THE SCOURGE OF "WHATEVER IT TAKES" MONETARY MISMANAGEMENT / CREDIT BUBBLE BULLETIN

The Scourge of “Whatever it Takes” Monetary Mismanagement

Doug Nolan


A global pandemic and historic economic downturn. A rapidly escalating U.S./China cold war. Surging U.S. unemployment and economic depression. A deeply fragmented society with intensifying animosity and conflict. Heightened social instability, with mounting protests (and even some ugly riots). Friday Drudge headline: “A Society On Brink of Complete and Utter Chaos…”

A booming stock market. Rapidly expanding “money” supply. Exceptionally loose financial conditions, with record debt issuance. Huge inflows into corporate investment-grade and high-yield bond ETFs. Record Treasury and investment-grade corporate debt prices.

It’s easy these days to question securities market sanity. Yet it’s a fundamental tenet of Credit Bubble analysis that things turn crazy at the end of cycles. In the waning days of history’s most spectacular financial Bubble, should we be too surprised by Complete and Utter Craziness?

“Stock market investors are looking over the valley” and “V-shaped recovery” have become the popular narrative. “In the long run, and even in the medium run, you wouldn’t want to bet against the American economy,” Chairman Powell shared with CBS’s “60 Minutes” audience on Sunday, May 17, 2020. Powell’s words came in the wake of bearish comments from hedge fund heavyweights Stanley Druckenmiller and David Tepper.

Sure enough, equities gapped higher in the Monday session following Powell’s interview. A powerful short squeeze was launched. What Powell actually meant was irrelevant. The message received in the marketplace: you had best cover your short positions and unwind bearish hedges.

In the seven sessions following Powell’s comments, the S&P500 gained 6.1%. The spectacular gains, however, were in sectors with large shorting and hedging activity. The Dow Transports surged 17.9% in seven sessions. The Philadelphia Oil Service Sector Index jumped 20.7%. The KBW Bank Index surged 22.8%, with the Nasdaq Bank Index up 24.3%. Some of the broader market indices have been popular short targets. And a reversal of bearish bets surely supported the sharp rally in the small cap Russell 2000 and S&P400 Midcaps (7-session gains 14.3% and 14.0%). Over this period, the Goldman Sachs Most Short Index jumped 11.9%.

Investment-grade CDS prices closed the Friday ahead of Powell’s interview at 96 bps. Prices ended this week at 77 bps, the low since March 5th. Over this period, high-yield CDS sank 146 bps to 540 bps, a six-week low. Curiously, in the face of “risk on” dynamics in equities and corporate Credit, 10-year Treasury yields were little changed.

Federal Reserve Assets jumped $60bn last week to a record $7.097 TN, pushing the 12-week gain to $2.856 TN. M2 “money supply” (with a week’s lag) expanded another $94bn, with a 12-week rise of $2.577 TN. Institutional Money Fund Assets (not included in M2) added $6bn, boosting its 12-week expansion to $960bn.

Q&A from Chairman Powell’s Friday online discussion, sponsored by Princeton University’s Griswold Center for Economic Policy Studies.

Question: “How sensitive is the Fed to the very difficult time that, in particular, the lower-end of the economic spectrum are experiencing these days compared to the extraordinary strength in the equity market that Wall Street has seen. And does that affect policy at all or is it just a necessary side effect – that, even if you aren’t rooting for it, it just happens?”

Powell: “We know that everyone is affected by the pandemic in a negative way to one degree or another. The burdens are falling very strongly on those who can least afford to bear them. The unemployed come very largely, so far, from parts of the service economy which involve dealing with large groups of people that are tightly together… Does that affect our policy? It does affect our policy. Part of our mandate is maximum employment. It’s maximum employment and stable prices - are our monetary policy mandates. We’re very focused on the full range of employment and doing whatever we can trying to get those people back to work or in a new job…”

Question: “Are the latest Fed policies likely to lead to more income inequality in the United States?

