Higher for Longer
Doug Nolan
Mohamed El-Erian:
“I worry that the economic and policy signals coming out of this Federal Reserve press conference may come across to many as both confused and confusing.
Some will deem this an inevitable consequence of this phase of the inflation and policy cycle; others will view it as further evidence of challenged Fed communication.”
Seema Shah, Chief Global Strategist, Principal Asset Management (appearing Friday on Bloomberg TV):
“I think the central banks really don’t know what’s going on.
They’re really confounded. We’ve heard from everyone that, actually, Powell is a little bit confused as he talked through the conference.
The questions, actually, he gave very, very unclear answers.
It was quite confusing.”
September 22 – Financial Times (Mohamed El-Erian):
“‘I know it’s complicated.’
That was European Central Bank president Christine Lagarde’s response to a question on the policy outlook earlier this month.
Lagarde isn’t the only central bank chief signalling the complex road ahead as their institutions embark on the ‘last mile’ of the battle against high inflation.
At last month’s Jackson Hole conference of central bankers, Federal Reserve chair Jay Powell concluded his speech by stating that ‘we are navigating by the stars under cloudy skies’.
On Wednesday, he stated six times the need to ‘proceed carefully’.”
“Anyone who isn’t confused really doesn’t understand the situation.” Edward R. Murrow
I had no major issues with Powell’s press conference.
We’d prefer to see the head of the Federal Reserve, the world’s preeminent central bank, decisive and exuding confidence.
Powell was instead notably humble and cautious, attributes befitting today’s extraordinary backdrop (not to mention recent Fed forecasting lapses).
Significant revisions to the committee’s Survey of Economic Projections (“dot plot”) only elevated Powell’s communications challenge.
Ten-year Treasury yields jumped nine bps Wednesday to 4.41%, and then Thursday traded above 4.50% for the first time since October 2007.
Benchmark MBS yields traded as high as 6.33% intraday Wednesday – matching the high back to July 2007 – before closing the week 12 bps higher at 6.17%.
Surging yields were not limited to Treasury and agency securities.
Sovereign yields hit at least decade highs this week in countries including Canada, Germany, France, Spain, Sweden, Belgium, Austria, Netherlands, Australia, New Zealand, and Japan.
Markets have been in denial.
Perhaps it was just seeing reality codified in the Fed’s “dot plot” that forced a reality check.
Economic momentum has persisted in the face of sharply higher policy rates, tempering labor market cooling while reinforcing inflation dynamics.
The bullish Goldilocks narrative of rapidly declining inflation, comfy economic deceleration, and an impending easing cycle was just too farfetched (and so previous cycle).
“Higher for Longer” is real and needs to be factored into analyses and asset prices.
It's intriguing to ponder how much the narrative has shifted in seven months.
Powell referred to “financial conditions” 11 times during his February 1st press conference.
Wednesday, goose eggs.
There were “demand conditions,” “market conditions,” and one “tighter Credit conditions for households and businesses.”
But the entire focus on financial conditions has quietly dropped out of sight – strangely MIA in a backdrop where it could shed some such critical light.
Powell: “I guess it’s fair to say that the economy has been stronger than many expected, given what’s been happening with interest rates.
Why is that?
Many candidate explanations.
Possibly a number of them make sense.
One is just that household balance sheets and business balance sheets have been stronger than we had understood, and so that spending has held up and that kind of thing.
We’re not sure about that.”
There’s little disagreement that the Fed waited too long to commence policy normalization.
In the words of Jamie Dimon, “a day late and a dollar short.”
Following an unprecedented $5 TN of monetary inflation, policy tightening faced multiple challenges.
Late to the game, the FOMC moved aggressively with rate hikes.
But less than a year into policy normalization, the Fed was compelled to respond aggressively to an unfolding banking crisis.
The collapse of SVB precipitated over $700 billion of combined liquidity injections from the Fed and FHLB.
Importantly, this bailout unfolded quickly – before de-risking/deleveraging had mustered momentum.
Essentially, another shot of liquidity was provided to a system highly over-liquefied from unprecedented pandemic monetary and fiscal stimulus.
Not only was the Washington liquidity backstop (“Fed put”) further validated, but the banking bailout also demonstrated that the Fed would respond more urgently than ever to heightened systemic stress.
Leveraged Speculators Emboldened.
Basically, crisis management operations usurped the tightening cycle.
This was a huge gift to a marketplace absorbed by late-cycle speculative dynamics.
First, Washington liquidity sparked a powerful liquidity-producing short squeeze and unwind of derivative hedges.
The addition of FOMO and derivatives-related buying propelled speculative melt-up dynamics.
Importantly, market financial conditions loosened dramatically.
