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 weekâ€™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 weekâ€™s message as similarly detached to Ben Bernankeâ€™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”,Â 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!”
10 thoughts on “The Fed ‘Substantially Increased The Chances Of A Major Crash’ In The Next 24 Months, One Bank Exclaims”
In any case, we are on the precipice of a major change.
Call it what you will, generational dynamics, waves, physics, populism, debt or just plain boredom, the entire financial world has been locked into defensive hibernation for nearly 10 years. ETF’s, funds of all flavors, algos and what is laughably called big data Ai, were the opioids.
Oh! I wish I was 21 again and know what I know now. I definitely would have quit drinking sooner and kept my second wife.
The next 25 – 30 years are going to be exciting, scary and so full of living that I envy the challenges for the young to be overcome ahead.
Thanks for the charts H / W.W.
Tom. This country will be mired in socialism in 10 years. The youth don’t know, haven’t really seen capitalism work. It is going to be tough. I feel for the kids of today.
How many people left the markets forever in 08 and how many more will leave soon? After this past week even I would not be surprised to see GOOGL trading at $600 at the end of next week or MSFT at $70. The movements aren’t really markets. $4-5tn have been destroyed in a few months ($4-5tn created the previous year or so). People dont do the work and rather just chase (if it goes up it is good if it goes down it is bad). Bitcoin was a scam imo but people believed in it. Real businesses with strong bal sheets and cash flows drop 25% in a few months or rally 50% on fears or dreams. This will have huge repercussions for capital allocation (cap ex), innovation, productivity, wealth etc. add in debt levels and governance and no wonder why it will be a tough road.
Life goes on. Acknowledge, adopt, absorb.
I’m no genius, but it works for MSFT and the Catholic church despite both their failings.
The past is history, the future a mystery, all there is the eternal now.
Trade the screen, not the dream.
Yes Tom. Still with my second wife. I also feel big changes coming and I’ve reduced my drinking and hope to arrive at a point where I can stop completely. As I get older and watch people have to interact with healthcare in the US, that becomes a frightening prospect…
Wow, all this happened in 50bps of rate increases and a few months of QT. Yes the market is awful, corp debt levels are too high and yes psychology can turn and reflexivity can kick in. BUT consumers are in ok shape, there is A LOT of capital out there looking for a home. Yields are still historically very low and spreads tight, corp FCF still is ok. Risk is not concentrated in the banks the oil in the machine but spread out among many investors.
I have been bearish for a while based on debt levels at corp and govt, peak margins, crowding out due to deficits, extreme valuations in debt and equity markets, the hollowing out of the middle class, trade policy, general political insanity, aging populations, etc.
But has a small trimming (QT) in the Fed bal sheet and 50bps really that meaningful?
Yes, sentiment can change everything. A run on the bank can happen at any time (good or bad economy). All you need is everyone to do it.
And no question companies have gotten more cautious in Q3 because of trade uncertainty and I full expect dialed back cap ex and layoffs. And I expect a recession which is normal but other than debt levels I don’t see excess inventories or other severe imbalances.
I would like to see his full note. What was written here feels incomplete and not all that convincing. But it does rate high on the panic meter.
In a world where everyone WAS searching for yield do they now realize that the spreads they were buying were not appropriate? The reality is most investment professional move with the crowd and look to other markets to justify valuations (relative valuations) rather than absolute valuations. In a 2.8% 10 yr world and with some great companies there is a lot of FCF degradation that can happen and still end up a fine investment.
American business is a bit better than the analyst suggests. This is not to say there isn’t more sentiment risk but I suspect we have no year of contraction in growth in the next 3 years.
But MANY industries are under supreme pressure and concentration of profits and wealth will continue to narrow but if we back off the trade craziness, regain a sense of stability in govt, and the Fed remains open to data (I don’t believe Powell is as dumb as Bernanke) we can avert the crisis Chris suggests. Economies do not change that rapidly.
I guess Chris just wants QE forever. Isn’t that partially why we are in this in the first place?
This is just one opinion meant to spur thought rather than any investment action. Markets overshoot all the time (AAPL and AMZN trillion $ mkt caps a few months ago) and they can remain irrational longer than an investor can remain solvent (and sane).
A “small trimming” of the balance sheet?
In the context of a doubled bond calendar, it’s hardly trivial.
I believe and will continue to believe to my grave and beyond that the mark to market accounting rule change and CDS were the reasons subprime almost blew up the world (and the system was very close to seizing more than the public knows).
Imagine your bank marked to market your home loan on your first home purchase. 80% loan to value. And one day no one places a bid. So the market says it is worth $0 because no one bid. The bank would have to mark it down even though you were current and the loan is performing. And bank capital gets hit causing the to either delever (sell assets depressing prices) or raise capital.
Now imagine $400bn worth of this and hedge duds are buying CDS (default protection) driving spreads up and values down hitting bank capital. An end around run on the bank with relatively small amount of capital making a large impact.
It truly was insane.
Now we have VaR (value at risk) that quants say volatility is risk so as vol goes higher risk goes higher even though the true value of the company has not changed much. So in there eyes FB was less risky at $220 because tge daily % movement was small (say 1% because it only went up) even though it traded at a 2% FCF yield or whatever (not cheap) while now at $125 and a 4% FCF yield (whatever it is it is just an example) it is more risky (even though it is cheaper though one could argue the business and future cash flows may have changed) because it trades in a 3% daily move (again just a guessing number not actual just to show an example).
Risk to me is loss potential while vol is opportunity but the stupid risk quants sadly don’t agree.
Another big structural issue (and similar imo issue to 08).
Banks had the choice to mark to market or Mark to model based on the level of assets. Let’s not act like they were some innocent bystander in all of this. The choice determined how much capital they needed to set aside to cover potential losses. It’s the classic when the tide rolls out you see who was swimming naked, the banks were insolvent because they had so highly leveraged themselves on the (poor) assumption that housing prices never go down and are local and on the business model of misleading investors is okay and the right thing to do because they won’t be caught (maybe the correct assumption unfortunately).
S&P hit generational low of 666 on March 6, 2009. FASB relaxed the mark to market measure on April 9, and it’s been pretty much straight up from there. Making a market based on what something should be worth as opposed to what it actually is worth are two different things. QE allowed people to buy the story; QT will force them to consider the reality. .
Generational low? Feel pretty confident eh? I would be surprised to see that again but who knew Trump could win?