“Absolutely not. And I’ll tell you why. As I mentioned, the pandemic is falling on those least able to bear its burdens. It is a great increaser of inequality. If you just look at labor market reports that the BLS puts out, you will see that it is low-paid workers in the service industries who are bearing the brunt of this; it’s also women to an extraordinary degree… So, everything we do – everything we do – is focused on creating an environment in which those people will have their best chance to keep their job or get a new job… Now, how does that work? Take, for example, a company that was investment-grade on March 22nd but has now been downgraded to so-called junk, a non-investment grade company. It has tens and tens of thousands of employees. Now, why would we include that company in our programs? These are very large companies – and there are many of them that would fit this description…

The reason is this: If a company doesn’t have market access and can’t roll over its debt and can’t have enough cash on hand to deal with obligations, what they’re going to do is lay people off. They’re going to cut costs… That is the choice they’ll make… By announcing our facility and including those companies, the ones who actually needed the credit in March, those companies have now been able to go out and finance themselves and now have lots of cash on their balance sheets… They’ve been able to avoid big layoffs. That is the point of all this. I think we have to keep our focus tightly on that goal of supporting the labor market and not get distracted by other goals.”

Powell didn’t want to touch the issues of a booming stock market and policies benefiting Wall Street, fixated instead on the narrative of Federal Reserve policy measures focused on supporting labor markets. I’m not convinced it’s credible, but the Fed clearly appreciates that the issue of inequality has become a major institutional risk for our central bank. “We’ve crossed a lot of red lines that had not been crossed before,” admits the Fed Chairman. Purchasing junk bonds is a line crossed.

So, there’s some rationale for Powell tying the loosening of risky company Credit with labor market and inequality concerns. Yet the Fed’s balance sheet has inflated $3.336 TN over the past 38 weeks, of which junk bond purchases have been an infinitesimal percentage. Rather conspicuously, the Federal Reserve’s primary focus has been supporting the securities markets. This has the Fed sliding into the hazardous waters of Credit and resource allocation.

Its policies have directly and indirectly favored parts of the economy and segments of society. Moreover, the Fed continues to feed a speculative Bubble. Federal Reserve Assets inflated an incredible 67% in twelve weeks.

How did things turn so crazy?

At its infancy, the Greenspan Fed years ago began offering markets some extra support. In general, Greenspan was a powerful advocate for market-based finance. The rationale must have been that after providing backing to get through a rough patch, markets would naturally return to sound mechanisms of self-adjustment and correction. Instead, financial markets became progressively distorted and dysfunctional.

Credit and speculative Bubbles took hold – and there was no turning back. Greenspan’s insidious support mutated into bailouts, emergency QE, rank market manipulation, and “whatever it takes” inflationism - all to sustain Bubbles. The problem of “too big to fail” institutions morphed into “too big to fail” market structure.

Markets now expect the Fed to eventually incorporate zero rates and “yield-curve control” measures.

May 27 – Bloomberg (Steve Matthews): “Federal Reserve Bank of New York President John Williams said policy makers are ‘thinking very hard’ about targeting specific yields on Treasury securities as a way of ensuring borrowing costs stay at rock-bottom levels beyond keeping the benchmark interest rate near zero. ‘Yield-curve control, which has now been used in a few other countries, is I think a tool that can complement -– potentially complement –- forward guidance and our other policy actions,’ he said… ‘So this is something that obviously we’re thinking very hard about. We’re analyzing not only what’s happened in other countries but also how that may work in the United States.”

“Yield-curve control” is another – somewhat more palatable – name for pegging inflated price levels in Treasury securities – the most important securities in the world and the bedrock for finance more generally. That the President of the New York Fed would admit the FOMC is “thinking very hard about” such measures support the view of unfolding market disintegration.

