Far From It
Doug Nolan
A snooze fest the October FOMC meeting was not. “…Far from it.”
An inebriated Wall Street didn’t see that coming.
After trading near a one-year low of 3.97% in early Wednesday trading, 10-year Treasury yields jumped to a Thursday high of 4.11% - before ending the week at 4.08%.
Two-year yields traded from 3.48% up to 3.63% - closing the week at 3.57%.
The rates market went from almost a 100% probability for a December rate cut to 68%.
Chair Powell:
“…strongly differing views in today’s meeting, as I pointed out in my remarks.
And that’s what leads me to say that we haven’t made a decision about December.
I always say that. It’s a fact that we don’t make decisions in advance.
But I’m saying something in addition here, is that it’s not to be seen as a foregone conclusion, in fact, far from it.”
“And so there’s a growing chorus now of feeling like maybe this is where we should at least wait a cycle…”
“There were strongly differing views today.”
“The strongly differing views were really about the future…”
“…Strongly differing views in today’s meeting, as I pointed out in my remarks.” “…
Everybody on the Committee is deeply committed to doing the right thing to achieve our goals, maximum employment and stable prices.
You have differences on how to do that…”
“When participants go out and talk, they’re very disparate views.”
“…Different risk aversions to the two different variables, which is common through all Federal Reserves… people just have different risk tolerances...
So that leads you to people with disparate views.”
According to JPMorgan’s Bob Michele, “Powell is losing his grip on the Fed.”
I would come at his from a different angle: the Federal Reserve’s flawed analytical framework has closed in on Powell, the Committee, and the entire organization.
Lacking a cohesive framework, the Fed is now deeply divided, just like about everything else.
The chasm will be filled by partisan “politics.”
“Perspectives of people on the Committee that we’ve now moved 150 bps and that we’re down into – you’re into that range between 3 and 4, where many estimates of the neutral rate live, in the 3 to 4% area, you’re there now - you’re above the median number for the Committee.
But I think there are people on the Committee who have higher estimates of the neutral rate, and you can argue these positions since they can’t be directly observed, the neutral rate.”
Guesswork as to the level of some unobservable hypothetical “neutral rate” is no way to run a central bank.
Traditionally, central bankers focused on bank lending and Credit conditions as primary mechanisms for policy rates to influence growth and inflation dynamics.
Today, financial markets dominate, highly speculative markets at that.
A “risk on” backdrop of risk-taking, speculative leverage and liquidity abundance requires significantly higher policy rates to restrain Credit growth and broad inflationary pressures (including asset inflation).
That same policy rate would turn restrictive in a “risk off” environment of risk aversion, deleveraging and waning liquidity excess.
It's imperative that the Federal Reserve incorporate thoughtful analysis of the market backdrop and financial conditions more specifically.
Ignore at our peril.
The Fed erred 13 months ago when it began loosening monetary policy despite dangerously loose conditions and speculative markets.
Nvidia’s stock inflated almost 80%.
For Oracle, it was 65%.
The Semiconductor Index has returned 50% since the Fed’s first cut, boosting three-year gains to over 200%.
A few weeks ago, investment-grade corporate spreads to Treasuries traded at 72 bps, the narrowest level since the (pre-LTCM crisis) summer of 1998.
Corporate debt issuance has boomed, Wall Street just reported record quarterly earnings, and, led by the AI mania/arms race, stocks have surged further into record territory.
Somehow, “financial conditions” didn’t get a mention in Powell’s prepared remarks or during his press conference.
It’s as if this critical issue off limits.
The Associated Press’ Chris Rugaber:
“So there’s a big investment boom in AI infrastructure right now, as you know, and wondering if the existence of such a boom would indicate that rates are not that restrictive after all.
And could further rate cuts at this point perhaps fuel an excess level of investment there, or market bubbles.
How is the Fed thinking about that?”
Powell:
“You’re right.
There’s a lot of data centers being built, and other investments being made around the country and around the world.
