David Stockman: That ‘Unicorn’ Isn’t Real

By David Stockman as originally published on Contra Corner and reprinted here with permission

The single most important price in all of capitalism is the interest rate—-and at all points on the maturity curve. And the single most important truth about honest interest rates is that they must be discovered by markets, not imposed by the state.

We got to ruminating about those core propositions when we read that San Francisco Fed head, John Williams, may be headed toward the true #2 job at the Fed. That is, President of the New York Fed—-the joint that actually runs the casinos domiciled in the canyons of Wall Street.

We did not burst out laughing exactly, but nearly so. After all, why do you even need Wall Street if you are going to have John Williams running the joint?

Recall that Dr. Williams claims to see a financial apparition that no one has ever touched, measured, photographed, X-rayed or otherwise proven the existence of. We are referring, of course, to the “Neutral Rate of Interest”.

By contrast, Dr. Williams is certain that he has spotted it, measured it and completely understood it. Indeed, he is so certain that in recent times it has been extraordinarily low, that he wants to run the entire $19.7 trillion US economy on the basis of it.

That is, peg actual interest rates in the money market based on a theoretical rate that might as well be the equivalent of a Monetary Unicorn. That’s because no one on the bond and bill trading desks of Wall Street has ever seen it, or ever will.

Not only that, but Dr. Williams now suggests that we actually need even more inflation than the sacred 2.00% target to cure whatever ails the US economy, and that his Monetary Unicorn told him so. Thus, as per the AM’s Wall Street Journal:

His influential research at the Fed includes his work with Thomas Laubach, a top Fed economist, on identifying the neutral rate of interest: the inflation-adjusted rate that neither spurs nor curbs growth. Understanding how to glean this unobservable rate is critical to setting Fed interest-rate policy.

Mr. Williams has argued, and many other officials have come to agree, that the neutral rate fell very low during the financial crisis and recession and hasn’t recovered much since. This conclusion became a key factor behind the Fed’s thinking in keeping its own benchmark federal-funds rate very low in recent years and then raising it slowly and cautiously.

More recently, Mr. Williams has been outspoken in calling on Fed officials to rethink their 2% inflation target, and allow periods where inflation might run higher to make up for times where it runs lower.

That’s right. There is not a pittance of evidence that 2.00% inflation is better than 1.00% inflation, but Dr. Williams wants to up the ante to 3.00% in order to make up for lost ground during the alleged “low-flation” of recent years.

Stated differently, he wants to empower the Fed to manage the entire financial system by targeting the inflation index level, not just the annual rate of gain; and to do so based on a invisible price of money (the Neutral Rate of Interest) that no one on Wall Street has ever seen; nor has anyone else with real financial skin in the game.

And they want to put him in charge of the casino!

Needless to say, the gamblers down there will doubtless think they have died and gone to carry trade heaven.

So at this point it is useless to say that you can’t make this stuff up—because they do day in and day out in our central bank driven financial fantasy land.

But perhaps the sheer irony of sending Dr. Williams to Wall Street at least provides an occasion to note the obvious. Namely, monetary central planning as practiced by the Fed and other central banks is the very antithesis of sound finance because its very modus operandi is based on setting administered debt prices that vary from the free market, and in recent times by considerable amounts.

Otherwise, why call it “emergency policy”; or if the variance from market prices is held to be minor, why bother in the first place?

Stated differently, if the central banks are doing what they claim—steering the economy through non-market interest rates and asset prices—it all boils down to a simple proposition: Namely, that central banks are in the business of materially falsifying market based financial asset prices (debt is somebody’s asset), and that’s all to the good.

Not being in the Cool Aid drinkers camp, we are inclined to ask: Why in the world would you believe that?

For instance, why would the 12 members of the FOMC be better equipped to price BBB corporate debt, than the daily tug and haul of tens of thousands of traders, issuers and bond managers?

