Time for Resolve
Doug Nolan
Markets assume that a 25 bps rate increase at the FOMC’s meeting next Wednesday will wrap up the Fed’s tightening cycle.
The rates market is pricing in less than 20% probability of one additional hike in either September or November.
We hear a lot these days about “long and variable lags,” a phrase coined by Milton Friedman: “There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable.”
So much has changed in the sixty years since the publication of Friedman’s “A Program for Monetary Stability.”
For starters, there have been momentous changes in the administration of monetary policy.
Federal Reserve assets have surged 153-fold, from $54 billion to almost $8.3 TN.
Economic structured has evolved, with the structure of today’s financial system would be unrecognizable to Friedman.
Irony is not in short supply.
The reality is one of six decades of monetary instability, with transcendent Monetary Disorder unleashed by Friedman disciple Ben Bernanke.
I’ve been an analyst long enough to remember when the Fed didn’t even announce policy changes.
There were the so-called “Fed Watchers” that would scrupulously analyze subtle shifts in the Fed’s reserve holdings to decipher policy shifts.
Monetary policy certainly worked with long and variable lags.
Policy easing provided accommodation by adding reserves that would expand banking system lending capacity.
Removing reserves would restrain the banking system’s lending capacity, on the margin tightening finance throughout the system.
Depending on the inflationary backdrop, Fed bank reserve adjustments had quite variable impacts on lending and economic activity.
A discontented Paul Volcker abruptly shifted focus to managing money growth to rein in excessive lending and inflation.
Resulting disinflation – and a historic collapse in bond yields – was a boon to fledgling non-bank financial intermediation as well as financial speculation.
Less than three months on the job, the 1987 stock market crash elicited a defining statement from the Greenspan Federal Reserve:
“The Federal Reserve, consistent with its responsibilities as the Nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
The post-crash accommodative backdrop underpinned bank lending, the expansion of non-bank finance, and destabilizing excesses, including Bubbles in the Savings & Loan industry, commercial real estate, M&A, and junk bonds.
The “decade of greed.”
The collapse of eighties Bubble excess left the U.S. banking system badly impaired.
Greenspan’s aggressive accommodation (3% fed funds and an artificially steep yield curve) was a powerful stimulant to the leveraged speculating community and market-based finance more generally.
The move to more transparency was also significant, as the Fed began releasing post-meeting policy statements.
Importantly, the mechanism by which Fed policy was transmitted to the economy was rapidly evolving.
No longer would subtle changes to bank reserves provide the primary impact, not with scores of hedge fund managers now hanging on Greenspan’s every word.
It all proved too seductive.
With the banking system hamstrung by problem loan portfolios, “The Maestro” could almost instantaneously trigger billions of additional speculative leverage and attendant loosening with a mere cryptic utterance.
I have argued that the current Fed tightening cycle would be the first actual tightening since 1994.
After nurturing unprecedented speculative leverage (bonds and derivatives), a 25 bps baby-step rate increase on February 4, 1994, triggered an almost disastrous bout of de-risking/deleveraging.
At 5.77% on February 3rd, 10-year yields spiked to 7.48% by early-May – and were above 8% by November.
Despite today’s more elevated CPI, 10-year Treasury yields sit at only 3.83% - and barely made it above 4% during this “tightening cycle.”
And with markets anticipating an imminent end to rate increases, most indicators point to loose conditions.
Junk bond spreads ended the week at 15-month lows, with investment-grade spreads at about the same level as February 2022.
Both high yield and investment-grade CDS prices are little changed since the Fed began raising rates.
The Nasdaq100 has gained 41% y-t-d and has returned 16% since the start of the tightening cycle.
Indicative of a highly speculative marketplace, the Goldman Sachs Short Index has gained 35% this year.
Apparently, this tightening cycle is about to wrap up without a meaningful tightening of financial conditions.
Everyone is okay with it.
Market analysts see new record highs in the offing, while many economists now view a soft-landing as a worst-case scenario.
I doubt it’s going to be this easy.
