Too Far Gone

Too Far Gone

I still think it’s a wild stretch to suggest that the Fed’s hawkish tilt at the June FOMC counted as a “momentous” event, especially when you step outside the figurative (and likely literal) bubble of capital markets.

But the reaction, both in the financial media and in some asset prices, said something important about just how far “gone” we are.

The Fed’s signaling of two hikes in 2023 didn’t land above the fold for The New York Times on Wednesday evening. Or at least not above the digital fold (I stopped getting the physical Times years ago). It wouldn’t have been the top story even if there hadn’t been a Biden-Putin summit that day. I was surprised the dot plot got a front-page slot at all outside the financial media.

That said, they (the Committee) were clearly looking to send a message, and I suppose what I’d note is that there was no real segue. It felt abrupt, not necessarily because they shouldn’t have pivoted, but rather because, as I put it Friday,

As far as anyone knew, the Fed was still committed to being patient (even recklessly patient) in the face of surging prices in the interest of not “abandoning” the lower- and middle-income cohorts Powell promised to protect via the tweaked mandate. Those tweaks, you’re reminded, amounted to a belated apology for years spent exacerbating the wealth divide in America.

But the Fed’s “fresh” (woke) mandate notwithstanding, there’s still considerable tension between, on one hand, record-low rates and QE and, on the other, pretensions to building a more inclusive labor market and generally fostering a more equitable society.

In the post-GFC era, policymakers were loath to acknowledge that the transmission channel between monetary accommodation and asset prices proved to be far more efficient than the “trickle down” effect to the real economy.

You laugh. Because that should be obvious, right? I’ve emphasized repeatedly that PhD economists aren’t conspiring against anyone. But at this point, it’s not an exaggeration to call the following excerpt from Ben Bernanke’s 2010 Op-Ed for The Washington Post laughably simplistic,

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.

All of that is true. The problem, though, is that because financial assets are disproportionately concentrated in the hands of the folks who are least likely to spend, and because perverse incentives compel corporate management teams to prioritize financial engineering (often over investment and almost always over higher wages), the “virtuous circle” Bernanke described doesn’t quite spin as theorized.

History offers ample evidence to support the contention that you can engineer an asset price boom by driving rates on risk-free assets lower. If you look back at the last, say, four centuries, most notable examples of speculative excess were accompanied by some version of a hunt for yield facilitated by low returns on safer assets.

However, there’s scant evidence to support the notion that driving investors out the risk curve and down the quality ladder reliably leads to robust outcomes in the real economy that are sustainable.

Sometimes, bubbles are useful when they channel funding to innovation and when their implosion isn’t systemic — that is, when the benefits that accrue to society from the products and services created by the surviving innovators outweigh the economic fallout of the collapse.

Now, though, even that seems like a questionable proposition.

For example, there’s little question that America’s tech titans have benefited society on net (Facebook notwithstanding). And yet, the persistence of low rates and the “slow-flation” macro environment (which, paradoxically, may have been exacerbated post-GFC by the very same policies designed to boost inflation and growth given that forestalling creative destruction can be deflationary), together created a conjuncture wherein virtually any valuation for those companies can be justified from a textbook perspective. Hence the (still) inexorable rise in their collective market cap (figure below).

While probably still a “net win” for society, those companies’ market dominance could eventually become a “net drag” due both to their monopoly power and the extent to which the stratospheric rise in share prices serves to exacerbate an already egregious wealth divide.

A dozen years on from the GFC, it’s not clear why anyone still believes ongoing, broad-based, ultra-accommodative central bank policies are good for anything other than promoting and pyramiding speculative excess. We rarely draw a distinction between actions taken (and facilities established) to ensure the proper functioning of, for example, short-term funding markets, and the broad-based easing campaigns that are now entering their second decade across advanced economies.

It’s reasonable to expect periodic intervention by monetary authorities to “unclog” the proverbial plumbing and/or backstop the myriad critical markets that make the world turn every day. But after more than a decade, it feels like everything now runs on the assumption of zero (or near-zero) policy rates and, at the least, the persistence of the QE “stock effect,” whereby even if the monthly “flow” of asset purchases is reduced, trillions in safe assets remain sequestered away on central bank balance sheets, creating artificial scarcity which, in turn, serves to keep yields low. The events of September of 2019 suggested that attempts to shrink those balance sheets are almost guaranteed to dead end in funding squeezes.

The “addiction” analogy is overused (to the point of being a cliché), but I think it can be taken almost literally now. It isn’t clear that markets (any of them) can function outside of a global regime characterized by rock-bottom policy rates and bloated central bank balance sheets. A testament to that is the extent to which the idea of central banks becoming active sellers of the assets they hold is generally seen as a total non-starter.

