sector, as measured by output per hour, is averaging 2 percent at an annualized rate this year, while aggregate hours worked in the business sector have risen at an average annual rate of 1.8 percent through the third quarter. This decomposition–in which the growth in output is broken down into measures of aggregate supply, the growth of aggregate hours and the growth of output per hour–suggests that the growth rates of productivity and hours worked in 2018 each have been exceeding their respective longer-run rates as estimated by the Congressional Budget Office. In other words, while growth in aggregate demand in 2018 has been above the expected long-run growth rate in aggregate supply, it has not been exceeding this year’s growth in actual aggregate supply.

Ultimately, hours growth will likely converge to a slower pace because of demographic factors. But how rapidly this happens will depend in part on the behavior of labor force participation. And recent years’ developments suggest there may still be some further room for participation in the job market‑‑especially in the prime-age group of 25-to-54-year-olds‑‑to rise. Labor participation by prime-age women has increased around 2 percentage points in the past three years and is now at its highest level in a decade. That said, it is still 1-1/2 percentage points below the peak level reached in 2000. Labor force participation among 25- to 54-year-old men has risen by roughly 1 percentage point in the past several years. But it is still 2 percentage points below levels seen a decade ago, and it is 3 percentage points below the levels that prevailed in the late 1990s.

As for productivity growth, there is considerable uncertainty about how much of the rebound in productivity growth that we have seen in recent quarters is cyclical and how much is structural. I believe both factors are at work. The structural, or trend, component of productivity growth is a function of capital deepening through business investment as well as a multifactor component sometimes referred to as the “Solow residual.” Initial estimates from the recent GDP release indicate that equipment and software investment in the third quarter moderated from the rapid pace recorded in the first half of the year. One data point does not make a trend, but an improvement in business investment will be important if the pickup in productivity growth that we have seen in recent quarters is to be sustained.


RIA Pro comment- The highlighted sentences in the paragraph above are important to understand. Productivity growth, demographics and levels of debt/money are the primary components of economic growth. Given, for the most part, that the amount of debt and demographic trends are a known commodity, productivity growth is the marginal determinant of growth. His statements above suggest that productivity growth has picked up recently but “one data point does not make a trend.” This means that a failure of continuing strength in capital investment by corporations will imply weaker productivity growth and therefore will signal weaker economic growth ahead.


As for the economic outlook, in the most recent Summary of Economic Projections (SEP) released in September, participants had a median projection for real GDP growth of 3.1 percent in 2018 and 2-1/2 percent in 2019. The unemployment rate was expected to decline to 3‑1/2 percent next year. And, for total PCE inflation, the median projection remains near 2 percent.

With a robust labor market and inflation at or close to our 2 percent inflation goal and based on the baseline economic outlook for 2019 I have just laid out, I believe monetary policy at this stage of the economic expansion should be aimed at sustaining growth and maximum employment at levels consistent with our inflation objective. At this stage of the interest rate cycle, I believe it will be especially important to monitor a wide range of data as we continually assess and calibrate whether the path for the policy rate is consistent with meeting our dual-mandate objectives on a sustained basis.


RIA Pro comment- As he implies above, the Fed is becoming more “data dependent.” Clarida has made that comment explicitly in prior speeches. In other words, their path towards more rate hikes or a suspension of hikes will be more heavily influenced by incoming economic data. This likely means that markets will become more volatile around major economic data releases. Furthermore, if the Fed does become more data dependent, that also suggests a reduced reliance on “forward guidance.” We will expand more on that later, but be aware that forward guidance is the Fed’s way of telegraphing to the markets where they expect rates to be in the future. In the past this guidance has proved comforting to the markets.


Data Dependence of Monetary Policy: What It Means and Why It Is Important
Economic research suggests that monetary policy should be “data dependent.” And, indeed, central banks around the world, including the Federal Reserve, often describe their policies in this way. I would now like to discuss how I think about two distinct roles that data dependence should play in the formulation and communication of monetary policy.

It is important to state up-front that data dependence is not, in and of itself, a monetary policy strategy. A monetary policy strategy must find a way to combine incoming data and a model of the economy with a healthy dose of judgment–and humility!–to formulate, and then communicate, a path for the policy rate most consistent with our policy objectives. In the case of the Fed, those objectives are assigned to us by the Congress, and they are to achieve maximum employment and price stability. Importantly, because households and firms must make long-term saving and investment decisions and because these decisions‑‑directly or indirectly‑‑depend on the expected future path for the policy rate, the central bank should find a way to communicate and explain how incoming data are or are not changing the expected path for the policy rate consistent with best meeting its objectives. Absent such communication, inefficient divergences between public expectations and central bank intentions for the policy rate path can emerge and persist in ways that are costly to the economy when reversed.


