Something of a Victory Lap
Doug Nolan
There’s always a summertime buzz heading into the Fed’s Jackson Hole Economic Symposium.
What’s topical in the world of economics?
What is on these central bankers’ minds?
What might they be thinking of tweaking or changing?
This year’s conference corresponds with an important shift in U.S. monetary policy.
The first rate cut in over four years is only a few short weeks away.
Would Powell signal the Fed is ready to move forcefully to get ahead of unfolding weakness in the labor market and economy?
Or might this be a more cautious, data-dependent Powell feeling much more confident about inflation, yet hesitant to endorse Wall Street forecasts for aggressive cuts?
Some were clamoring for more.
“The Stakes Are High for Powell at Jackson Hole,” is the title of Mohamed El-Erian’s Monday Bloomberg Opinion piece:
“This year’s presentation by Chair Jerome Powell is eagerly awaited due to the economic fluidity and financial volatility that the US has been experiencing, and its spillovers to the rest of the world.
It comes in the context of an ocean of genuine uncertainty, both domestic and global, that’s amplified by the erosion of three key anchors of stability: steady and predictable economic growth, effective forward policy guidance, and only small pockets of technical vulnerability involving over-leveraged positions and excessive risk-taking by market participants.
This is why it is critical for Powell to take advantage of the golden opportunity he has this Friday to regain control of the economic and policy narrative.
The Fed’s paramount goal this year should be to re-establish the effectiveness of its forward policy guidance.”
I’m on board with “over-leveraged positions and excessive risk-taking.”
We can only hope Mr. El-Erian is correct (and I’m wrong) in his “only small pockets of technical vulnerability.”
As far as re-establishing the effectiveness of forward guidance and regaining policy and economic narratives, Powell’s presentation fell short.
The Fed Chair was more focused on the past than the future.
Markets might have fancied a more cultivated essay on enhancements to the Fed’s policy framework, reaction function and transmission mechanism, but they got what they wanted:
“The time has come for policy to adjust.
The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Powell:
“At this podium two years ago, I discussed the possibility that addressing inflation could bring some pain in the form of higher unemployment and slower growth.
Some argued that getting inflation under control would require a recession and a lengthy period of high unemployment.
I expressed our unconditional commitment to fully restoring price stability and to keeping at it until the job is done.”
August 23 – Associated Press (Christopher Rugaber):
“In what amounted to something of a victory lap, Powell noted… that the Fed had succeeded in conquering high inflation without causing a recession or a sharp rise in unemployment, which many economists had long predicted.
He attributed that outcome to the unraveling of the pandemic's disruptions to supply chains and labor markets and a reduction in job vacancies, which allowed wage growth to cool.”
Before our central bankers dangle a “Mission Accomplished” banner outside the Marriner S. Eccles Federal Reserve Board Building, there’s more to the inflation story to contemplate.
The proverbial elephant in the room: asset inflation, Bubbles, and deficits – ignore them at everyone’s peril.
Powell:
“How did inflation fall without a sharp rise in unemployment above its estimated natural rate?”
Powell highlighted the forces of post-pandemic supply-side normalization that worked to curb price inflation.
There were several references to “labor markets” and one to “commodity markets.”
The Chair’s presentation avoided any mention of the stock market, as if it had no impact.
Since Powell’s 2022 Jackson Hole presentation, the S&P500 has returned 43.3%, the Nasdaq100 (NDX) 59%, and the Semiconductor Index (SOX) 91%.
Nvidia surged almost 700%.
“Mania” somehow didn’t make it into Powell’s speech.
Financial conditions have loosened dramatically since August 2022.
For example, investment grade spreads to Treasuries narrowed from 140 bps to this week’s 94 bps close, with high yield spreads narrowing from 450 to 312 bps.
Credit default swap (CDS) prices closed the week at 49 bps, down from the 86 bps on August 26, 2022.
High yield CDS dropped to 320 bps from 500 bps.
It’s also worth noting that a September 2022 jump saw investment-grade CDS rise to 108 bps and high yield to 610 bps.
While a far cry from equities, corporate debt has generated solid returns.
The iShares Investment Grade Corporate Bond ETF (LQD) returned 8.8% in two years, with the iShares High Yield Bond ETF (HYG) returning 15.9%.
It would be a different policy discussion today, had the dramatic loosening of financial conditions not fueled such stellar market gains.
Booming financial markets were undoubtedly instrumental in supporting the economy and job growth.
Powell:
“Disinflation while preserving labor market strength is only possible with anchored inflation expectations, which reflect the public’s confidence that the central bank will bring about 2% inflation over time.”
I would give more credit to well-anchored confidence that the central bank will ensure asset inflation (i.e., higher stock prices and portfolio returns) over time.
It was no surprise Powell ignored this year’s theme, “Reassessing the Effectiveness and Transmission of Monetary Policy.”
I look forward to reading papers addressing such an important topic.
While not addressed by Powell, it would behoove the Fed to delve deeply into the critical issue of why general financial conditions remained largely immune to its monetary “tightening”.
Powell:
“Four and a half years after COVID-19's arrival, the worst of the pandemic-related economic distortions are fading.”
True enough with respect to economic distortions.
But what about distortions within the financial sphere?
The Fed orchestrated an unprecedented $5 TN QE program.
At $7.14 TN, the Fed’s balance sheet still remains almost double the size from (pre-QE) September 2019.
The Federal Reserve in March 2020 bailed out the levered players, “basis trades” and “carry trades” in particular, and financial markets in general.