And big U.S. companies are just investing a lot of resources in thinking about how AI… run through data centers, is going to affect their businesses.
So, it’s a big deal.
I don’t think that the spending that happens to build data centers all over the country is especially interest sensitive.
It’s based on longer run assessments that this is an area where there’s going to be a lot of investment and that’s going to drive higher productivity and that sort of thing.
I don’t know how those investments will work out.
But I don’t think they’re particularly interest sensitive compared to some of the other sectors.”
Considering historic dynamics - company market capitalizations, the incredible ramp up of spending, and all the hype - Powell surely knew AI questions were coming.
Hard to believe he prepared to respond so ineffectively.
Apparently, it’s not rate-related – not an issue of or for the Federal Reserve.
But the AI mania and arms race have and continue to feed off late-cycle loose financial conditions and liquidity abundance.
This backdrop has everything to do with monetary policy.
Bloomberg’s Michael McKee:
“Do you have any concerns that equity markets are, or are close to being overvalued at this point?”
Powell:
“We don’t look at any one asset price and say hey, that’s wrong.
It’s not our job to do that.
We look at the overall financial system, and we ask whether it’s stable and whether it could withstand shocks, right?
So, banks are well capitalized… households are in good shape financially.
Relatively manageable levels of debt…
And you don’t see too much leverage in the banking system or the financial system…
It’s not appropriate -- we don’t set asset prices, markets do that.”
Mike McKee follow-up:
“Well, you must be well-aware by lowering interest rates, you’re contributing to additional asset price increases.
And I wonder how you balance the idea that lowering rates would help the labor market with the reality that it seems more likely to be stimulating increased investment in AI, which is the rationale for thousands of job cuts that have been announced in the last few weeks.”
Powell:
“Yeah, I don’t think interest rates are an important part of the AI -- the data center story.
People think there are great economics in building these data centers, and they’re making a lot of money building them and I think they have very high present value and all this sort of thing, it’s not really about 25 bps here or there.
We use our tools to support the labor market and to create price stability.
That’s what we do.”
Politico’s Victoria Guida:
“On AI, I’m just wondering, it seems like a lot of the economic growth that we’ve been seeing is fed by investments in AI.
So, how worried are you about what the sudden contraction in tech investment would mean for the overall economy, is there enough strength in other sectors?
And specifically, are there any lessons that you take from the 1990s in how you might approach what's happening right now?”
Powell:
“Yeah, this is different in the sense that these companies, the companies that are so highly valued actually have earnings and stuff like that.
So, you go back to the ‘90s and the dot-com, these were ideas rather than companies.
So, there’s a clear bubble there, whereas - I won’t go into particular names - but they actually have earnings and it looks like they have business models and profits and that kind of thing.
So, it’s really a different thing.
You know, the investment we’re getting in equipment and all those things that go into creating data centers and feeding the AI, it’s clearly one of the big sources of growth in the economy.”
Yahoo Finance’s Jennifer Schonberger:
“Both regional and large banks have taken losses on loans given delinquencies on sub-prime auto loans.
JPMorgan's CEO, Jamie Dimon, warned when you see one cockroach, there may be more likely.
I’m curious how the Fed is looking at these loan losses and if it poses risks to the financial system or the outlook for the economy.
Is it a warning sign?”
Powell:
“So, obviously we watch these things very carefully, credit conditions very carefully.
You’re right, you’ve seen rising defaults in subprime credit for some time now, and now you’ve seen a number of subprime credit -- automobile credit institutions having significant losses, and some of those losses are now showing up on the books of banks.
We’re looking at it carefully. We’re paying close attention.
I don’t see, at this point, a broader credit issue.
It doesn’t seem to be something that has very broad application across financial institutions.
But we’re going to be monitoring this quite carefully and making sure that that is the case.”
Jennifer Schonberger follow up:
“How much of consumer spending continuing hinges on the stock market remaining strong?
In some odd way, does the market help keep the economy buoyant?”
Powell:
“So there is some relationship there.
