Mary Daly’s protestations aside, the Fed knows that continuing to hike policy rates in large intervals atop what’s already the most aggressive starting pace in history will in fact “break something,” to employ one, among many, nebulous colloquialisms for the collateral damage that invariably accompanies US tightening cycles.
We pretend every nation (or currency bloc) is free to make its own choices about the appropriate course of policy, and so on, but that’s fiction.
“This notion of separate nation states with separate currencies is something that was inherited in our minds from World War II, when that system had all broken down, but that’s not the world we live in now,” Perry Mehrling told Bloomberg last month. “It’s a global dollar system and US dollar monetary policy gets filtered out to the rest of the world.”
When the Fed goes into “discipline mode,” as Mehrling euphemistically described the current policy bent at the Eccles building, we get to see “where the weak points are in the global system.”
This happens over and over, time and again. And, as sure as night follows day, Fed tightening cycles end in tears for someone, somewhere. It’s just a matter of who, and where.
Currently, the concern is twofold. First, the Fed is poised to hike 425bps in nine months. Second, that torrid pace comes on the heels of a dozen years (or more, depending on how you date the institution of the vaunted “Fed put”) spent in a regime defined by the pervasive deployment of leverage, and the herding of investors out the risk curve and down the quality ladder, in an increasingly desperate, globalized hunt for yield. The viability (and stability) of that regime depended entirely on central banks operating in vol-suppression mode, mostly via forward guidance. Modern market structure was built around and atop the attendant low-vol regime.
When you withdraw forward guidance and inject unprecedented levels of rates volatility against that backdrop, you court disaster. You saw it earlier this month in the UK pension complex, and you’ll see it again. BofA spelled it out last week in a note called “Risking a Bear Stearns moment.”
This is poorly understood outside of finance circles. Even among people who should understand it well enough. Larry Summers is one such person. He should understand it. At least conceptually. He was Treasury Secretary, after all. But in his latest remarks to Bloomberg Television for the network’s “Wall Street Week” program, he sounded borderline oblivious.
“It’s a real mistake to suggest that somehow we shouldn’t do the monetary policies that are necessary to avoid inflation becoming entrenched because of concerns about financial stability,” he said. Summers conceded that “there’s risk of some kind of financially traumatic event,” but ultimately concluded that “the chances of something large enough to divert the Fed are really quite low.”
I disagree. As BofA explained last week, the deployment of leverage since Lehman means it may not be possible to know how traumatic a prospective “event” might be until it’s too late. Indeed, that was the case even before Lehman. Just ask… well, Lehman.
“Even when the main risk facing markets is visible and relatively slow-moving (as CB tightening has been this year), markets are full of hidden risks and non-linearities that only reveal themselves in times of stress,” the bank warned, calling the UK LDI episode a “remind[er] of the existence of ‘unknown unknown’ secondary effects.”
Everyone keeps talking about emerging market fragility and corporate credit cracks and unsellable LBO debt and so on, but how many people had “UK LDI implosion” on their policy tightening blow-up bingo card? Someone, I assume. And probably a lot of someones in that industry. But even if you were concerned about managing those particular derivative positions, it was impossible to predict the scope and rapidity of the gilt selloff that occurred in the 72 hours around Liz Truss’s fiscal unveil. That selloff was exacerbated by the Bank of England’s plan to actively trim its own gilt holdings.
That episode was a microcosm of the entire global financial system as it exists post-Lehman. If Summers understands the implications of that, it wasn’t obvious. He spoke in wholly nebulous terms, which would be apt were he trying to communicate the extent to which we don’t know where the landmines are, but that wasn’t the case. Rather, Summers seemed to simply be acknowledging the risk of “breakage” in rote fashion because that’s this month’s topic du jour.
