BofAML has had enough of your bullshit for one week.
See, people like you (and me) keep perpetuating this idea that the Fed has adopted a “shadow” or a “third” mandate in the face of persistently easy financial conditions.
That, of course, is another way of saying that people like you (and me) are starting to get the idea that maybe the Fed understands what everyone else understands: that clinging to crisis-era policies for damn near a decade after the actual crisis is inflating bubbles in financial assets.
As evidence of our “third” mandate hypothesis, we cite, well, we cite shit Fed officials have actually said about asset prices and financial conditions.
But beyond that (i.e. if you’re the type of person who thinks “actions speak louder than words”) we cite the committee’s readily apparent willingness to ignore lackluster incoming data on inflation – lackluster data like we got on Friday morning.
If you’re long risk, you want that data to stay some semblance of lackluster. Because as long as it does, the Fed is likely to find themselves hamstrung. That is, there are only so many consecutive CPI misses you can stomach before you have to admit that there isn’t anything “transitory” about this. And that right there explains why investors were busy buying tech stocks this morning even as the dollar and yields collapsed:
At this point, you have two options if you’re the Fed:
- slam on the brakes and slow the pace of normalization
- say “fuck it” and admit you’re targeting financial assets, so unless and until stocks correct, you’re going to stay the course on normalization
Well, as tipped here at the outset, BofAML isn’t buying that.
“There is a narrative in the markets that the Fed has made a hawkish pivot to respond to concerns over financial stability risks,” the bank writes on Friday morning, adding that “we think this story is a bit misplaced.”
Yes, “a bit misplaced.” Or, as they put it in the title:
A misunderstood narrative
There is a narrative in the markets that global central banks have made a hawkish pivot to respond to concerns over financial stability risks. We think this story is a bit misplaced. In our view, it is true that easy financial conditions – which underpin future economic growth – have encouraged Fed hikes. But it is not true that the Fed is hiking to address vulnerabilities in the financial system or “pop” asset bubbles.
What has the Fed been saying?
The latest June FOMC minutes highlighted concerns owing to subdued market volatility and low equity premiums. This is not new for the Fed. We look back at the FOMC minutes since 2015 for mentions of financial stability risks (Chart 1). We find that financial stability risk is a regularly discussed topic, showing up in 15 out of 20 minutes. The most commonly cited source, reflecting hawks on the committee, was that financial stability risks could arise from keeping interest rates too low and policy accommodative for too long. The “other” category refers to fairly specific concerns, such as the impact of money market reform, housing finance reform and risk of deregulation. Moreover, a frequent caveat to financial stability concerns is that Fed officials believe the financial system has become stronger and safer given higher capital and liquidity requirements among other macro-prudential tools.
Understanding the framework
The latest Monetary Policy Report associated with Yellen’s semi-annual testimony offers a good summary of the Fed’s current view, including several sections on financial market stability and corporate bond market liquidity. The paper described the vulnerabilities in the US financial system as “moderate on balance.” Vulnerability is the key word – it captures weaknesses in the financial system which would amplify or transmit shocks, threatening the overall economy.
Digging deeper, the Treasury’s Office of Financial Research (OFR) offers a detailed framework for monitoring financial stability that mimics Fed thinking:
1. Macroeconomic: cost of funding, inflation volatility/expectations, sovereign financing needs
2. Market: duration, risk premia, valuations, volatility, positioning, FX/ALM mismatches
3. Credit: corporate credit spreads, asset quality of households, lending conditions
4. Funding/liquidity: broker-dealer inventories, short-term funding rates and spreads
5. Contagion: cross-board exposures, correlation risk, sovereign-bank exposures
The OFR releases an annual report on financial stability at year-end but provides updates periodically. As of the December 2016 report, the OFR described risks to financial stability in the “medium range”.
The Fed and the OFR seem convinced that the banking sector remains in good health. Capital and liquidity ratios at US banks are at historical highs and banks have replaced short-term wholesale funding (such as commercial paper held by money market funds) with more stable core deposits. The news, in general, has also been more favorable for leverage with a decline in household debt as a percent of income and a shift toward higher credit scores for new debt. While leverage for nonfinancial businesses is elevated, the Fed notes that it has been falling or flat over the past two years (Chart 2).
However, there is concern about the measures that roll-up into the “market” category. According to the OFR, that is the most risky category with interest rate risk flashing red (significant risk) and positioning and asset valuations also high on the list of concern. Similarly, the Fed notes that valuations continue to rise across a range of assets, including Treasury securities, equities (Chart 3), corporate bonds and commercial real estate (CRE). The Fed also specifically mentioned concern over low term premiums on Treasury securities (Chart 4).
There is also concern over market liquidity. Although the Fed argued that most metrics (such as the bid-ask spread) show that liquidity strains in corporate bond markets have been minimal, there are still some reasons for unease. In particular, broker-dealer inventories have been lean, which could reflect regulatory changes.
Linkages to the economy
The focus, ultimately, is on vulnerabilities of the financial system which would turn an adverse market event into a systemic crisis. We therefore need to understand the linkages of financial stability into the real economy. Chart 5 shows a simplified flow chart of how these vulnerabilities manifest. Consider the impact of low interest rates. In theory this leads to increased borrowing (leverage), of which some can be unproductive. This helps to fuel asset price bubbles (think the housing bubble), therefore fueling back into higher leverage. Low rates and high valuations also drive a search for yield which can lead to irresponsible market making. If the banking sector is vulnerable with these conditions, it can lead to a systemic crisis, feeding back into the real economy and spreading to the global markets. This means you must consider all of the linkages and not focus just on one metric of financial stability.
The Fed is not hiking because of financial stability concerns
We can debate whether the Fed is underappreciating the risks – although the banking sector is well capitalized, the non-bank system is left with more limited oversight. Although standard metrics of market liquidity are supportive, the markets did not fare well under recent stress events. For example, back in October 2014 during the Treasury “flash rally”, bond market liquidity experienced significant duress following the release of disappointing retail sales, PPI, and Empire manufacturing data. And contagion risks could be larger given the interconnectedness of the global financial system.
However, fear of systemic risks from the US financial system is NOT the main reason for the hawkish turn in Fed policy. As Chair Yellen made clear at her testimony this week, she believes the financial system is stable and resilient. In June, she argued another financial crisis in our lifetimes is unlikely. The pivot toward faster normalization of policy reflects the data (tighter labor market) and supportive financial conditions. This means that if the data turn – inflation remains weak – the Fed will feel comfortable pausing the hiking cycle. Financial stability concerns will not keep the Fed hawkish.