The Speculative Cycle
Doug Nolan
While economists won’t ratchet Q3 growth estimates up to match the Atlanta Fed GDPNow’s 5.9%, forecasts will be moving higher.
The Unemployment Rate is expected to remain unchanged for August, near a multi-decade low 3.5%.
August Services PMI data point to some cooling, while stronger-than-expected (17-month high) New Home Sales data (July) suggest construction will for now support economic expansion.
Who would have thought the homebuilders would have it so good (Homebuilder ETF up 32% y-t-d!) after more than 500 bps of Fed rate hikes?
Thirty-year mortgage rates rose eight bps this week to 7.30%, the high back to December 2000.
MBS yields traded up to 6.27% in Tuesday trading, the peak since July 2007, before ending the week down seven bps at 6.08%.
Ten-year Treasury yields rose to 4.36% intraday Tuesday, the high since November 2007.
Two-year Treasury yields traded as high as 5.09% in Friday trading, surpassing the March 8th (pre-SVB) peak to the high back to June 2007.
August 25 – Barron’s (Megan Cassella):
“One of the buzziest topics heading into the Jackson Hole symposium this year was a fairly wonky one: At what level would the real interest rate be considered neutral?
The economy’s surprising strength had sparked a debate over whether the neutral rate, which economists call R-star, or r*, was actually higher than previously thought.
That could signal in turn that monetary policy would have to get more restrictive than anticipated, too.
The trick with r* is that it is impossible to measure in the moment, so economists were on high alert for whether Federal Reserve Chairman Jerome Powell, in his Friday speech, would tip his hat about where he believed neutral rates were and what that might indicate about how much work the Fed has left to do.”
August 25 – Bloomberg (Ruth Carson):
“An abstract interest-rate metric is dominating discussions across trading desks ahead of the Jackson Hole symposium, with investors wondering if Federal Reserve Chair Jerome Powell will weigh in, and bracing for further declines in US Treasuries if he does.
Fidelity International, Jupiter Asset Management and hedge fund Blue Edge Advisors are among those pondering the implications of whether there has been an increase in the neutral rate, also known as R*.
That’s the theoretical level at which rates neither stimulate nor restrict an economy.
If the Fed wants to contain a price surge – as it does now – it raises its benchmark above that level.”
It was more “Balanced Powell” Friday at Jackson Hole.
By no stretch an economic theory wonk, Powell did address the neutral rate:
Powell:
“There are some challenges that are common to all tightening cycles.
For example, real interest rates are now positive and well above mainstream estimates of the neutral policy rate.
We see the current stance of policy as restrictive, putting downward pressure on economic activity, hiring, and inflation.
But we cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint.”
I’ve been no fan of contemporary “neutral rate” (“neither restrictive nor expansionary”/“neither stimulates nor restricts the economy”) theorizing.
I understand why the neutral/natural rate was such a focal point of great economic thinkers, from Henry Thornton and Knut Wicksell, to Dennis Robertson, J.M. Keynes and the great Austrian economists Ludwig von Mises and Friedrich Hayek.
Simplistically, think in terms of a banking system lending for capital investment as the prevailing source of money and Credit entering the system.
If the rate charged by banks was in excess of the return on capital investment, businesses would boost borrowings to build additional plant and equipment.
If the bank rate was too high, they would borrow and spend less.
Excess investment would increase capacity/supply, driving down returns on investments.
Vice versa for under-investment.
In such an environment, there is a theoretical bank rate – a “neutral” or “natural” rate - that over time converged with real economic returns to promote relative stability – a so-called “equilibrium.”
For a number of reasons, this “neutral rate” theoretical framework is hopelessly antiquated.
Economic systems today are extremely complex, with services and finance dominating factors like never before.
Bank lending for capital investment is certainly not a primary source of system monetary expansion.
And, when it comes to a policy rate working to regulate monetary expansion and profits, there are today two distinct spheres of profits that operate with disparate dynamics: real economy earnings and financial returns.
