By Kevin Muir of “The Macro Tourist” fame; reposted here with permission
It’s never easy being a central banker. Too many of us, with the benefit of hindsight, look back and proclaim judgment on policies they took (or didn’t take) often forgetting that the future is never easy to predict. I am by no means innocent of this charge. I take potshots at central bankers all the time without consideration of the difficulty of their jobs.
Even the most revered central banker in history, Paul Volcker, was only admired years later.
Amid his administering the harsh medicine to stop spiraling inflation, there were howls of protest from the public who were being squeezed by the high cost of money. And by no means was Wall Street all-aboard either. Here are some of Volcker’s own recollections of the period from a 2013 NBER interview:
I decided we had to change the play book a little bit and we threw everything we could into the October 1979 announcement. I had this naive hope, I knew the short-term rates would go up, but I thought, “Ah, we will instill confidence and long-term rates will not go up.” Long-term rates went up, too, just about as much as the short-term rates, which was a disappointment. But it showed how strong the psychology was.
…raising interest rates quite visibly and openly is not the easiest thing in the world for central bankers or anybody. It’s much easier to lower interest rates than it is to raise interest rates, I think it’s fair to say, in almost any circumstances. That 4-3 vote that I referred to reflected something of that reluctance.
Although Volcker is now almost universally lauded as a hero, back then consensus would have been closer to a bum. Change is always hard. And Volcker was definitely trying to change things. Human beings are not easily swayed from their ways and there is always a great deal of push back whenever the status quo is tossed out the window.
Why do I bring this up? The other day I was fortunate enough to have dinner with a new friend who presented his analysis of Fed Chairman Powell’s policies in a way that really struck a chord with me. When I describe it, you might not think it that novel, but what I liked was the way he extended his thinking past the immediate implications, and had thought through what it might mean over a longer time period.
I have adopted it as my own base case for Fed policy going forward.
There is a ton of anecdotal evidence concluding that Powell is not one to rock the boat. People that know him describe him as “steady” and someone to be counted on.
But what will that mean as a Fed Chairman? There is plenty of speculation about Powell being of a new breed of Fed leaders who won’t kowtow to Wall Street’s every whim. Yet there are also critics who argue he doesn’t have the stomach to reign in Wall Street’s excesses.
My new pal agreed that Powell will continue to tighten every second meeting, just as the market expects. It was the next part of his theory that got me. He said there are two outcomes to this rigidness.
Powell overshoots on the tightening
The first possibility would be that increasingly tighter rates would cause markets (and maybe the economy) to stall. During the Bernanke and Yellen Fed reigns this caused the FOMC to pause their tightening campaigns. This is what pundits refer to as the “Fed put”. When markets wobbled, the Federal Reserve was loathe to tighten monetary policy for fear of causing a further market decline which might hurt the economy. So they often eased the pace of tightening during stock market sell-offs. Yet my friend’s theory centers on the idea that Powell does not care about Wall Street, but is instead focused on Main Street. Powell will no longer play the “wealth effect” game that Bernanke embraced. In a November 2010 op-ed defending quantitative easing, Bernanke wrote:
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Notice the direct connection between higher stock prices and increased spending. The trouble with this policy is that if you believe higher stock prices helps the economy, then you also have to believe lower stock prices hurt the economy. And having a central bank that is tuning to the twists and turns of the stock market is not productive. Powell does not believe in the Fed put. His focus is on the real economy, not the financial economy. Therefore he will continue hiking rates at a measured pace for as long as economic numbers are relatively strong regardless of financial market movements.
Markets have been conditioned to believe the Federal Reserve is sensitive to sudden tightening of financial conditions, but this might well now be a mistake. Powell seems much more ready to tell Wall Street that monetary policy is not beholden to the market’s every worry. This might be a dangerous situation for those Pavlovian-stock-dip-buyers.
This insight isn’t that original. Many commentators have noticed Powell’s rejection of Fed dogma. But it’s the next part that my buddy’s comments that got me.