I believe actual tightening is both necessary and inevitable.
“Immaculate disinflation” has similar analytical underpinnings as “transitory” inflation and Bernanke’s pre-GFC “global savings glut” thesis.
The world is transitioning to a new cycle, and the inflation dynamics of the previous cycle were aberrational.
The good old days of loose conditions and liquidity abundance staying well contained within the confines of financial assets have run their course.
New inflationary dynamics are driven by the likes of de-globalization, climate change, and a distressingly unstable geopolitical backdrop.
This week provided a timely reminder of New Cycle Inflation Risks:
July 20 – The Hill (Nick Robertson):
“The price of wheat continues to rise in the United States and elsewhere after Russia pulled out of a United Nations-negotiated deal to export grain from Ukraine Monday.
Wheat commodity futures have risen about 12% since Russia announced it would suspend the Black Sea Grain Initiative…
Russia has also continued to attack Ukrainian port infrastructure and cities with missiles and drones, damaging the ability to export wheat if the deal were to resume.
Those strikes have destroyed 60,000 tons of grain…”
Crude prices rose 2.0%, with gasoline futures jumping 5.8%.
Rallying 1.5%, the Bloomberg Commodities Index traded to a three-month high.
Watch out above when commodities speculative fervor is rekindled.
A Friday Bloomberg headline: “Ukraine Grain Now Relies on a River Drying in the Drought.”
The hostile climate was palpable for most of us this week, with global heat domes and a developing El Niño exacerbating already elevated food price risks.
July 20 – Reuters (Rajendra Jadhav, Mayank Bhardwaj and Shivam Patel):
“India… ordered a halt to its largest rice export category in a move that will roughly halve shipments by the world's largest exporter of the grain, triggering fears of further inflation on global food markets.
The government said it was imposing a ban on non-basmati white rice after retail rice prices climbed 3% in a month after late but heavy monsoon rains caused significant damage to crops.”
July 20 – Bloomberg (Josh Eidelson):
“More than 650,000 American workers are threatening to go on strike this summer — or have already done so — in an avalanche of union activity not seen in the US in decades.
The combined actors and writers strikes in Hollywood are already a once-in-a-generation event.
Unions for United Parcel Service Inc. and Detroit’s Big Three automakers are poised to join them in coming weeks if contract negotiations fall through…
And while logistics experts and financial analysts expected the Teamsters to reach a deal with UPS, their confidence has dwindled as the July 31 deadline approaches.
‘This will be the biggest moment of striking, really, since the 1970s,’ said labor historian Nelson Lichtenstein, who directs the University of California, Santa Barbara’s Center for the Study of Work, Labor and Democracy.”
It is difficult to believe the Fed can conclude a tightening cycle with the unemployment rate at 3.6%.
Labor today enjoys a strong negotiating position.
And as strikes result in sizable pay increases, expect only growing enthusiasm to join picket lines.
This is not the makings of disinflation and 2% CPI.
July 21 – Bloomberg (Edward Dufner):
“‘This excessive data dependence of the Fed is an unwillingness or inability to take a strategic view of the economy,’ [Mohamed] El-Erian said.
El-Erian said Powell ultimately will have to settle on a new target rate closer to 3% than the current 2% — a shift that would let the Fed declare victory earlier, and with less risk of damage to the US economy.
‘That may not sound like a big difference, but it is, over time… My big worry… is if the Fed focuses on 2% in a relatively rapid time frame, we will end up in recession… There is no reason for the US economy to fall into recession.
The endogenous elements of this economy are strong enough to power through this period.
The big risk is that we follow the wrong inflation target and end up tipping this economy into recession.”
Mohamed El-Erian is one of the preeminent macro analysts of this era.
I am hard-pressed to think of an individual whose analysis I mull over more closely.
And when I disagree with Mr. El-Erian, I’m compelled to find a mirror and warn that gray-haired analyst to be prepared to be wrong.
But I’m not wrong on this.
This is precisely the wrong time to go soft on the inflation target.