Simplifying and cutting to the chase, neutral rate discussion and debate ignore what has become a dominant force in contemporary finance and economics: the Speculative Cycle.
Speculative leverage and flows have evolved into a prevailing source of market and system liquidity.
“Risk on” leveraging and flows will loosen financial conditions, while “risk off” can lead to abrupt and highly destabilizing tightening.
And as we’ve witnessed over the past 18 months, the Speculative Cycle can take on a life of its own irrespective of Fed monetary policy tightening.
Powell:
“Restrictive monetary policy has tightened financial conditions, supporting the expectation of below-trend growth.
Since last year's symposium, the two-year real yield is up about 250 bps, and longer-term real yields are higher as well—by nearly 150 bps.
Beyond changes in interest rates, bank lending standards have tightened, and loan growth has slowed sharply.
Such a tightening of broad financial conditions typically contributes to a slowing in the growth of economic activity, and there is evidence of that in this cycle as well.”
“Such a broad tightening of financial conditions”?
The S&P500 has returned 10.5% since Powell spoke almost a year ago to the day.
The Nasdaq100 has returned 19.6%, with the Semiconductors returning 26.8%.
A.I. golden child Nvidia has skyrocketed 182%.
To gauge financial conditions, we can look to corporate debt risk premiums.
Investment-grade spreads to Treasuries have declined from 137 to 119 basis points over the past year.
High yield spreads narrowed to 380 from 452 bps.
Credit default swap (CDS) prices provide valuable financial conditions indicators.
Investment-grade CDS over the past year fell from 86 to 65 bps.
High yield CDS dropped from 499 to 438 bps.
Bank CDS are interesting.
JPMorgan CDS closed the week at 56, down from the year ago 80 bps.
Citigroup CDS declined from 93 to 69 bps, and Bank of America CDS was down three to 80 bps.
Keep in mind that bank CDS prices have declined despite the March banking crisis.
Indeed, we can point directly to the crisis response for an explanation of why CDS – and market financial conditions generally – loosened in the face of Fed tightening measures.
Importantly, massive Fed and FHLB liquidity injections unleashed a powerful Speculative Cycle – triggering a short squeeze, unwind of hedges, FOMO flows and derivative-related (i.e., hedging of call options written) melt-up dynamics.
This latest chapter of a most protracted Speculative Cycle bolstered system conditions through typical channels - speculative leverage, wealth effects, powerful financial flows, and debt issuance – working in concert to offset the bank lending slowdown.
August 25 – Bloomberg (Michael Gambale):
“Investment-grade bond sellers are poised to swarm the market with new debt offerings in September, with much of it expected to come in the four days following the US Labor Day holiday.
Banks that underwrite the bonds expect about $120 billion to be issued next month, much more than the $78 billion sold in September 2022…”
According to S&P Global Market Intelligence, first-half corporate debt issuance jumped 36% from comparable 2022 to $398 billion.
The financial system over the past three decades went through a historic transformation.
Market-based finance – led by the GSEs, Wall Street securitizations and derivatives, and the money fund complex – evolved to become a commanding force in Credit creation.
The rise of non-bank lending fundamentally loosened system Credit.
Meanwhile, the GSEs joined with the Federal Reserve to provide a full proof market liquidity backstop.
And when the Federal Reserve responded to new financial structure instability by aggressively slashing rates, the backdrop became only more conducive to speculation and speculative leveraging.
What policy rate would be “neutral” for a major Bubble?
There is no neutral – no equilibrium or even stability - for Bubbles.
Bubbles know no middle ground; they either inflate or deflate.
And for three decades, the Fed (and global central bank community) has responded to Bubble deflation and collapse with ever more powerful reflationary stimulus measures, feeding the greatest Speculative Cycle in human history.
So why is there so little discussion of the momentous role speculation now plays in determining system financial conditions?