And it should come as little surprise that surging stock prices and a strong corporate debt market recovery helped sustain household borrowing and spending, corporate hiring and investment, and general government expenditures.
Moreover, the resulting A.I. mania resuscitated a deflating “tech” Bubble, unleashing a potent market and economic phenomenon.
I hold a strong minority opinion on this.
Colossal late-cycle pandemic monetary and fiscal stimulus and the resulting spikes in inflation and speculative excess demanded the Fed “slam on the brakes.”
Otherwise, given enough time, inflation would become deeply embedded, and highly speculative markets would succumb to only greater destabilizing excess.
CPI (y-o-y) had jumped to 4.2% by April 2021.
And here we are 30 months later, with financial conditions still not sufficiently tight.
There were compelling arguments for the Fed to impose a painful tightening.
After all, household holdings of money-like instruments (deposits, money market funds, Treasury and Agency Securities) had inflated an incredible $4.3 TN in the pandemic’s first 10 quarters.
Moreover, despite economic recovery and resurgent markets, egregious fiscal stimulus was unrelenting.
U.S. and global economies had developed powerful inflationary biases.
“Deglobalization”, infrastructure spending, climate change and the energy transition, along with scores of new technologies, combined with accommodative financial markets to provide ample spending to sustain economic expansions.
This locomotive required significantly less financial accommodation.
The unemployment rate was down to 3.8% by February 2022, the same level reported last month.
Major tightening and recessionary conditions would have been required to restore the necessary labor market slack to avoid a wage-price spiral.
Central bankers have become increasingly uncomfortable.
Few have experience with wage-price spirals and “second-round” inflation effects outside of textbooks.
I’ll assume they now recognize their focus on tighter bank lending was too narrow, these days better appreciating the stimulative effects from loose market financial conditions.
Yet they lack a framework for incorporating market financial conditions into their analyses, forecasts, and decision-making.
Their only answer is to fall back on nebulous “data dependent” and “Higher for Longer.”
But “Higher for Longer” is a big problem.
It’s a problem for our federal government’s massive debt load, with ballooning debt service costs at the cusp of spiraling out of control.
It’s a problem for risky corporate borrowers with a Trillion of debt to refinance over the next two years.
It’s a problem for a banking system sitting on enormous underwater “held to maturity” bond portfolios, along with an equities market dominated by over-valued growth stocks.
It’s a problem for millions of households who have loaded up on debt.
It is a big problem for an over-indebted world.
September 19 – Reuters (Rodrigo Campos):
“Global debt hit a record $307 trillion in the second quarter of the year despite rising interest rates curbing bank credit, with markets such as the United States and Japan driving the rise, the Institute of International Finance (IIF) said…
The financial services trade group said… global debt in dollar terms had risen by $10 trillion in the first half of 2023 and by $100 trillion over the past decade.
It said the latest increase has lifted the global debt-to-GDP ratio for a second straight quarter to 336%.
Prior to 2023, the debt ratio had been declining for seven quarters.”
And, to a great extent, deleterious “Higher for Longer” effects will unfold over time.
And such analysis is all fine and dandy – except that today’s highly speculative markets have a pretty short-term focus.
For those interested in more immediately impactful analysis, let me propose that “Higher for Longer” is today a critical issue for fragile global markets.
“Higher for Longer” is an immediate issue for China.
The renminbi is under major selling pressure, as finance flees Chinese stocks, Credit instruments, and China more generally.
Beijing needs lower interest rates, rather than widening interest-rate differentials.
It’s worth noting that the renminbi was down 0.32% this week and has already given back about half of the meager Beijing-induced rally (“PBOC: Says Resolutely Put an End to Speculation in FX Market”).
Stakes are rising.
We can assume huge positions are accumulating in currency and swaps derivatives markets, with exposures rapidly mounting at the big Chinese banks.
“Higher for Longer” is an immediate issue for the Japanese yen.
The $/yen closed Friday trading at 148.37, an 11-month low for the Japanese currency.
The Bank of Japan (BOJ) desperately needs to commence monetary policy normalization, yet another meeting passed without action.
They needed waning global inflation to take pressure off global policy tightening and surging market yields.
“Higher for Longer” only exacerbates interest-rate differentials, placing critical pressure on the yen.
Meanwhile, surging global yields place additional pressure on the Japanese bond market, with yield curve control (YCC) buying equating to additional BOJ liquidity creation further pressuring the yen.
The $/yen breached 150 in October for the first time since 1990.
A breakout above this level risks a disorderly currency market dislocation.
Bolstered by the weak yen and renminbi, the Dollar Index closed the week at 105.583, right near a 10-month high.
EM currencies were under further pressure this week, with the Hungarian forint down 1.67%, the Brazilian real 1.46%, the Colombian peso 1.37%, and the Chilean peso 0.96%.