But remember, the more wealth someone has, the lower an additional dollar of wealth matters.
So, your marginal propensity to consume declines quite dramatically as you reach levels of stock market wealth.
So, the stock market, it would affect spending if the stock market went down.
But it wouldn’t drop sharply unless there were quite a sharp drop in the stock market.”
This is such an unprecedented environment, with various momentous developments.
Whether responding to questions regarding AI investment, Bubble possibilities, inflated equities markets, or recent Credit issues – Powell’s answers leave me uncomfortable.
Is he purposely downplaying their significance – loath to make waves – or is he and the committee not on top of such consequential and far-reaching developments?
Why not offer cautious comments on conspicuous signs of excess throughout tech and AI?
Why dismiss obvious signs of a dangerous arms race and Bubble?
How could Powell not allude to the First Brands collapse and potential ramifications across “Wall Street finance?”
How can he stay mum after Bank of England’s Andrew Bailey’s astute “alarm bells” were ringing comments from a week ago?
With recent concerns voiced by Bailey, the IMF, BIS, rating agencies and others, Powell should have been asked about potential Fed concerns with bank exposure to “non-depository financial institutions.”
October 30 – Reuters (Andrea Shalal and David Lawder):
“U.S. Treasury Secretary Scott Bessent… applauded the Federal Reserve’s decision to cut interest rates by a quarter percentage point, but said comments casting doubt on another rate cut this year showed the institution needed a major revamp…
The goal, he said, was to find a new leader for the U.S. central bank who would overhaul the entire institution.
‘The decision by the Federal Reserve yesterday - the decision to cut rates by 25 bps, I applaud, but the language that went with it, tells me that this Fed is stuck in the past.
Their inflation estimates have been terrible so far this year…
Their models are broken.’
Bessent said he could not understand why the Fed was signaling that it didn’t want to cut rates at its December meeting, saying their estimates of gross domestic product and inflation had been ‘consistently wrong.’
‘We’re going to find a leader who is going to revamp the entire institution in terms of process and inner workings,’ he said.”
This is most inopportune timing for the Fed Chair and FOMC to be running scared.
Finance has evolved momentously over recent decades.
The Fed has failed to construct coherent analytical and policymaking frameworks.
This will cost them Federal Reserve independence.
It already is.
October 25 – Financial Times (James Politi):
“From the sofa in his office overlooking the White House, Scott Bessent, Donald Trump’s Treasury secretary, summed up how he approaches the job.
‘We want the most America-first policies that are possible, without incurring market wrath,’ said the… hedge fund manager… who now runs the cabinet agency responsible for the world’s… most important debt market…
‘Unlike most of my predecessors, I have a very healthy scepticism of elite institutions and elite opinion, whereas I think they didn’t,’ Bessent said.
‘But I have a healthy regard for the market’…
He also distanced himself from other populist governments around the world with unorthodox policies.
‘What gets the people in trouble is they come in, they have these ideas, but they don’t respect the market… you’ve got to respect the market.’”
October 27 – Wall Street Journal (Nick Timiraos):
“President Trump said… he might announce before year-end his pick to succeed Federal Reserve Chair Jerome Powell, whose term expires next May, and is on track to choose from five finalists.
Treasury Secretary Scott Bessent plans to conduct a second round of interviews with the current slate next month…
The five include two sitting Fed governors who were initially nominated to the central bank’s board by Trump: Christopher Waller and Michelle Bowman… Two candidates are widely seen as front-runners: Kevin Hassett… and Kevin Warsh…
Rick Rieder, a senior executive at BlackRock who oversees the firm’s massive bond business, rounds out the five.”
My hunch is Bessent would prefer BlackRock’s Rick Rieder to replace Powell (ASAP).
What a super-cycle climax dynamic: Hedge fund and asset management communities unite to demolish and reconstruct the Federal Reserve system (to their and Trump’s liking).
