BACK FOR A SECOND ATTEMPT / CREDIT BUBBLE BULLETIN

Back For a Second Attempt

Doug Nolan 

Chair Powell: 

“So, what we said was that uncertainty about the economic outlook has diminished but remains elevated. 

Many, many surveys say that… And that’s actually a line from the Teal book, which you can see in five years. 

Remember to check that.”

Journalist: 

“Maybe the world will be over by then.”

Powell: 

“No. 

But if you think about it, tariff uncertainty really peaked in April, and since then has come down. 

And that’s really what that’s acknowledging. 

It’s diminished but still elevated, that it’s uncertainty. 

So, I think that’s an accurate statement.”

The Fed’s forecasting track record has been less than stellar over recent years. 

Hoping Powell’s pushback (“no”) on the end of the world within five years proves prescient.

Can a Powell press conference be simultaneously humdrum and extraordinary? 

It seemingly couldn’t be a more incredible environment: truly the most extreme uncertainty. 

The Trump administration’s policies, in particular tariffs, trade policy and immigration. 

“De-globalization” and a new world order. 

Acute geopolitical instability – the ongoing Ukraine/Russia war, and now Israel/Iran (with direct U.S. involvement likely), and the Middle East at the brink. 

And the unfolding U.S./China battle for global supremacy – just for starters.

It’s obvious what has most garnered the Fed’s attention: “Tariffs” was used 35 times during Chair Powell’s Wednesday post-meeting press conference.

“It takes some time for tariffs to work their way through the chain of distribution to the end consumer. 

A good example of that would be goods being sold at retailers today may have been imported several months ago, before tariffs were imposed. 

So, we’re beginning to see some effects, and we do expect to see more of them over the coming months… 

We do also see price increases in some of the relevant categories, like personal computers and audiovisual equipment, and things like that that are attributable to tariff increases.”

“The amount of the tariff effects, the size of the tariff effects, their duration and the time it will take are all highly uncertain.”

“And in particular, we feel like we’re going to learn a great deal more over the summer on tariffs. 

We hadn’t expected them to show up much by now, and they haven’t. 

And we will see the extent to which they do over coming months.”

“We’ll be watching the labor market very carefully for signs of weakness and strength, and tariffs for signs of what’s going to happen there.”

“What you start with is what’s the effective tariff rate overall, and people are managing to that. 

But the pass-through of tariffs to consumer price inflation is a whole process that’s very uncertain.”

“There are many parties in that chain. 

There’s the manufacturer, the exporter, the importer, the retailer, and the consumer. 

And each one of those is going to be trying not to be the one to pay for the tariff. 

But together, they will all pay for it together, or maybe one party will pay it all. 

But that process is very hard to predict… 

And we haven’t been through a situation like this, and I think we have to be humble about our ability to forecast it.”

“We’ve learned that tariffs are going to be substantially larger than forecasters generally thought. 

Our forecasts are generally not particularly different from those of other well-resourced forecasting operations. 

So, what we learned particularly in April was that substantially larger tariffs were coming, and that would mean higher inflation. 

That’s what happened. You saw 2.5% [SEP] forecast in December, you saw 2.8% in March, and you see 3.1% now.”

“So, I think we have to learn a little more about tariffs. 

I don’t know what the right way for us to react will be. 

I think it’s hard to know with any confidence how we should react until we see really the size of the effects, and then we could start to make a better judgment.”

“What we’re waiting for to reduce rates is to understand what will happen with, really, the tariff inflation. 

And there’s a lot of uncertainty about that.”

“Everyone that I know is forecasting a meaningful increase in inflation in coming months from tariffs, because someone has to pay for the tariffs. 

And it will be someone in that chain that I mentioned, between the manufacturer, the exporter, the importer, the retailer, ultimately somebody putting it into a good of some kind, or just the consumer buying it.”

“So, of course, this is something we sort of know is coming. 

We just don’t know the size of it. And again, the economy seems to be in solid shape. 

The labor market is not crying out for a rate cut. 

Businesses were in a bit of shock after April 2. 

But you talk to business people now, there’s a very different feeling now - that people are working their way through this and they understand how they’re going to go. 

And it feels much more positive and constructive than it did three months ago, let’s say.”

“It’s certainly a time of real change from a geopolitical standpoint, from a trade standpoint, from an immigration standpoint. You see this not just here but everywhere. 

So, there’s quite a lot going on. 

It doesn’t change the way we do monetary policy in the near-term…”

Tariff’s 35 to “stagflation’s” zero. 

Very real stagflation risk warranted a question (or two) and thoughtful response. 

More importantly, it was also a goose egg for “financial conditions.” 

Financial conditions are today the critical issue, which only weeks after April’s acute market instability has somehow completely vanished off the radar.