EM bonds were also under pressure.
Local currency yields rose 49 bps in Colombia (11.36%), 18 bps in the Czech Republic (4.36%), 17 bps in South Africa (12.23%), 15 bps in Poland (5.76%), and 14 bps in Mexico (9.75%).
There was notable pressure on dollar-denominated EM bonds.
Dollar yields rose 17 bps in Ukraine (28.25%), 13 bps in Panama (6.47%), 13 bps in Russia (19.19%), 13 bps in Chile (5.52%), 11 bps in Peru (5.75%), 11 bps in Saudi Arabia (5.29%), 11 bps in Philippines (5.36%), 11 bps in Mexico (6.12%) and 10 bps in Brazil (6.64%).
“Higher for Longer” risks exacerbating the strong dollar/EM outflows/surging yields “doom loop.”
The strong dollar and rising global yields are already pressuring levered EM “carry trades.”
Especially in the event of disorderly declines in the renminbi and yen (likely concurrently), a destabilizing de-risking/deleveraging dynamic could quickly gather momentum.
September 22 – Bloomberg (Isabelle Lee):
“A breed of quant investor that spreads bets across assets is reeling this week as the hawkish monetary era intensifies.
The synchronized slide across stocks, bonds and many commodities following the Federal Reserve meeting hammered the investing approach known as risk parity.
The strategy… divides a portfolio across assets based on the perceived risk of each.
It tends to rely on government debt to hedge equity declines, so can suffer in a broad selloff.
The cross-asset declines handed the $926 million RPAR Risk Parity ETF its worst day since December and sent the fund to its lowest in 10 months.
A key gauge of the strategy suffered one of its biggest drops this year.”
Many indicators suggested fledgling de-risking/deleveraging.
Interestingly, U.S. Investment-Grade Credit default swap (CDS) prices jumped nine basis points (to 73), the largest weekly rise since the week of the SVB collapse.
It appeared that Bank CDS prices were leading the surge in risk premiums – and it was a global phenomenon.
China Development Bank CDS jumped nine to 92 bps, China Construction Bank seven to 98 bps, Bank of China seven to 97 bps, and Industrial and Commercial Bank six to 96 bps.
Chinese bank CDS are quickly approaching late-August – pre-Beijing stimulus measures - spike highs.
China sovereign CDS jumped 10 to 80 bps, second only this year to the 22 bps surge the week of August 18th.
European (subordinated) bank debt CDS surged 17 bps this week to an 11-week high of 161 bps, the largest weekly gain since the March banking crisis.
Deutsche Bank, NatWest and UniCredit were at the top of the week’s leaderboard.
But U.S. banks were not far behind.
JPMorgan CDS rose three, Bank of America six, and Citigroup seven – the largest weekly increases since early May.
High-yield CDS surged 21 to a one-month high 445 bps.
September 18 – Financial Times (Kate Duguid):
“A build-up of leveraged bets has the potential to ‘dislocate’ trading in the $25tn US Treasuries market, the umbrella group for central banks said, the latest high-profile warning over the potential for crowded hedge fund bets to sow instability.
The Bank for International Settlements issued a warning in its quarterly report… about the growth of the so-called basis trade…
‘The current build-up of leveraged short positions in US Treasury futures is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger,’ the BIS said…
‘Margin deleveraging, if disorderly, has the potential to dislocate core fixed-income markets,’ it said…
As evidence of a build-up in the trade, the BIS cited data… showing a rise of short positions in Treasury futures contracts to record levels in some maturities in recent weeks.
The BIS values short positions in Treasury futures at about $600bn.”
While the so-called “basis trade” is not necessarily directly vulnerable to “Higher for Longer,” a bout of global de-risking/deleveraging would put this huge speculative leverage at considerable risk.
And this is where the analysis gets interesting.
Seemingly impervious to the Fed’s aggressive rate hike cycle, it’s easy these days to argue that our markets and economy are robust and inherently resilient.
For most, there’s no obvious catalyst that would alter this positive backdrop.
But I see a Bubble acutely vulnerable to an abrupt tightening of financial conditions – an expected consequence of a global de-risking/deleveraging episode.
Stated differently, I increasingly see the unfolding global “risk off” dynamic as a catalyst for U.S. market deleveraging.
This would surprise highly speculative markets.
It would also catch the Fed flat-footed.
At this point, they have a well-defined plan for timely management of bank runs and banking system liquidity issues.
Global de-risking/deleveraging would present a completely different dynamic – with illiquidity and dislocation erupting unpredictably across markets.
And with inflation and “Higher for Longer” currently occupying their minds, I wouldn’t bet on proactive crisis management in the scope necessary to counter major speculative deleveraging.
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