The Case Against Skip
Doug Nolan
It’s not a close call.
If the Fed “Skips” policy tightening at the June 14th FOMC meeting, it will be yet another big policy mistake.
The long string of errors has greatly damaged the Federal Reserve’s inflation-fighting credibility.
It has also promoted dangerously dysfunctional market structure.
At this point, the Fed should err on the side of demonstrating resolve in reining in inflationary excesses.
The Fed currently faces two major inflationary issues.
Consumer price inflation remains highly elevated, with little to indicate that price gains will recede to the Fed’s 2% target anytime soon.
Second, rampant securities market inflation is inconsistent with stable prices and financial stability.
Markets remain precariously speculative, with resulting loose financial conditions counteracting the Fed’s rate policy tightening.
May 31 – Wall Street Journal (Nick Timiraos):
“Federal Reserve officials signaled they are increasingly likely to hold interest rates steady at their June meeting before preparing to raise them again later this summer.
Investors in recent days had expected the Fed would lift rates at its meeting June 13-14, prompting two policy makers Wednesday to publicly underscore their preference to forgo a hike…
The strategy would give officials more time to study the economic effects of the Fed’s 10 consecutive prior rate rises…
They have lifted rates by five percentage points since March 2022 to combat high inflation, most recently on May 3 to a range between 5% and 5.25%, a 16-year high.
‘A decision to hold our policy rate constant at a coming meeting should not be interpreted to mean that we have reached the peak rate for this cycle,’ Fed governor Philip Jefferson said…
‘Indeed, skipping a rate hike at a coming meeting would allow the committee to see more data before making decisions about the extent of additional policy firming.’”
How much more data does the Fed need to see?
The April “JOLTS” report underscored the extraordinary nature of today’s jobs market.
Job openings surged back above 10 million, coming in 700,000 above forecast.
March openings were revised 150,000 higher.
For the 20-year period 2000 through 2019, job openings averaged 4.5 million, exceeding eight million for the first time in 2021.
ADP reported an employment increase of 278,000, versus the estimate of 170,000.
And Friday’s May non-farm payroll report once again surprised to the upside, with an increase of 339,000 (previous months revised higher).
I don’t buy the “mixed” description of the data.
Sure, the 0.3% gain Average Weekly Hourly Earnings is weaker than some highly elevated prints from 2021 and 2022.
But with workers' demand for higher compensation justified, ongoing tight labor markets are poised to sustain inflationary momentum.
May 31 – Reuters (Shankar Ramakrishnan, Matt Tracy and Laura Matthews):
“Large U.S. companies have been on a bond issuance binge…
Investment-grade rated companies issued $152 billion in May, making it the busiest May since 2020 when the pandemic crisis prompted record debt issuance volumes, according to… Informa Global Markets.
Junk-rated companies meanwhile raised $22.1 billion, for the busiest May since 2021 when 73 companies raised $49.1 billion.”
Financial markets are also poised to sustain inflationary pressures.
Resurgent Bubble Dynamics have fueled a major loosening of financial conditions.
Surveys and anecdotes point to a degree of bank lending tightening.
But this has been more than offset by risk embracement, leveraged speculation, and liquidity excess throughout the financial markets.
In a more normal environment, it would be reasonable for the Fed to watch and wait for tighter bank lending to restrain demand and output.
Typically, a meaningful tightening of lending standards would be reflected in the financial markets, with risk aversion and deleveraging ensuring waning liquidity excess and tighter conditions.
But today’s backdrop is categorically abnormal.
Conventional thinking holds that the banking crisis triggered tighter conditions.
But the exact opposite has unfolded over the past couple of months.
We know that Fed Assets expanded $364 billion over three weeks in March in banking crisis liquidity operations.
Assets remain about $45 billion above the March 1st level.
And we also know that FHLB assets expanded an unprecedented $317 billion during Q1 ($802bn over 4 quarters).
Indicative of the liquidity surge, money market fund assets inflated $384 billion in the five weeks beginning March 8th.
Most view such a jump in money fund assets as evidence of risk aversion and tightened market conditions.
I take a different view.
This growth was reflective of a surge in financial sector Credit, in this case aggressive FHLB money market borrowings to finance its massive banking liquidity support operations.
And while the banking liquidity crisis has abated, the extraordinary expansion of money fund assets is ongoing.
Money fund assets were up another $31 billion last week, despite risk embracement and record equity fund inflows.
June 2 – Bloomberg (Sagarika Jaisinghani):
“The buzz around artificial intelligence has investors pouring a record amount of money into tech stocks, Bank of America Corp. says.
A ‘baby bubble’ in AI was the dominant market theme in May, strategist Michael Hartnett said, with tech funds attracting an all-time high of $8.5 billion in the week through May 31, according to… EPFR Global data.”
Money fund assets have expanded an unprecedented $526 billion, or 51% annualized, over 12 weeks to a record $5.420 TN – with one-year growth of $894 billion, or 19.7%.
I appreciate that equity bulls salivate at the thought of this “money on the sidelines” making a mad dash for the risk markets.
Yet such spectacular monetary inflation deserves serious contemplation.
The March episode was just one more in a long series of aggressive market interventions.
While it was not on the scale of March 2020’s pandemic crisis operations, combined Fed and FHLB liquidity operations were not that much smaller than 2008.
Importantly, this intervention came after markets had several months to recover from last fall’s heightened risk aversion.
It was a notably strong start to the year, with the Nasdaq100 already sporting double-digit gains by early March.