Last week’s CBB highlighted the Fed’s Q1 Z.1 data and the “real economy sphere vs. financial sphere” analytical precept. 

Some (virtually all) readers surely lacked the necessary zeal to slog through the tedium. 

I’m Back For a Second Attempt with data worthy of careful attention, hopefully with a more manageable allotment.

Broker/Dealer Assets expanded $490 billion, or 37.2% annualized, during Q1 to $5.759 TN. 

This was the strongest quarterly growth since Q1 2007 – to the highest level since Q3 2008. 

One-year growth was boosted to $614 billion, or 11.9%, the strongest annual expansion since 2007 ($619bn).

For Q1, Broker/Dealer Repo Assets surged a quarterly record $240 billion, or 56.8% annualized, surpassing (banking crisis) Q1 2023’s $199 billion - to a record $1.930 TN. 

Over 10 quarters, Repo Assets have ballooned $600 billion, or 45%. 

For some perspective, Broker/Dealer Repo Assets jumped $303 billion, or 21%, over 10 quarters for a September 2008 cycle peak of $1.778 TN.

Broker/Dealer Debt Securities holdings surged $145 billion, or 56% annualized, surpassing Q1 2008’s $1.111 TN to a record $1.174 TN (1-yr $233bn, 24.7%). 

Debt Securities were up $523 billion, or 82%, over 21 quarters. 

Broker/Dealer Agency Securities holdings ballooned $105 billion (91% ann.) during Q1 and an unprecedented $407 billion (255%) over one year – to a record $566 billion. 

Treasury holdings gained $33 billion (29% ann.) during Q1 and $97 billion (25%) y-o-y to a record $488 billion. 

Treasury holdings ballooned $260 billion, or 114%, over 21 quarters.

How did Wall Street finance such remarkable balance sheet expansion? 

Repo Liabilities ballooned $361 billion, or 61.8% annualized, during Q1 to $2.697 TN – the high since Q3 2008. 

Repo Liabilities inflated $1.083 TN, or 67%, over 10 quarters. 

For comparison, Broker/Dealer Repo Liabilities expanded $989 billion, or 46%, over 10 quarters to a Q3 2007 cycle peak of $3.132 TN.

Sticking with Repos, total system Repo Assets surged $717 billion, or 41% annualized, to a record $7.779 TN. 

One-year growth of $1.074 TN compares to peak mortgage finance Bubble 2007’s $655 billion (to $4.541 TN). 

Repo Assets ballooned $2.965 TN, or 62%, over 21 quarters.

Money Market Funds (MMF) are the largest holder of Repos. 

MMF Assets rose $155 billion, or 8.5%, during Q1 to a record $7.398 TN – with incredible one-year growth of $957 billion, or 14.9%. 

MMF Assets ballooned $2.314 TN (46%) over 10 quarters and an astounding $3.395 TN, or 85%, over 21 quarters. 

MMF Repo holdings surged $201 billion, or 31% annualized, during Q1 to $2.821 TN – with one-year growth of $440 billion, or 19%, and 21-quarter ballooning of $1.579 TN, or 127%.

As discussed in last week’s “Real Economy Sphere vs. Financial Sphere” analysis, the first quarter experienced remarkable divergence between slowing non-financial debt growth and rapid acceleration in financial sector borrowings. 

Listening to Powell’s press conference, questions focused on real economy risks (i.e., tariffs, labor, immigration, GDP, inflation…). 

Lacking was any discussion related to the booming financial sector. 

Considering Powell and the Fed’s focus on the full employment and stable prices “dual mandate,” the line of questioning is understandable. 

As usual, the Fed’s overarching responsibility to promote and safeguard financial stability has seemingly been relegated to history (aka ignored completely). 

And it is the perpetually overlooked “financial sphere” that poses clear and present danger to system stability.

Imagination time…

“Doug Noland from the Credit Bubble Bulletin. 

Chair Powell, thank you for taking our questions. 

First, are you concerned with the ongoing rapid growth in the “repo” market, Wall Street’s use of “repo” to finance huge balance sheet expansion, and the $2.3 TN growth in money market fund assets over the past two and a half years – financial sector ballooning reminiscent of the market backdrop leading up to the Great Financial Crisis? 

And, if I may, a follow-up question: Do you have concerns – does the Federal Reserve have concerns – for the “basis trade,” “carry trades,” and what appears trillions worth of speculative leverage throughout the Treasury and Credit market? 

The Financial Times reported that hedge funds hold $3.4 TN of Treasuries. 

Especially with massive deficit spending, elevated inflation risk, dollar weakness, and unprecedented uncertainty generally, how concerned are you about the potential for a disorderly unwind of this leverage?