Powell could be too slow on tightening
He wasn’t sure if Powell would make a mistake by being too tight, or by not being tight enough. The reality is that it is difficult to determine the correct price for the rate of money. You can stick all the numbers you want into your fancy economic formulas, but the human element – the animal spirit part of the equation – makes it almost impossible to determine the correct price.
Have a look at the velocity of money over the past half-century.
When the velocity of money was stable, it was much easier to determine a “fair” price for the rate of interest. Yet with the plunging over the past decade, it has made many of the economists’ models almost useless. This is my main problem with trying to turn economics into a hard science. It’s simply not. There are too many variables that result from human beings’ behaviour to forecast future economic performance with any accuracy.
Which brings us to Powell’s second potential error. He has a plan. He will raise rates every second meeting until something changes in the real economy to cause him to change his plan.
I don’t know if the current rate of interest is too high, too low, or just right for today’s economy. I have a guess, but it’s just a guess. But I know one thing. Over the past decade, there has been a huge amount of monetary stimulus applied to the global financial system. One of my favourite charts is the Federal Reserve’s total balance sheet. But what I love to point out is the Greenspan’s Year-2000-liquidity-flooding-stimulus that caused the final manic sprint higher in DotCom stocks.
The reason that Greenspan’s Y2K liquidity boost had such a dramatic effect? Velocity of money was at its peak. The extra money went straight into the economy and had an immediate dramatic multiplier effect. This was in contrast to the collapse in the velocity in money since the Great Financial Crisis.
This is the “human element” that economists cannot incorporate into their model.
But what if that decline in the velocity of money has run its course? What if Trump’s pro-business plans, along with maybe even some infrastructure spending, combined with some household formation from the millennials, causes velocity to tick higher? What if this huge pile of monetary stimulus finally ignites and creates a self-reinforcing economic expansion?
Yeah, I know… Robust growth and inflation are never coming back. But then again, housing prices were never supposed to decline on a national level, so a good investor never says never.
How will Powell react to this scenario? My buddy’s argument is that Powell will be slow to react to this development. Powell will be hesitant to cause direct pain to the heavily indebted consumer. After all, it has been a long time since the economy has been strong enough to cause decent wage gains for the average Joe. It would take a strong Volcker-type to aggressively raise rates given the years of Wall Street winning while Main Street lost. Powell is no Volcker. It would rightfully seem heartless to crank rates the moment Main street finally enjoys some economic growth.
Powell is above all else, not one to swap horses midstream. So his plan of a hike every second meeting will likely be rigidly held in an economic melt-up. Whereas the previous Fed Chairs might have been more inclined to worry about rocketing financial asset prices and increase the pace of tightening in this environment, Powell will maintain status quo even in this scenario.
Putting it all together
Powell has got a plan, and his sticking to it so vehemently will ultimately be a mistake. The big difference between him and previous Fed Chairs will be his reluctance to alter that plan as conditions change. That might mean he keeps raising rates too long into an economic slowdown, but it could just as easily mean he doesn’t increase quickly enough in a dramatic economic uptick.
Powell’s reaction function is much, much less sensitive to short-term market and economic indicator fluctuations than previous Fed Chairs.
What does that mean for markets? The most obvious conclusion is that the yield curve will be much more volatile than I previously expected. Unfortunately trading yield-curve-options is something best suited for those with ISDAs.
And some of the smart ones with that capability are already leaning this way. From Business Insider last year:
The fund, called the Brevan Howard CMS Curve Cap Master Fund, will be led by senior trader Rishi Shah, who has been with the firm since 2010 in Geneva and New York, according to documents seen by Business Insider.
The new fund will use what are called constant maturity swap curve caps to bet on both a steepening of the US yield curve and an increase in curve volatility.
Getting long the yield curve has definitely been a popular trade with the Connecticut/Mayfair sect, and unfortunately, I have been swept up into this group-think.
Although I still think it is a terrific long-term trade, I am now worried about the potential for an increase in the volatility of the spread. The rewards of calling it correctly are increasing, but so are the risks. We could blow out back to 200 bps, but it might first zip down to negative 50. Damn, I sure wish I could buy long-term steepener call options. Maybe I will give Rishi Shah a call and ask him how he is doing it…