Doug Noland: Regime Change

Excerpts:

Noland comment: It is a disturbing flaw in Powell’s (and conventional) thinking to equate sound money to relatively contained consumer price inflation. After all, asset inflation and Bubbles are this era’s greatest threats to monetary stability and sound money more generally. Unfettered “money” and Credit is the root cause. Massive monetary inflation and fiscal deficits are categorically incompatible with sound money. And unsound money is incompatible with social and political stability.

Inequality, speculative Bubbles and manias, resource misallocation, wealth redistribution and destruction, and deep economic structural impairment are all consequences of years of unsound money. And it’s back to this fundamental flaw I’ve been railing against for too long: it is impossible to resolve Monetary Disorder and the fallout from unsound money through additional monetary inflation. It’s destined for catastrophic failure, and it was another week when inklings of a failing system were observable to those with discerning eyes.

It may be archaic and relegated to the dustbin of history. But one cannot overstate the peril associated with entrenched unsound money. An insidious corruption of price mechanisms over time jeopardizes the very foundation of Capitalism. And as Capitalism decays Democracy flounders. Society frays, while insecurity, animosity, anxiety, and the forces of distrust are left to fill the void. And as we continue to witness, the consequences of unsound money incite only more perilous inflationism.

Representative Warren Davidson (House Financial Services Committee hearing: 2/24/21): We’re able to navigate them because we still can borrow. I wonder, sir, do you have a definition of sound money?”

Fed Chairman Powell: “We target inflation that averages two percent over time. That is what we consider to be…”

Davidson: “Well, that’s the policy, but I mean, when you think of sound money, what would you say constitutes sound money?”

Powell: “Where the public has confidence in the currency, which they do, which the world does. That’s really what it comes down to – that people believe that the United States currency is perfectly reliable and stable in value.”

Davidson: “Okay, so as a store of value. It clearly isn’t stable in value. It is not. What is a store value? The U.S. dollar really, is it diluted as a store value when M2 goes up by more than 25% in one year? Does the printing of more U.S. dollars somehow diminish the value of the dollars that others hold?”

Powell: “You know there was a time when monetary aggregates were important determinants of inflation and that has not been the case for a long time. So you’ll see if you look back, the correlation between movements in different aggregates – you mentioned M2 – and inflation is just very, very low, and you see that now where inflation is at 1.4% for this year…”

Davidson: “Yeah, you keep using that, you keep using it to talk about inflation. And I don’t think that’s the only proxy for whether the dollar is a store value and an efficient means of exchange. It is clearly still the world’s reserve currency, but we’re putting it under a pretty big stress test by diluting the value of the dollar. And I think one of the indicators of that is when the U.S. government issues debt for all this spending that we’ve done as a country, it isn’t really funded, is it? There’s not a true market demand for this much debt. It’s not being lent. When there’s borrowing there’s actually a lender. How much has the Federal Reserve had to purchase to bridge the gap between market demand for Treasuries and the actual need to finance the spending?”

Powell: “That’s not at all what’s happening. We don’t have to purchase any of this. We purchased it because it is providing accommodative financial conditions and supporting the economy in keeping with our mandate. There’s plenty of demand for U.S. Treasury paper around the world.”

Davidson: “So, all of it would sell – you’re competing, so are you bidding up the price then? Is it your contention that you’re inflating asset prices by increasing this purchase?”

Powell: “No. I think that we could sell all of our debt. The reason we do it – by the way, we issue debt – we issue United States obligations in the form of reserves when we buy Treasuries, so we’re not actually changing the amount of obligations outstanding on the part of the Treasury — what we’re doing is we’re substituting an overnight reserve for a Treasury bill. It has no effect on the overall outstanding obligations to the United States when we do that.”

Davidson: “Right. So, the growth of the Federal Reserve’s balance sheet – you don’t think that has anything to do with the disconnect between Wall Street and Main Street? Let’s just take as an example the confidence people have expressed in bitcoin and other cryptocurrencies and you know well-respected proven investors like Ray Dalio – who said ‘cash is trash’ – isn’t it because the U.S. dollar is being destroyed by fiscal and monetary policy?”

Powell: “It’s hard to say that it’s being destroyed. Another way to look at the dollar, you mentioned the dollar, you can ask domestically what can it purchase and that’s a question of inflation. You can also look at it in terms of a basket of other currencies and…”

Davidson: “I understand, but if you look at it, if you look at it, sir… the key to this is the Fed has done a horrible job at predicting asset Bubbles. They have. And if the pensions are going up because the market prices are going up, people with marketable securities have their basket of wealth going up and wages aren’t. Teachers, for example, they have a great pension but their current consumption isn’t going up. So, CPI lags what’s going on in the investment. I think it’s a big concern and I would just implore you and the other members of the Fed to pay attention to monetary inflation, not just price inflation.”


Regime Change

by Doug Noland

Ten-year Treasury yields closed out a tumultuous week at 1.41% bps, pulling back after Thursday’s spike to a one-year high 1.61%. Ten-year Treasury yields are now up 49 bps from the start of the year and almost 100 bps (1 percentage point) off August 2020 lows. More dramatic, five-year yields jumped 16 bps this week to 0.73%.