How could this subject matter not be central to discussions of the inability of Fed hikes to tighten broad financial conditions?
Well, Wall Street economists clearly would rather not go there.
And for the economics community, there’s no place in econometric models for a Speculative Cycle.
Greed and Fear are rather unruly factors for modeling.
And if you can’t model it, you disregard it.
Yet these Speculative Cycles are about the most fascinating dynamics around.
The old bank lending model could assume rational actors and reasonable behavior.
Speculative markets are a different animal.
Fun and games; mania and panics.
It is often stated that manic speculative markets are creatures of irrationality.
I tend to emphasize that if markets inflate long enough, with reassuring liquidity backstops and bailouts along the way, it becomes perfectly rational to aggressively speculate and leverage.
Irrationality seems to apply to the chumps on the sidelines.
Especially late in the cycle, there’s a thin line between a bursting Bubble and speculative melt-up.
If the Fed and FHLB hadn’t come hastily in March with $700 billion of additional liquidity, we’d be today in a different Speculative Cycle phase.
And if A.I. wasn’t a fledgling Bubble back in March, this liquidity-induced Speculative Cycle would have much different dynamics.
If “private Credit” and “De-Fi” weren’t enveloped in Bubble Dynamics, it would have been challenging for market-based finance to take up the slack from tighter bank Credit.
But Fed rate hikes, along with the likelihood of tighter conditions puncturing the “tech” Bubble, ensured large short positions, hedging and downside derivative bets.
The Big Squeeze and loosened conditions then played out perfectly for the bullish A.I. narrative, unleashing powerful speculative dynamics – including for the market-leading “magnificent seven.”
As an aside, Ben Bernanke is fond of eviscerating the 1929 “Bubble poppers,” while blaming tight Fed policies for the market crash that precipitated the Great Depression.
The key issue, however, was not tight policy.
Instead, ultra-loose market conditions fueled a culminating, run amok speculative blow-off to conclude a historic Speculative Cycle.
Speculative leverage had evolved to become the dominant source of system liquidity, and the situation spun out of the Federal Reserve’s control.
The only cure for a Bubble is not to let it inflate.
A crash was inevitable.
Our era will be studied and debated for generations.
There will be those who argue that the Fed’s aggressive tightening measures were responsible for financial and economic crises.
A year of higher rates is not the problem.
It’s loose financial conditions for the better part of three decades.
It’s repeated market bailouts.
It’s runaway Credit growth and a historic Speculative Cycle.
There are eerie parallels between 1929 and today.
Powerful speculative excess continues in the face of acute fragilities and faltering Bubbles (i.e., startups and commercial real estate) here at home, while Bubble deflation gathers momentum globally (i.e., China).
Yet so long as the Speculative Cycle runs unabated, loose conditions will bolster spending and inflation.
Meanwhile, system underpinnings turn only more fragile.
Powell and Fed officials continue to talk “higher for longer.”
The market is now pricing a 63% probability of one additional rate increase (by the November 1st meeting).
But then the market prices in about 100 bps of cuts for 2024.
What Fed policy rate would today be “neutral”?
Neutral for what?
To neutralize inflation back to the Fed’s 2% target?
Neutral for the real economy?
Neutral for financial conditions?
Or neutral for highly speculative financial markets and asset prices?
Well, at this point, the Speculative Cycle will dictate so much.
And after the big March liquidity bailout, this imposing Speculative Bubble scoffs at Fed “tightening.”
Powell:
“Two percent is and will remain our inflation target.”
Those advocating raising the inflation target completely miss a critical point: even a 2% inflation target was grossly deficient in promoting a sound monetary environment.
Money and Credit growth were excessive, asset price inflation was excessive, and speculation and speculative leverage were precariously excessive.
The inflationists would like to believe that raising the target today will protect the economy from aggressive tightening measures.
More likely, a higher inflation target would only guarantee a more precarious Speculative Cycle.
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