And please accept my apology. 

I appreciate that we are limited to two questions. 

But I’ve waited decades for this opportunity. 

Please indulge me with one final question: All this speculative leverage has created liquidity over-abundance that has helped fuel another “subprime” Bubble, this time in “private Credit,” leveraged lending, and other high-risk corporate and consumer loans. 

How would you gauge the systemic risks associated with this interplay between speculative leverage, liquidity excess, and high-risk lending? 

Do you see this as a risk to financial and economic stability? 

Thank you.”

In response to the 2007 subprime blowup, the Fed slashed rates seven times – 325 bps – to an April 30th, 2008, rate of 2.0%. 

From a “real economy sphere” perspective, the Federal Reserve moved aggressively to loosen monetary policy ahead of looming economic fallout.

Bubbles are real phenomena. 

They have consequential characteristics and dynamics. 

Allowed to inflate over years to great excess, these characteristics and dynamics tend toward monumental. 

I often refer to late-stage “terminal phase excess.” 

The rapid expansion of increasingly unsound Credit coupled with manic speculative excess propels a parabolic rise in systemic risk.

Major Bubbles are a calamity for central bankers. 

“Real economy sphere” fragility beckons for monetary policy largess. 

Meanwhile, precarious late cycle “financial sphere” excess will feast on any loosening of conditions. 

There is simply no escaping this harsh reality: any modest “real economy” benefit from looser conditions will be overwhelmed by the disastrous consequences of extending terminal phase “financial sphere” excess.

The historical record lacks a thorough and accurate mortgage finance Bubble post mortem. 

Sound analysis would underscore that the Fed’s aggressive monetary easing extended “terminal phase” “financial sphere” excess. 

Instead of the system commencing requisite adjustment starting in mid-2007 (subprime eruption), aggressive policy easing stoked additional excess in key sectors beset with powerful inflationary biases – including “AAA” mortgage securities, the “repo” market, stocks, and key commodities (i.e., crude). 

I’m convinced that an final 15-month period of parabolic excess was a major factor that intensified crisis dynamics.

In the six quarters Q2 2007 through Q3 2008, Money Market Fund assets ballooned $1.002 TN, or 42% - with “repo” holdings surging 53% to $605 billion. 

Broker/Dealer “repo” assets jumped $303 billion, or 21%, to a record $1.778 TN. Outstanding GSE/Agency Securities rose $1.444 TN, or 22%, in six quarters. 

Between the end of Q1 2007 and the July 2, 2008 peak, the Bloomberg Commodities Index surged almost 39%. 

Crude oil spiked from $66 to a July 3, 2008, high of $145.

The Fed erred last year in slashing rates 100 bps starting on September 18th. 

The “real economy” didn’t require monetary accommodation. 

The overheated “financial sphere” took it and ran manically. 

Money Market Fund assets have surged $700 billion, or 11%, since the September cut. 

From the September 17th close to December 17th all-time high, the Bloomberg MAG7 index surged 29% - and closed this week 18% higher than 9/17. 

After closing September 17th at $116, Nvidia traded at an all-time high of $153 on January 7th - as AI went manic. 

Bitcoin inflated 75% in three months – and remains 72% higher. 

Gold has gained 31% since September 18th, silver 17%, and platinum 29%.

Powell posits that “uncertainty about the economic outlook has diminished.” 

The same certainly cannot be said for the “financial sphere.” 

After April’s abrupt tightening, loose financial conditions have returned with a vengeance. 

And when it comes to “terminal phase excess” and late-cycle “inflationary biases,” I would point to “private Credit.”

June 18 – Wall Street Journal (Matt Wirz): 

“An investment arm of insurer Prudential Financial will buy up to $500 million of consumer loans from technology-backed consumer lender Affirm Holdings for a period of three years. 

Most of the loans come due in six months and Affirm will be able to re-lend the investment throughout the life of the deal, allowing it to finance $3 billion of buy-now-pay-later loans. 

The deal is part of a growing wave of transactions pairing a handful of large private-credit investors with financial technology companies that are replacing banks as go-to lenders for the American public.”

A perilous late cycle “risk on/risk off” dynamic creates extraordinary instability and uncertainty. 

As we saw in April, latent fragilities mean “risk off” can quickly spiral into deleveraging, illiquidity, and market dislocation. 

But the unwind of bearish hedges and positioning (squeeze dynamic) triggered a speculative marketplace conditioned for “risk on”, “buy the dip” and FOMO buying. 

The corresponding loosening of financial conditions then stokes additional speculative leveraging, liquidity abundance, and high-risk lending. 

Such an overheated “financial sphere” inflating in an uber high-risk world is an accident waiting to happen.