If the Fed went with three, it wouldn’t be long before it would be four and then five percent.
And there’s so much more at stake than moderately higher inflation.
No one wants a recession, though they serve a fundamental and critical role in business cycles.
Yet I’ll assume El-Erian is most concerned about the Fed breaking something – about a financial crisis.
It’s a legitimate concern.
I’m from the school that believes it’s advisable to take one’s medicine as soon as possible.
Postponing market and economic adjustment only ensures more destabilizing adjustments later.
So, why haven’t financial conditions tightened?
How have markets been able to counter Fed tightening measures?
Because the system has avoided de-risking/deleveraging.
Leveraged speculation, the marginal source of marketplace and system liquidity, has been undeterred by Fed rate hikes.
Risk embracement has persisted, holding risk aversion and associated tightening at bay.
Importantly, leveraged speculators are today more emboldened than ever.
Markets have been bailed out so many times that risk perceptions – and market pricing - have become profoundly distorted.
There was the unprecedented response to the 2008 crisis.
There was Draghi’s “whatever it takes” that took central bankers everywhere by storm.
There was Yellen’s super slow-motion slithering start to rate normalization.
More important was Powell’s dovish pivot and 2019 return to QE in response to “repo” market instability, despite solid economic growth and booming asset markets.
And the Fed demonstrated in March 2020 that there was basically no ceiling on the size of QE purchases or its composition.
No qualms with $5 TN.
No issue with buying corporate debt and ETFs.
Worries that the scope of leveraged speculation had outgrown the central bank liquidity safety net were allayed.
But then consumer and producer price inflation (finally) took off.
There were understandable concerns for the status of the “Fed put.”
How could the Fed again resort to QE with inflation running wild?
But then crisis erupted at the heart of the financial system.
A systemic bank run and three of the four largest bank failures in history.
What if runs expanded to money market funds and ETFs?
In a matter of weeks, the Fed and FHLB responded with upwards of $700 billion of additional liquidity.
Moreover, these measures were in the wake of the Bank of England’s crisis response and a notable softening of global central bank inflation resolve.
Speculators everywhere received all the confirmation they could have dreamed of that the central bank liquidity backstop was as secure as ever.
And it’s not a situation where markets fear crisis dynamics attaining momentum in the shadows undetected by central bankers.
Banking fragilities ensure central banks are on guard with immediate and powerful measures to bolster system liquidity.
The March liquidity response triggered a short squeeze and unwind of hedges, as the Federal Reserve reinforced a grossly unlevel market playing field.
The resulting surge in liquidity and market prices unleashed FOMO.
Bullish derivative bets (i.e., call options trading “in the money”) then stoked reinforcing liquidity excess.
Speculative leverage, FOMO flows, and derivative-related trading fueled a major loosening of financial conditions.
There are costs to years/decades of low rates, market interventions and bailouts.
Financial conditions are remaining too loose – and will remain dangerously loose until “risk off” and associated deleveraging.
And there are two key costs today from loose conditions.
First, inflation is becoming only more deeply entrenched, raising the risk of a destabilizing spike in market yields.
Second, speculative Bubbles are inflating dangerously at major Credit, economic and geopolitical cycle inflection points.
Mr. El-Erian is misguided.
There are multiple reasons for the economy to fall into recession, including decades of flawed policymaking, prolonged Monetary Disorder, egregious speculative and lending excess, and historic financial and economic structural maladjustment.
Moreover, the economy and financial markets have become precariously dependent on liquidity emanating from leveraged speculation, creating latent fragilities.
The big risk to system stability is that the Fed continues to accommodate runaway speculative Bubbles.
The Fed Wednesday must show resolve.
It’s time for the Chair to ditch “balanced Powell” and show resolve.
The “skip” was already imprudent speculative Bubble accommodation.
This is no time to even hint “mission accomplished.”
There’s potentially a lot more work to do.
Financial conditions need to tighten.
And if recession is part of the cost of safeguarding the system from additional speculative leverage, dangerous Bubble excess, and years of problematic inflation – then so be it.
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