“We are headed for a collision of some kind or other, and we’ve just got to manage that collision carefully,” he told David Westin. He alluded to managing “some slowdown” in the economy. That’s not the concern. If that’s what you’re worried about, you’re not thinking about this correctly. Sure, it’s worrisome that a million people could lose their jobs. And yes, it’s concerning that the US housing market could grind to a “halt” (as Harley Bassman cautioned last week) and that housing markets in other locales (e.g., Canada, Sweden, New Zealand and Australia) could experience severe corrections. But the real risk at the current juncture is a UK pension-type moment that isn’t averted at the last minute. There are innumerable such setups just waiting for risk limits to be breached. We haven’t seen the last VaR shock of this cycle.
As noted above, Summers did acknowledge that his “collisions” could be financial events, not just the sort of economic “pain” Jerome Powell telegraphed during his Jackson Hole address. In fact, that was ostensibly the centerpiece of the discussion. And in that context, Summers managed to get one thing right.
“I think that should be the occasion for some soul-searching,” he said, when Westin asked about the tradeoff between fighting inflation and insuring against financial shocks. “If we have an economy where we think there’s going to be substantial financial breakage because the Fed lifts the funds rate to 4.5%, then we have an inadequately supervised financial system and an insufficiently active financial regulator.”
Now if only we knew who was involved in regulating and supervising large banks, ensuring the generalized integrity of the financial system and monitoring risk-taking on the part of systemically-important entities, and also which group of policymakers keeps encouraging recklessness on the part of market participants, we could report all such derelict parties to the Fed.
The good news we are off the zero bound for short rates. The bad news is because of the speed and magnitude of getting off zero we are likely to have to revisit it again pretty soon.
It’s like watching an indy car race, to watch for the crashes.
“But the real risk at the current juncture is a UK pension-type moment that isn’t averted at the last minute. There are innumerable such setups just waiting for risk limits to be breached. We haven’t seen the last VaR shock of this cycle.”
To misquote Pete Towhshend, I’ll bet the new shock is the same as the old shock — when the UK pension tilt starts leaning again. As Pete never said, “We Will Get Fooled Again.”
It would be helpful if all the great minds frequenting this site would contribute ideas on how to weather the approaching storm. I have 30 years on the street, and I’ll be damned if I know best strategies…cash aside.
Forum, anyone?
Us treasury bonds
I’ve been banging the drum on residential real estate in locales that make it hard to build more residential construction (think cities in blue states) as they will be far behind the supply curve coming out of this.
Beyond that, I actually think now is a good time to just buy the Nasdaq. The contrarian buy signals are there: everyone expects a big negative event (which I would agree is likely), cash is king, and in the event something breaks, rates can go down in a hurry. Just like the pandemic, we could dip a ways from here yet, but any dip will likely see a rapid recovery as soon as the Fed put reasserts itself.
Admittedly, I could do a better job of fostering comments. Some readers are, I think, worried I might criticize market commentary I don’t like or think is wrong. Such worries are (mostly) misplaced. Occasionally I’ll get irritable about something, but that doesn’t mean comments aren’t welcome. The ratio of unique commenters to subscribers on Heisenberg Report is very low. The number of people willing to comment is growing but not nearly as fast as the subscriber count, which means the ratio tends to trend lower over time. Part of it too, I suspect, is that I don’t do well with comments that aren’t additive the discussion.
If you visit sites with hundreds of comments on every article, what you’ll invariably discover is that 50% of them (at least) are throwaway comments. There are almost no throwaway comments on Heisenberg Report, which is obviously great. I’ve cut some geopolitical comment sections short, but I haven’t had to remove a comment in months, which says a lot about the quality of the readership.
All of that to agree with the original commenter (above) that yes, it’d be great if more people felt comfortable commenting, but at the same time, I realize it can be an intimidating prospect, particularly on articles about relatively esoteric market dynamics.
Relatedly, I’ll take this opportunity to remind the Street folks out there that if you chose your real name as your comment display name and don’t know how to change it to something anonymous, you can always send me an email and I can change it for you if that’d make it easier to comment.
If someone wants to change their comment display name – just go to Premium Subscriber Profile -> Edit Profile – Display name and type something. Otherwise, your name provided in the account is what would appear in the comments by default.
One thing that will likely help generate more engagement in the comments is an email notification when someone replies to a comment you posted. Maybe that exists and I just haven’t found it.