A White House keenly aware that cracks in financing Washington’s massive debt load would torpedo their agenda – and a hot shot Wall Street bond manager willing to work together creatively to postpone The Day of Reckoning.
I think the Trump folks pretty much despise central bankers – how they’re educated; how they think and operate.
Bessent: “We’re going to find a leader who is going to revamp the entire institution…”
To get things going, placate uneasy markets with a seemingly conventional search process.
But they will want someone from the outside, so Waller and Bowman are out.
Warsh might be too much of an independent thinker.
Hassett would suffice, but he lacks market gravitas.
Rick – “whoever ends up being the Fed chair, there’s so many innovative things… how to use the balance sheet, how to use liquidity, where the yield curve is” – Rieder; the administration’s archetypal made-for-television masculinity - the skillful salesman and market operator.
It may only be a case of (global) markets buying into a Rieder chairmanship.
This could move fast, with Bessent expecting to present “a ‘good slate’ to Trump after the Thanksgiving holiday.”
Powell’s term as Chair ends on May 15th.
Time might be of the essence.
I expect markets to turn more circumspect of the Trump/Bessent Fed scheme when things start to unravel.
KKR dropped another 2.4% this week – and is down 22% from September highs and traded intraday Friday at lows since June.
Blackstone sank 5.1% this week and Blue Owl 5.5%.
Credit issues fester.
October 31 – Bloomberg (Jeannine Amodeo):
“The US leveraged-loan market ended Octoberwith another tepid week for launches, putting monthly volumes on track to be the third-slowest of the year following a record 3Q.”
October 31 – Bloomberg (Gowri Gurumurthy):
“US junk bonds tumbled, posting their steepest one-day loss in three weeks, as the risk premium climbed to 278 bps after Chair Powell cautioned that a December rate cut is not a foregone conclusion.
Yields rose 11 bps to 6.76%, the biggest one-day jump in three weeks…
CCC yields, the riskiest tier of the high yield market, climbed 14 bps to 9.84%.
Spreads rose 14 bps to 607 — the biggest one-day widening in three weeks.”
October 27 – Financial Times (Lee Harris and Euan Healy):
“Credit ratings on private loans held by US insurers may have been systematically inflated, the Bank for International Settlements has warned in a new paper on the growing risk of ‘fire sales’ during periods of financial turmoil.
Ratings on private credit investments have come under scrutiny following a rise in insolvencies and recent high-profile bankruptcies at car parts maker First Brands and auto lender Tricolor.
The rapid collapse of the two businesses has rattled credit markets, with some investors highlighting concerns over their complex funding structures.
Smaller rating agencies have captured market share in the fast-growing world of private credit by providing so-called private letter ratings, which are typically only visible to an issuer and select investors.
US life insurers have been among the biggest buyers of such debt.”
I am reminded of the focus on inflated ratings and ratings companies after the 2007 subprime blowup.
More from Lee Harris’s and Euan Healy’s insightful FT article:
“The number of insurance securities rated by Moody’s, S&P and Fitch… has been largely flat in recent years, while the quantity rated by smaller providers has grown rapidly.
Smaller groups may face commercial pressure to assign more favourable scores, according to the BIS, which said the strategy could ‘lead to inflated assessments of creditworthiness’ and ‘obscure the true risk of complex assets’.
Insurers with links to private equity groups have been heavy users of private letter ratings.
About a quarter of those insurers’ investments relied on such ratings as of 2024…”
“‘If market users are part of the mechanism for keeping rating agencies honest, it’s not working,’ Ann Rutledge, a former senior Moody’s analyst and now chief executive of rating agency CreditSpectrum, told the Financial Times…
Private equity’s growing stake in insurance through direct acquisitions of insurers or management of their assets, may have raised ‘systemic vulnerabilities’ in the sector, the BIS said.
Insurers affiliated with alternative investment managers invest about 24% of their portfolios to private credit, as well as riskier and more complex assets, compared with 6% at non-affiliated insurers, Fitch said…”
Along with BOE Governor Andrew Bailey's warning, last week I highlighted a comment from BOE deputy governor Sarah Breeden:
“We can see the vulnerabilities here, the opacity, the leverage, the weak underwriting standards, the interconnections.