When put that baldly it’s pretty obvious that the academics and apparatchiks who dominate the FOMC don’t have a clue about risks and rewards in this border-line region between junk and investment grade, where more than half of so-called investment grade bonds are now rated.

In fact, it is not even a close call because by definition BBB issuers are in risky businesses, have risky balance sheets and compete in highly competitive and dynamically changing, not to say unstable, global markets. After all, there is a reason why BBBs are not meant for the accounts of blue-haired widows.

Of course, we do not mean that the monetary politburo literally sets the price of BBB corporates like traders do in each separate transaction, but they are priced at a spread off the 10-year UST. And we do know that in the last 20 years the Fed has expanded its balance sheet from $400 billion to $4.4 trillion.

That means, in turn, that it purchased $4.o trillion of USTs and their GSE cousins. So doing, it drove up the price of the 10-year benchmark, encouraged front-running speculators to do the same, and also forced mercantilist central banks abroad to sterilize these dollar emissions via FX interventions and purchase of even more USTs.

In all, the Fed’s $4 trillion bond buying spree since 1997 triggered a whole bunch of yield repression in the US sovereign debt market, thereby triggering a whole lot of consternation—sometimes even panic—among bond portfolio managers (PMs). So they responded to falsified benchmark bond prices by stretching mightily for yield.

And one place the yield chasers landed was in the corporate BBB sector which more than quadruped in size during this period. That, and also, it fell like a stone in terms of yield and the carry cost to issuers.

As shown by the blue line in the chart, during the halcyon days of the tech boom, BBB yields hovered around 7.5% prior to the recession triggered spike after 2000. Since the CPI averaged about 2.5%during the second half of the 1990s, call the real yield about 5.0%.

By the same token, the 5-6% nominal yield during the Greenspan mortgage/credit boom over 2003-2007 translated to 3-4% in real terms.  And then came the finale of the Fed bond buying spree after the 2008 financial meltdown, causing nominal yields on the BBB to hover around just 3.75% during most of the last six years.

Contrary to the low-flation narrative, of course, CPI inflation has not dropped by a commensurate amount, averaging about 1.75% during recent years.  So the Fed price-setting committee (i.e. the FOMC) did apparently get the real corporate BBB yield down to just 2.0%.

What happened?

Why, corporate America did well and truly go on a borrowing spree. Back in early 1997, corporate debt outstanding totaled $4.6 trillion and it computed to 54% of GDP. By contrast, by Q3 2017 it had soared to $14 trillion, and amounted to 72% of GDP.

There is absolutely no reason to assume that somehow the US corporate sector was “underleveraged” in 1997, and that the Fed’s monetary central planners helped to get it properly buried in debt.

Still, had the debt ratio stayed at the 54% of GDP level, corporate debt today would be a cool $3.5 trillion lower.

The theory of monetary central planners like Dr Williams, of course, is that they were just helping the business community borrow hand-over-fist—-that’s what the nearly $10 trillion gain since 1997 amounts to—-in order to invest at higher rates than slow-witted corporate executives would do on their own.

We could say wrong again, but why bother?

The data is dispositive, but completely ignored by our omnipotent monetary central planners. In fact, net investment has been heading straight downhill on a trend basis since the late 1990s, and is still 35% lower after 10 years of Fed stimulated “recovery” and drastically falsified interest rates, as illustrated by corporate BBBs.

Then again, maybe the C-suites are not as slow-witted as Dr. Williams presumes. Since 1997 they have cycled upwards of $20 trillion into financial engineering plays. That is, stock buybacks, M&A deals, leveraged recapitalizations and cash extractions of every imaginable shape and kind have flowed back into the canyons of Wall Street, inflating stock prices and options values along the way.

As we said, the Fed is in the fundamental business of falsifying interest rates and other financial asset prices. The problem is, it fuels financial bubbles and malinvestments, not capitalist prosperity.

By now that much should be obvious. Except to the likes of power-seeking apparatchiks like Dr. Williams who would run the world based on financial fairy tales rather than allow free markets to do the honest work of price discovery.