‘Minsky Moments Almost Certainly Await’

It’s now mostly impossible to avoid the 2018 comparisons when it comes to Fed policy.

Wall Street has coalesced around three (and, increasingly, four) rate hikes in 2022. And it’s obvious the Fed has (at least internally) adopted an “ASAP” mindset when it comes to the onset of balance sheet runoff, even if officials studiously avoid alarmist rhetoric this week during a packed calendar of speaking engagements. Jerome Powell and Lael Brainard appear before Congress, with December’s CPI report sandwiched between their confirmation hearings.

One certainly hopes Powell learned from the 2018 experience what not to say, even if he’s condemned, by the bipartisan nature of inflation concerns, to adopt a conceptually similar policy bent, albeit starting from a much more accommodative baseline.

Everyone remembers “long way from neutral” (October 2018) and “autopilot” (December 2018), but it’s worth mentioning that in May of that year, at an IMF/SNB event, Powell said the following of emerging markets’ purported resilience to tighter Fed policy:

Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

That too was an example of tone deaf rhetoric and it certainly didn’t help EMs at a time when idiosyncratic flareups were afoot in Argentina, Turkey and Brazil.

In a Monday note, Nomura’s Charlie McElligott offered some thoughts on what might be in store as the Fed attempts the impossible.

“I absolutely do believe that the Fed has already ‘made their bed’ with pretty darn clear messaging of late,” he said, before reiterating that the vaunted Fed Put is “now being struck substantially lower.”

The Fed is keen to tighten, and that effort will proceed on two fronts simultaneously: Rate hikes and balance sheet runoff. Both are likely to commence before summer, with liftoff fully priced (basically) for March and the Street pulling forward forecasts for QT seemingly every other day.

What does a 2018 redux look like? Well, as McElligott wrote Monday, the “last time around, QT led to rolling ‘VaR Shocks’ across legacy positioning in EM, Carry, Momentum, Trend and Crowding factors throughout 2018.”

He proceeded to drive the point home. “In other words, ‘Minsky Moments’ almost certainly await, as exposures accumulated and leveraged into periods of stability and low volatility then see bouts of stress on the unwind as Vol moves higher, dictating mechanical ‘grossing-down’ of risk into a fixed-income environment where real price discovery is forced via [a] transfer from the ‘Fed-as-buyer’ backdrop [to] private investor hands moving forward.”

Remember (and I can’t emphasize this enough), we don’t really know what market clearing prices are for some assets anymore. While 2022’s Fed tightening won’t entail the kind of existential crisis that might unfold if, for example, the market were allowed to decide spreads on periphery EGBs with no “input” from the ECB, it still has the potential to be highly disruptive.

“Private Investors are inherently more price-sensitive, while many on the MBS side too will have to convexity hedge,” McElligott went on to say, adding that the combination of increased TIPS supply and a Fed that steps back from the market may have a “substantial optical impact on breakevens.”

Crucially, QE effects (and the impact of extreme accommodation more generally) are embedded across all assets by default. I’ve repeatedly emphasized that over a half-decade spent writing for public consumption. When QE morphs into QT, the process goes into reverse.

That’s the simplified version. McElligott on Monday offered the play-by-play. As the Fed “begins to unwind their balance sheet, excess reserves are drained, and all this collateral needs to find a new home with private investors,” he wrote, adding that,

[This] is occurring alongside a reduction in the cash side, as those excess reserves held in shorter-term, liquid securities go ‘poof.’ So, it’s really a crappy set-up: Less cash available to help absorb more collateral, which is now being put back to private investors, as the Fed’s price-insensitive buying disappears. This is where [the] ‘mechanical’ impact of the QE-to-QT ‘Cash / Collateral paradigm shift’ then bleeds into other asset classes. The cost of borrowing rises / repo rates move higher, which impacts risk-free benchmarks as owning government securities becomes more expensive, and this then reverberates out into risk assets, knocking-on into widening of spread product like MBS and credit, which then further spills over into all parts of the capital structure and securities universe.

The Fed understands all of this. Sort of. The problem isn’t that policymakers are intellectually bereft. They can discuss most of the issues, and even if they can’t, they employ an army of staff whose job it is to make sure they don’t come across as hopelessly out of touch when speaking on the record.

That said, they still manage to serve up a veritable cornucopia of cringeworthy soundbites, which serve as endless cannon fodder for thousands of netizens who spend their days pretending to be PMs on Twitter. Occasionally, Neel Kashkari will engage critics, for reasons I’ve never been able to comprehend.

Whatever the case, policymakers certainly aren’t good at spotting bubbles in real time, nor are they particularly adept at gaming out the possible ramifications of policy tweaks.

What I’d say, in their defense, is that hindsight is the only infallible lens. And we’re all bereft on that score until after the fact.

Even if you believe you can spot bubbles, the only thing more difficult than predicting precisely when they’re poised to burst is mapping out the butterfly effect from policy maneuvers aimed at orchestrating a controlled demolition. The Fed is implicitly tasked with doing both.


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