Fed/FHLB liquidity operations lit a fire under a fledgling speculative Bubble.
Powerful speculative impulses had taken hold throughout the derivatives marketplace - a potent “inflationary bias” was smoldering.
In particular, an options trading craze had enveloped individual and institutional traders alike.
Washington liquidity operations stoked speculative excess that developed into a powerful melt-up dynamic.
And I believe derivatives markets have become a powerful source of system liquidity creation.
Over the years, Fed/GSE interventions have increasingly distorted market risk perceptions.
Why not speculate and leverage knowing there was a “Fed put” just below the market to minimize potential losses?
Stocks always recover and go higher.
And nowhere were market risk distortions more pronounced than in the derivatives markets.
As I’ve highlighted in the past, derivatives markets operate on the assumption of liquid and continuous markets, despite a long history of markets facing recurring bouts of illiquidity and discontinuity (i.e., panics and crashes).
Basically, derivatives markets have always assumed Washington would quickly resolve dislocations and thwart collapses.
Sellers could price their derivative products confident they would not find themselves on the wrong side of a market crash.
Basically, the Fed/GSE liquidity backstop was integral to the pricing and liquidity dynamics that made derivatives so appealing for both hedging and speculating.
And the bigger this complex became – and the more critical to the markets and economy – the more the Fed was compelled to quickly intervene to stabilize markets.
Last year’s heightened concerns that the tightening cycle created ambiguity with respect to the Fed’s liquidity backstop were allayed by the Bank of England’s September and the Federal Reserve’s March interventions.
Today, derivatives markets pose a monumental risk to financial stability.
There is clear risk of huge (downside) put option positions sparking cascading sell orders and a crash.
Yet repeated market interventions have provided a competitive advantage to buyers of (upside) call options.
With speculative impulses already percolating, the March Fed/FHLB intervention sparked a stampede of call buying in the big technology stocks.
March liquidity injections stoked buying of the underlying stocks, including short covering and the unwind of bearish hedges.
And then the enormous quantity of outstanding call options (and other upside derivatives) unleashed self-reinforcing buying and associated liquidity excess.
Importantly, the sellers of call options were increasingly forced to buy the underlying stocks (chiefly the big tech stocks, ETFs and indexes), in what has developed into a self-feeding FOMO (fear of missing out) “melt-up” dynamic.
It's imperative that the Fed leans against speculative excess.
Their repeated market bailouts have been fundamental to the explosive growth in derivatives speculation.
And we’re at the point where the derivatives complex and associated speculative leverage are a major source of system Credit and liquidity creation.
And I’ll go one step further: derivatives are today at the Epicenter of Monetary Disorder – a historic Bubble that poses acute risk to financial and economic stability.
The Bank of England intervened last September to stop a derivatives-induced dislocation in the UK bond market.
Surging yields had triggered self-reinforcing liquidation – deleveraging and selling to hedge derivative positions.
Central bankers clearly understand this type of derivatives risk.
UK and U.S. bond markets have again begun to indicate vulnerability to a self-reinforcing yield surge.
Two-year Treasury yields traded to 4.60% in Tuesday trading.
With Fed vice chair nominee Philip Jefferson talking pause, yields ended Wednesday session at 4.40%.
The rates market probability for a June hike dropped from 70% to 30% following Jefferson’s comments.
MBS yields, often a hotbed of derivative-related hedging activities, saw yields spike 32 basis points last week – only to reverse 29 bps lower this week.
I can’t help but wonder whether fear of a derivatives-induced spike in market yields helps explain support for skipping this month’s hike.
It's not the data.
May 30 – Bloomberg (Lu Wang and Elena Popina):
“Stock investors who planned for one thing in 2023 are getting something else entirely.
Now, with the tech-obsessed market at risk of running away from them, the race is on to catch up…
With the seven tech behemoths surging a median 44% this year — a gain almost five times that of the S&P 500 — there are signs traders are getting desperate for ways to keep up.
It’s visible in the options market, where the expected volatility rose alongside the Nasdaq 100 and the cost of bullish options spiked.
‘There’s FOMO in the tech space,’ said Brent Kochuba, founder of options platform SpotGamma.
‘It’s a clear chase.’
Demand for upside calls on the Nasdaq ETF is surging…
‘The ‘call exuberance’ is so high that it is distorting the options market,’ said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets.
‘This is a bit reminiscent of the YOLO/meme craze of call buying we saw during the pandemic.’
Increasingly, traders are opting to use derivatives to gamble on big tech.”
The Fed is indeed trapped.
They have not been able to tighten financial conditions sufficiently to cool the labor market and slow demand.
Yields have remained relatively low throughout this tightening cycle, with the bond market instinctively pricing in an early dovish pivot.
And when surging yields did spark a banking crisis, liquidity operations triggered a major market loosening and resurgent speculative Bubble.
The numbers are big.
The Nasdaq100 Index, up a third y-t-d, has added almost $4 TN of market capitalization so far this year.
The amount of associated speculative leverage and liquidity-creation, especially from derivative trading and hedging, must be enormous.
Moreover, this type of speculative Credit is particularly destabilizing.
While fueling Bubble excess on the upside, the system becomes increasingly vulnerable to a downside market reversal and destabilizing collapse in speculative leverage and liquidity.
This is no time to Skip.
It is imperative that the Fed demonstrates resolve in tightening financial conditions.
Allowing this speculative Bubble to run unchecked poses an extraordinary risk to system stability.
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