RIA Pro comment- Clarida alludes to something we wrote about in Everyone Hears the Fed, But Few Listen. Essentially, the comment highlighted above is in reference to the fact that the Fed is still projecting another 1% increase in the Fed Funds rate, while the market is currently estimating a smaller increase of .37%. Whether the Fed backs down from their forecast or they talk the market up to their level is important to follow. The reason it is important comes back to the topic of forward guidance. The difference in rate expectations (1% versus 0.37%) is evidence of less investor certainty about what the Fed may do. That uncertainty contributes to volatility by challenging the notion, as John Maynard Keynes put it, “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.”


Within this general framework, let me now consider two distinct ways in which I think that the path for the federal funds rate should be data dependent. U.S. monetary policy has for some time and will, I believe, continue to be data dependent in the sense that incoming data reveal at the time of each Federal Open Market Committee (FOMC) meeting where the economy is at the time of each meeting relative to the goals of monetary policy. This information on where the economy is relative to the goals of monetary policy is an important input into the policy decision. If, for example, incoming data in the months ahead were to reveal that inflation and inflation expectations are running higher than projected at present and in ways that are inconsistent with our 2 percent objective, then I would be receptive to increasing the policy rate by more than I currently expect will be necessary. Data dependence in this sense is easy to understand, as it is of the type implied by a large family of policy rules in which the parameters of the economy are known.

But what if key parameters that describe the long-run destination of the economy are unknown? This is indeed the relevant case that the FOMC and other monetary policymakers face in practice. The two most important unknown parameters needed to conduct‑‑and communicate‑‑monetary policy are the rate of unemployment consistent with maximum employment, u*, and the riskless real rate of interest consistent with price stability, r*. As a result, in the real world, monetary policy should, I believe, be data dependent in a second sense: that incoming data can reveal at each FOMC meeting signals that will enable it to update its estimates of r* and u* in order to obtain its best estimate of where the economy is heading. And, indeed, as indicated by the SEP, FOMC participants have, over the past nearly seven years, revised their estimates of both u* and r* substantially lower as unemployment fell and real interest rates remained well below prior estimates of neutral without the rise in inflation or inflation expectations those earlier estimates would have predicted. And these revisions to u* and r* almost certainly did have an important influence on the path for the policy rate that was actually realized in recent years. I would expect to revise my estimates of r* and u* as appropriate if incoming data on future inflation and unemployment diverge materially and persistently from my baseline projections today.


RIA Pro comment- Clarida resorts to economic jargon in the paragraph above to affirm his belief in the Phillips Curve. He is saying that lower levels of unemployment spur wage growth, and if that is occurring, interest rates should be higher to offset the effects of higher inflation caused by wage growth. This statement tells us that the monthly labor report from the Bureau of Labor Statistics (BLS) should be followed closely for signs of further strength in employment. Within the labor report, other important statistics include hours worked, wages and the participation rate.


Consequences for Monetary Policy

What does this mean for the conduct of monetary policy? As the economy has moved to a neighborhood consistent with the Fed’s dual-mandate objectives, risks have become more symmetric and less skewed to the downside than when the current rate cycle began three years ago. Raising rates too quickly could unnecessarily shorten the economic expansion, while moving too slowly could result in rising inflation and inflation expectations down the road that could be costly to reverse, as well as potentially pose financial stability risks.

Although the real federal funds rate today is just below the range of longer-run estimates presented in the September SEP, 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. As I have already stressed, r* and u* are uncertain, and I believe we should continue to update our estimates of them as new data arrive. This process of learning about r* and u* as new data arrive supports the case for gradual policy normalization, as it will allow the Fed to accumulate more information from the data about the ultimate destination for the policy rate and the unemployment rate at a time when inflation is close to our 2 percent objective.


RIA Pro comment- In the final two paragraphs, Clarida is essentially relaying that the Fed Funds rate is much closer to its terminal value than when they started raising rates in 2015. While obvious, the statement seems to convey a feeling that future rate hikes will require more robust data than that seen over the last three years.


RIA Pro Summary:

In general, we are not swayed that Clarida is looking to stop Fed Funds rate hikes, but he makes it apparent that weakening economic growth and any slowdown in employment data will result in a more dovish Fed. As is now customary for Federal Reserve officials, Clarida is making a bold attempt to “have his cake and eat it too.” Broadcasting the Fed’s tendencies with regard to interest rates through forward guidance has afforded the Fed tremendous power over guiding market expectations and thereby reducing volatility. Their wish is to maintain that influence, but doing so while raising interest rates is a very different circumstance than doing so while lowering them.

As was the case when the Fed expressed 100% certainty about implementing extraordinary policies, they are now desperately trying the same approach but while keeping a foot in the exit door. More than anything else, what they want to avoid is being caught dead wrong as they were about the housing market and economy in 2007-2008.

Simply said, on the one hand, Clarida wants to convey certitude about the economic outlook and the Fed’s path, on the other hand, he is trying to reserve the right to be wrong. We would applaud an honest acknowledgment of possible alternative outcomes, but his approach in this speech was more than a little ham-handed.