I talked at length about all of this in “Yen And The Art Of Bridge Maintenance.” In that linked article, I suggested that fiscal authorities (i.e., politicians) deserve some of the blame. Specifically, I wrote that,

The longer central banks are forced to shoulder the burden, the more dovish they have to be. That’s because the bubbles they’re being forced to inflate are taking assets so far away from what would otherwise be market clearing prices, that allowing the market to suddenly determine the price would lead to a simultaneous collapse across most of the fixed income universe, with God only knows what consequences for equities that are priced off record-low bond yields and quantitative risk models that were built and calibrated during an era of persistently suppressed volatility.

If you’re looking to assign blame, you should at least consider fiscal policy and lawmakers in developed nations who have had 12 years since the last crisis to figure things out, develop a more nuanced view on how best to stabilize their economies, and otherwise pass legislation that makes common sense, as opposed to making “sense” in the very uncommon way that one decides to implement austerity in the middle of a downturn or during a shaky recovery just because someone said, in a textbook one time, that there are imaginary budget lines which can’t be crossed.

After this week, I worry it might be too late for fiscal-monetary coordination to help correct the situation.

Actually, let me rephrase. I actually don’t “worry,” because it doesn’t affect me. And unlike almost every other human being who weighs in with any semblance of regularity on economics and capital markets, I’m not going to sit here and claim I’m “concerned” or “nervous,” when the reality is I’ll be fine irrespective of what happens.

But, what I would suggest is that the hyperbolic language employed by the financial media to describe a half-percentage point shift in the median projection for policy rates two years in the future, and the accompanying violent reaction in the curve (figure below), were indicative of a situation that admits of no readily discernible exit ramp from accommodation for the Fed, and likely not for the ECB or the BoJ either. The financial universe (inclusive of the media) is now just one giant, leveraged trade on monetary policy.

No fiscal renaissance is going to change this. Obviously, markets respond when the fiscal winds shift. The post-US election reflation trade is a prime example. But that trade was predicated in no small part on monetary policy, and specifically the notion that the Fed would underwrite fiscal largesse. If there were any lingering doubts about that, they were dispelled when Janet Yellen, less than four years removed from her post atop the Fed, was installed at Treasury.

I’d argue the final price tag on any US infrastructure proposal that manages to become law matters far less to markets than i) the evolution of the Fed dots and ii) the timing, composition and pace of the taper. Even if Joe Biden managed to somehow pass the entire $2.25 trillion plan as proposed (a virtual impossibility), it would matter less for markets than another dot plot shift. Biden’s American Families Plan is virtually meaningless for markets relative to the outlook for the Fed’s balance sheet. How absurd is that?

Note that there was scarcely any mention of fiscal policy this week. All that mattered were those silly dots (and they are silly) and then, Jim Bullard’s comments on “his” dot.

“Friday’s price action in the wake of Bullard’s surprising hawkish sentiment confirmed the curve flattener has replaced the steepener as the Fed trade – at least for the time being,” BMO’s US rates team said, in a Friday afternoon note.

We’ve well and truly passed the point of no return when the mere suggestion, as communicated by a diagram, that policymakers might raise the price of money by a half-percentage point two years down the road, is enough to i) prompt a wholesale rethink of the proper way to trade the yield curve, and ii) throw off headlines like (from Bloomberg) “Fed Shocks Stocks With Blow to Dreams of Value Investor Nirvana.”

In an interview with Reuters Friday, Neel Kashkari said he’d prefer to keep rates at zero at least through the end of 2023. That’s ostensibly necessary in order give the labor market time to heal. “I still have no hikes in the SEP forecast horizon because I think it’s going to take time for us to really achieve maximum employment, and I do believe that these higher inflation readings are going to be transitory.”

Kashkari won’t have to push the issue too hard with his colleagues. The Fed may be able to pull off a truncated version of the last taper, and mount a similarly abbreviated rendition of the last ill-fated attempt to embark on a hiking cycle, but there’s no way out of this (now 13-year-old) “experiment.” If monetary policy were ever actually normalized across the US, the UK, the EU and Japan, financial assets of every size and shape would collapse.

A while back, I read someone’s belabored attempt to explain why, some years ago, his company decided to “diversify” their previously narrow field of inquiry by expanding beyond markets and economics into geopolitics (and, by now, every other topic imaginable, including celebrity gossip).

It was an entirely disingenuous narrative designed to excuse a desperate money-grab (he alluded to his own looming “insolvency”) in the face of a big-tech crackdown on misinformation and propaganda in the media.

But that comically unfortunate fellow was right about one thing: Starting in 2008, the history of capital markets became the story of central bank intervention. We live in a world of administered prices, and I don’t think you or I will live long enough to see that change.

For the likes of Bloomberg, that’s a boon, apparently. But for the tabloid owner I just referenced, it makes covering markets an exercise in futility. I’d remind him that so is life.