We can see parallels with the global financial crisis.
What we don’t know is how macro-significant those issues are.”
Unfolding Credit issues could not be more “macro-significant.”
This most-protracted Credit cycle went to historic extremes.
Epic “terminal phase excess” has unleashed a perilous AI arms race blowoff.
October 30 – Wall Street Journal (Meghan Bobrowsky):
“Silicon Valley’s biggest companies are already planning to pour $400 billion into artificial intelligence efforts this year.
They all say it’s nowhere near enough.
Meta Platforms says it is still running up against capacity constraints as it tries to train new AI models and power its existing products at the same time.
Microsoft says it is seeing so much customer demand for its data-center-driven services that it plans to double its data-center footprint in the next two years.
And Amazon.com says it is racing to bring more cloud capacity online as soon as it can.
‘We’ve been short [on computing power] now for many quarters.
I thought we were going to catch up.
We are not.
Demand is increasing,’ said Amy Hood, Microsoft’s chief financial officer.
‘When you see these kinds of demand signals and we know we’re behind, we do need to spend.’”
October 31 – Bloomberg (Carmen Arroyo):
“Just this month, Meta Platforms Inc. has secured about $60 billion in capital to build data centers, part of its spending to get ahead in the artificial intelligence race.
Half of that won’t show up on the social media giant’s balance sheet as debt.
Meta is among firms popularizing a way for debt to sit completely off balance sheet, allowing enormous sums to be raised while limiting impact on its financial health.
Morgan Stanley structured a $30 billion deal — the largest private capital transaction on record — where the debt would sit in a special purpose vehicle tied to Blue Owl Capital Inc.
That made it easier for Meta to raise another $30 billion this week the usual way, in the corporate bond market.
Off-balance-sheet debt, through an SPV or a joint venture tied to assets like chips or real estate, is becoming the go-to for AI data center deals, bankers say.
Morgan Stanley estimates that tech firms and others will need as much as $800 billion from private credit in deals tied to specific assets, including in SPV format, by 2028.”
October 29 – Bloomberg (Caleb Mutua):
“Credit traders are buying protection against Oracle Corp. defaulting on its debt, a trend that Morgan Stanley sees continuing in the near term as the tech giant pours billions into artificial intelligence.
The cost to insure against default on the company's debt over the next five years is hovering near its highest since Oct. 2023…
The company’s 4.9% bonds maturing in February 2033 widened 26 bps to 83 bps…
Morgan Stanley expects Oracle’s net adjusted debt to more than double to roughly $290 billion by fiscal year 2028 from around $100 billion and is recommending that investors buy the company’s five-year CDS and its five-year bonds.”
Tech Credit default swap (CDS) prices have begun moving.
Concerns are mounting.
Curiously, Oracle CDS jumped another 10 bps this week to 86 bps – having now doubled since mid-September.
Oracle just tapped the debt markets for $38 billion, followed by Meta’s $30 billion.
As spending skyrockets, big tech’s big cash positions will no longer suffice.
The great AI buildout will increasingly be at the whim of the debt markets.
Off balance sheet debt and structured finance to fund the AI buildout?
Really?
Considering mounting Credit issues, the AI Bubble is vulnerable.
October 29 – Telegraph (Hans van Leeuwen):
“The $3tn shadow banking industry has developed ‘bubble-like characteristics’ that could risk triggering a wider global financial shock, the credit ratings agency Fitch has warned.
Fitch said that if a crisis took hold in the private credit market, then it could ripple out to fund managers, banks and insurers who bankroll the market.
The warning, issued this week, adds to a drumbeat of concern after the $12bn collapse of US auto parts giant First Brands was followed by two regional US banks sounding the alarm over bad loans.
This has prompted fears that the incidents could be symptomatic of more serious problems in the market.”
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