I don’t know if anybody else has noticed this yet (my apologies if it’s all over the place already), but BofAML’s Chris Flanagan put something out on Friday that sounds like it walked out of that scene in Ghostbusters when Bill Murray is trying to convey the urgency of the situation to the Mayor.
And by that I mean Chris is extremely concerned about the possibility that the Fed made a potentially disastrous mistake on Wednesday. Specifically, Flanagan is calling this “the Fed’s new ‘subprime is contained’ moment”.
After saying (right up front) that in his view, “this week’s hawkish Fed meeting outcome substantially increased the chances of a major financial and economic crash in the next 1-2 years, brought on by a liquidity shock”, Chris delivers a gut punch to the Powell Fed by likening this week to one of the most notorious soundbites in the history of modern finance. To wit, from the note:
We think the chances are good that history will someday view this week’s message as similarly detached to Ben Bernanke’s May 2007 assertion: “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
For those who need a refresher, you can find the full remarks from Bernanke that Chris is referencing here.
Flanagan goes on to critique what happened on Wednesday in some pretty harsh terms.
“The Fed may believe it had no choice other than to continue tightening, on two fronts no less (rates, balance sheet), and perhaps that the real economy is a very different concern than financial markets”, he says, before contending that whatever the Fed was thinking, “they failed to adequately make the supporting arguments (not even close) and mistakenly ignored important market signals that it was time to at least pause on policy tightening [especially considering] there was nothing to prevent the Fed from pausing and resuming tightening at some point in the future when financial market conditions were more stable, particularly when year-end liquidity effects subside.”
Having thus told you what he really thinks, Flanagan lays out a pretty simple rationale for his criticism. As alluded to above, it’s mainly couched in terms of liquidity risk as measured by BofAML’s GFSI liquidity risk indicator (it’s a measure of funding stress in the global financial system derived from spread-based relationships in rates, credit and currencies).
“Currently, liquidity risk is at levels seen in April 2000 and August 2007, just prior to two recessions and when, in one instance, the Fed was already easing aggressively”, Flanagan writes, adding that “when the Fed tightened policy into this level of liquidity risk in late 2015, it was only the first hike of the cycle but it then paused for a year [and] when liquidity risk hit these elevated levels in 2011, the Fed eventually responded with QE3 in 2012.” He’s describing the following chart which we’ve recreated.
But it’s not just liquidity Flanagan thinks the Fed is ignoring. He’s also concerned about collapsing breakevens. Basically, Chris thinks Powell shouldn’t have ignored the 40bp decline shown in the following chart, because if history is any guide, “the directional change in the 10y breakeven rate does a pretty good job of signaling the directional change in PCE inflation.”
Finally, Flanagan reminds you that “over the past 40 years, every time the 2y10y spread turned negative, the unemployment rate increased.” Given that, the following setup appears precarious.
On liquidity, he does acknowledge that once the seasonality fades, things could improve and on breakevens and the curve, he begrudgingly notes that this time could be different. But on that latter point, he sticks to the line adopted by many an analyst and pundit lately – namely that this time is probably not different. To wit:
Our perspective on this is that conditions are proceeding according to normal cyclical dynamics: the Fed is in the process of overtightening, ignoring market signals such as a flattening yield curve and widening credit spreads, asserting this time is different; credit will be increasingly rationed as spreads widen further and the Fed tightens further; hiring will ultimately turn to layoffs; the unemployment rate will eventually rise, albeit from lower levels; as usual, the rise will surprise and seemingly come out of nowhere, just as the recent market meltdown did.
BofAML’s prediction is that market participants will not believe the Fed and will proceed to “ration credit.” That, the bank says, is “how this cycle will ultimately end.”
After that, things progress logically to locust swarms, widespread drought, famine, pestilence and, ultimately, the sun exploding.
“Dogs and cats, living together, mass hysteria!”