It’s a complete breakdown of even a pretense of monetary discipline – with resulting Monetary Disorder again the root cause of late-cycle craziness. I am reminded of Mises “crackup boom” analysis. Mises’ focus was on reckless late-cycle monetary inflation, the loss of confidence in money throughout the general economy, and resulting consumer expectations for runaway inflation.

Today, crack up boom dynamics are at work throughout the financial markets. Market participants now expect unending Federal Reserve-induced monetary expansion. The Fed is trapped in a glass cage for everyone to see.

The March experience demonstrated how abruptly faltering global Bubbles can thrust the world to the brink of financial collapse. It took Trillions to pull the system back from the precipice – and it will require untold Trillions more as central bankers struggle to hold crisis at bay.

“Money” is destined to continue suffering extraordinary devaluation. Meanwhile, securities prices – including stocks, Treasuries, MBS, investment-grade corporate bonds, and even high-yield corporate ETFs – are supported by Federal Reserve buying.

This sophisticated financial scheme is highly problematic. For one, it’s an unparalleled multifaceted global Bubble. At this point, the consequences of a collapse are so frightening that policymakers will justify and rationalize “whatever it takes” measures.

Yet Jay Powell – and central bankers more generally – are delusional if they don’t believe their policies will exacerbate inequalities. Furthermore, these inequalities will flourish both within and between nations. Festering U.S. social tensions are increasingly coming into full view, while mounting geopolitical stresses are taking an ominous turn for the worse.

The Fed has abandoned its overarching responsibility for maintaining monetary stability (sustaining Bubbles being antithesis to monetary stability). No amount of monetary expansion is too much - no degree of market intervention excessive. They’ll gladly monetize even the most egregious federal deficits. Zero rates – negative real returns for savers – are fine for as far as the eye can see. No crackpot theory is unworthy of consideration.

And why do markets expect it’s only a matter of time until negative rates – despite pushback from Fed officials? Because markets believe efforts to sustain highly inflated Bubbles will foment “kitchen sink” desperation. The Fed may not today fancy the idea of negative rates, but highly leveraged speculative Bubbles will eventually demand negative borrowing costs – along with “yield-curve control”, Fed stock purchases and about any market-supporting measure a creative mind can conceive. Nothing will be off the table.

Stocks rallied late-Friday on President Trump’s China news conference. As expected, the administration will commence the process of removing Hong Kong’s special trade status. There will be some sanctions on Chinese individuals and institutions, also as expected. But the speech was short on details – though clear on the President’s hesitancy to threaten the phase-one trade deal.

Bloomberg’s headline: “Trump’s China Announcement Leaves Room to De-Escalate Tensions.” The tone supported the view that there will be more bark than bite heading into the election. But are the testy Chinese willing to play the election-cycle whipping boy?

As I’m working to wrap up this week’s CBB, protests and violence are escalating in cities across the country. We’re seeing the most inflamed racial tensions in years. From a political perspective, the country is the most bitterly divided in decades. Wealth inequalities are, as well, tearing away at our nation’s social fabric. And somehow the pandemic strikes with freakish timing and ferocity – dousing gas on myriad smoldering social, political, financial, economic and geopolitical fires.

It’s the worst-case scenario - my worry list coming to fruition.

Social and political instability; a global pandemic; a runaway Fed balance sheet swiftly on its way to $10 TN; faltering Chinese and EM Bubbles; rapidly deteriorating U.S. and China relations; a disintegrating geopolitical backdrop; along with a final speculative “blow-off” throughout global finance. Markets have been corrupted, while the masses are increasingly disillusioned and insecure. A wrecking ball is chipping away at trust in our institutions.

The global Bubble has been pierced, though unprecedented monetary inflation only exacerbates the epic divergence between inflating asset prices and deflating economic prospects.

As I’ve written over the years – and as demonstrated rather conspicuously in March: contemporary finance seems to operate miraculously – so long as it’s inflating. It just doesn’t work in reverse.

These days it’s even more frightening to contemplate how this all ends. The Scourge of “Whatever it Takes” Monetary Mismanagement.