This open-ended “whatever it takes” fundamentally altered market risk perceptions, including the perceived risk vs. reward calculus for risk-taking and levered speculation.
Lingering concerns that policy “tightening” might suppress the Fed’s propensity for timely market bailouts was allayed with the $740 billion Fed/FHLB March 2023 bank crisis liquidity response.
This “tightening” cycle accompanied a headline CPI (y-o-y) spike to 9.1%.
Yet 10-year Treasury yields didn’t exceed 5% - and were somewhat above 4.5% for only a few weeks.
By comparison, 10-year yields jumped to 6.75% (CPI 3%) in January 2000 and reached 8% (CPI 3.8%) during the 1994 tightening cycle.
The Fed’s massive Treasury and MBS purchases monetized much of the federal government’s prolific pandemic borrowing and spending.
Moreover, open-ended QE and bailouts incentivized leveraged speculation – the highly levered Treasury “basis trade” in particular.
Speculative demand was integral to financing enormous deficits at depressed yields.
We can’t overstate the significance of Fed-induced market distortions.
The Fed accommodated leveraged speculation, emboldening only greater risk-taking and leverage.
Our central bank and the leveraged speculating community accommodated unprecedented federal borrowing, emboldening Washington’s profligate spenders.
All the “soft landing” talk disregards critical festering issues.
Powell:
“The limits of our knowledge—so clearly evident during the pandemic—demand humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges.”
Caution is in order.
Asset inflation and speculative Bubbles were fundamental to the painless nature of the Fed’s “tightening” cycle.
In the process, the monetary policy transmission mechanism has been precariously compromised.
Truth be told, the Fed relinquished command over monetary management to highly speculative markets.
These days, “risk on” and associated leveraged speculation equate to looser financial conditions, while highly destabilizing de-risking/deleveraging lurks in the shadows.
Meanwhile, the CBO forecasts a $2.0 TN 2024 federal deficit, or about 7% of GDP.
Ten-year Treasury yields are down 90 bps in four months to 3.80%, a yield that will certainly not discipline an undisciplined Washington.
Mohamed El-Erian and other Wall Street economists were hoping Powell would address the so-called “neutral rate” or R-star (the long-run equilibrium interest rate).
They would like the Powell Fed to deemphasize “data dependent,” while providing a semblance of clarity for the expected policy rate destination.
Too late for any of this.
At intraday August 5th panic lows, the rates market was pricing 148 bps of rate cuts by the completion of the Fed’s December 18th meeting.
The market ended this week at 103 bps.
The week’s data offered little to indicate economic weakness.
The preliminary August Services PMI was reported at a stronger-than-expected 55.2 (near 15-month high).
At a 739,000 annualized rate, New Home Sales blew away estimates to about the highest level since February 2022.
The homebuilders (XHB EFT) surged 8.2% this week, boosting y-t-d gains to almost 25%.
There are still the August non-farm payrolls and CPI reports to hit before the September 18th FOMC meeting.
Other data seems to matter little.
The Fed has pre-committed to cut, though the totality of economic data doesn’t argue for 50 bps.
Market expectations for 100 bps of rate reduction by year-end appear excessive, but there’s complexity here.
Especially after August 5th, markets will factor in the probabilities of a destabilizing deleveraging episode that would trigger aggressive Fed rate cuts.
From this perspective, 100 bps by year-end is reasonable.
Outside of the small caps and the heavily shorted stock universe, the yen showed about the most sensitivity to Powell’s dovishness.
The yen gained 1.33% for the session to close the week 2.26% higher at 144.37 to the dollar.
“Risk on” has hardly missed a beat since the August 5th reversal.
Yet the yen ended the week close to the August 5th close (144.18) and not far off the intraday yen “carry trade” unwind panic level (141.70).
Ten-year Treasury yields closed the week at 3.80%, one basis point higher than the August 5th close (3.68% intraday low).
“Risk on” holds court for now, but I doubt we’ve heard the last of yen “carry trade” instability.
The Dollar Index closed the week at a one-year low.
Between June 2021 and October 2022, the Dollar Index surged almost 26%.
It appears the days of the strong dollar working to restrain inflationary pressures are now in the rear-view mirror.
Bloomberg Intelligence’s Brian Meehan was out Friday with timely research:
“Can Historic $1.1 Trillion Net Short Basis Trade Hold or Crack?
Leveraged net shorts of Treasury futures have surged to a historic $1.1 trillion in notional value, accelerating 38% in the past four months.
While the record short position alone doesn’t suggest the basis trade will blow up, it’s more than double when massive leveraged funding trades cracked in 2019 and 2020 -- and could require the Fed to bail out traders again if the repo market gets overly stressed…
The net short position in US Treasury futures held by leveraged accounts per the CFTC Commitment of Traders has increased by $300 billion in notional the past four months…
The size of the position alone doesn’t mean a blowup is pending, as funding markets have been quiet ahead of expected Fed easing.
But given that the trade has blown out several times in the past 20 years, it's likely more a question of when, not if.”
Three hundred billion, or 38%, inflation in four months.
“Terminal phase excess”, and further evidence that the Fed erred in signaling an easing cycle with markets in the throes of a speculative Bubble.
And that a faltering Bubble will indeed require “the Fed to bail out traders again” reinforces lower market yields, looser conditions, speculative leverage, and only greater underlying fragility.
With yen “carry trade” instability, a volatile U.S. election, a Middle East at the precipice, and dangerous Ukraine/Russia war escalations, it’s an especially precarious time to stoke speculation.
One Hell of a Bubble.
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