I would also suggest implementing a thread of all comments across articles. I genuinely enjoy reading all of the comments here, but it can be tough to keep up when new comments are added on prior articles.
When I leave a comment, there are two small square check boxes below the comment box — for some reason, they are unlabeled in my browser (I don’t think they used to be). But if you check those, you will get an e-mail notification from WordPress to subscribe to the comments for that post, then notifications thereafter of any new ones. (At least that’s how it works for me).
PS — Sometimes I find myself making a comment just in order to subscribe to future comments, otherwise I have to manually go back and check the post for new ones. It would help shut me up a little if I could subscribe to comments for selected posts without having to comment first.
This is very helpful, thank you FuriousA. I now see the two unlabelled checkboxes. This seems like a user experience glitch. Getting those properly labeled so people can subscribe to comments will likely help with the engagement in the comments section.
You’ve designed the comment section very well. You’ve made it clear from the beginning you aren’t going to tolerate various conspiracy theories from discredited sources which keeps this from devolving into a space for yahoos.
I’ll also add that most of your retail readership (of which I am one) is smart enough to realize they aren’t going to add anything of note to most of your articles.
my request would be for access for archived comments for all of us if that was possible…I feel very lucky to be part of this enlightened community, and very much appreciate the balance of the quality and quantity in the comment section, which of course also is reflective of our wonderful host…so grateful to be a part of the “Jimmy” Heisenberg Experience…
USD, of course.
Resi is interesting but I am wary of REITs so there are few ways of deploying cash there quickly. Some RE PE funds would be great but, again, not typical Street stuff, I think.
I like the Nasdaq too. Obviously managing exposure to being able to withstand a shock but it’s 30% down. Any kind of slightly speculative stock (ROKU, CRWD, it doesn’t matter) got slammed 70+%. IDK but those stocks are still growing fast…
I continue, as an avidly fascinated “retail guy” appreciate opportunity to access elucidation of aforementioned. Should my take be unknown abysmal financial cataclysms potential warrants FED choosing endemic inflation possibility as lesser of evils? Seems to be built on and around that presumption?
So many people have been using their HELOC as an “ATM” to purchase cars, take vacations, buy stuff. The best description I ever heard of this ATM withdrawal habit was when I heard someone say, “gotta have my spendy-money”! This (bad) behavior has come to a complete standstill with negative implications for the economy.
I am already noticing that forward airline prices are getting very, very inexpensive. I am absolutely deferring any major purchases- my kitchen can wait a few more years, however, I will still be able to take advantage of cheap airline tickets. Plus, international travel with the USD is a “sweet spot” in what, otherwise, is so depressing.
Loved the punchline.
Me too!
LME proved that, when the wheels come off, we can just press the reset button and cancel all trades for the prior 24 hours. Why are we worried?!
Just kidding. Mostly…
I’d bet dollars to donuts that your subscribers are a heck of a lot smarter than most….just a thought
Mmm… Donuts.
Best two word comment! Love it
To get back to the subject, I had a colleague once who wrote his PhD dissertation on the subject of the dangers of derivatives for which banks were at risk. The amount he found was something like 80-100 billion. Sounded dangerous at the time. Now, I commonly see estimates of the notional values for derivatives entangling banks that run well into hundreds of trillions of dollars, something like 5 times annual global GDP. Neither Summers nor anyone else actually has any idea what a rapid unraveling of these obligations would leave in its wake. Lehman was just a taste. That’s what makes me lose sleep because my money is in there somewhere and it will probably go away first. Among other things, my wife was a math type who like to study the concept of risk, actually so did I but she had better math skills. Mostly we worry about the risk of loss, but there are also risks from exceeding expectations. More companies get in trouble from growing too fast than from not growing fast enough, for example.
Your readers are right. This site attracts the best comments, at least from my perspective, because the topics on here are mostly concerned with the complex financial, economic, and industrial environments which underpin all investing. Many of the commenters were or are still experts in the areas about which they contribute. Oh, and those little boxes did once have labels and I get results from just checking the top one.