Surging yields are a global phenomenon. Ten-year yields were up 12 bps in Canada (to 1.35%), 30 bps in Australia (1.90%), 28 bps in New Zealand (1.89%), five bps in Germany (-0.26%), and five bps in Japan (0.16%) – with Japanese JGB yields hitting a five-year-high.

“Periphery” bond markets were under intense pressure, Europe’s and EM. Greek yields surged 22 bps to 1.11%, while Italian yields rose 14 bps to 0.76%. EM dollar bonds were bloodied. Yields were up 31 bps in Turkey (5.90%), 28 bps in the Philippines (5.90%), 25 bps in Peru (2.39%), 23 bps in Indonesia (2.57%), 16 bps in Qatar (2.14), 16 bps in Ukraine (6.95%), and 16 bps in Mexico (2.92%). Local currency bonds were walloped. Yields were up 125 bps in Lebanon, 31 bps in Brazil, 29 bps in Colombia, 27 bps in Romania, 19 bps in Poland, and 17 bps in Hungary.

Global bond markets have an inflation problem. The international central bank community has an inflation problem. Perhaps Treasuries and the Fed face the biggest challenge in managing around mounting inflationary risks.

The U.S., after all, is running unprecedented peacetime deficits, with a new $1.9 TN stimulus package scooting through Congress. This legislation will be followed by what is sure to be a major infrastructure program. There is literally colossal deficits and Treasury issuance as far as the eye can see.

February 23 – Bloomberg (Gerson Freitas Jr.): “Commodities rose to their highest in almost eight years amid booming investor appetite for everything from oil to corn. Hedge funds have piled into what’s become the biggest bullish wager on the asset class in at least a decade, a collective bet that government stimulus plus near-zero interest rates will fuel demand, generate inflation and further weaken the U.S. dollar as the economy rebounds from the pandemic. The Bloomberg Commodity Spot Index, which tracks price movements for 23 raw materials, rose 1.6% on Monday to its highest since March 2013. The gauge has already gained more than 60% since reaching a four-year low in March 2020.”

February 25 – Bloomberg (Vince Golle and Olivia Rockeman): “U.S. consumer prices are headed higher -– at least according to the people who set them. Corporate leaders are increasingly confident that they can charge more for their products without losing business. On recent earnings calls, plenty of executives said they boosted prices in response to the higher costs they’re having to pay. And many expect further increases, with economic growth speeding up and commodity prices showing no sign of coming off the boil. ‘There is a cost headwind and we continue thus far to be able to experience pretty positive ability to price,’ said Melinda Whittington, chief financial officer of La-Z-Boy…”

Inflationary pressures are mounting and broadening – food, energy, housing and beyond. There are worsening inflationary bottlenecks (i.e. semiconductors, global shipping, trucking, steel, myriad supply chains, and so on). And we’re in uncharted territory with respect to massive fiscal deficits, with another year of a $3.0 TN plus shortfall in the offing. Meanwhile, the Fed is trapped with rates at zero along with a $120 billion monthly QE operation.

I appreciated the Bloomberg headline (Mike Dolan): “Tantrum Without the Taper.” It’s a bond rout lacking even a hint of future QE tapering. Rather than sooth, the old dovish salve is starting to burn.

Senator Pat Toomey (Senate Banking Committee hearing: 2/23/21): “As you know, the TIPS 10-year Breakeven on inflation is now over 2%, up from six-tenths of 1%. My point is that, at some point, we’ve got too much liquidity going into the system. The economy is recovering very, very well. Problems are isolated and should be addressed narrowly. And I hope that $120 billion a month of bond buying doesn’t become a permanent situation. One of the things that I’m concerned about – I wonder if you could comment on: the risk that we would have an increase in inflation, an increase in bond yields that would correspond to that, but without being back at full employment. What would that imply — which I think is a very plausible scenario for later this year. What does that imply for the bond-buying program?”

Fed Chairman Powell: “Well, so what we said about the bond-buying program is that it will continue at least at the current pace until we make substantial further progress toward our goals. And we’ve also said that as we monitor that progress, we’ll communicate well in advance of any actual purchases. And so, that’s what it will take for us to begin to moderate the level of purchases. It’s substantial further progress toward our goals, which we haven’t really been making for the last three months. But expectations are that that will pick up as the pandemic subsides.”

Powell and fellow Fed officials have gone out of their way to offer markets strong assurances they will stick with ultra-loose policies – economic recovery or mounting inflation risk notwithstanding. A few notable headlines: “Powell Says Inflation Goal is Still Years Away;” “Fed Officials Shrug Off Rise in Longer-Term Yields;” “Bostic Says Economy Can Run ‘Pretty Hot’ Without Inflation Spike;” “Fed’s Williams Says He Expects Inflation to Remain Subdued…;” “Fed’s Bullard Says Rise in Yields ‘Probably a Good Sign;’” ”Fed’s George Says It’s Too Soon to Pull Back on Monetary Support for Economy;” “Clarida: Robust Demand Won’t Generate Sustained Price Pressures;’ and “Brainard Says Fed Won’t React to Transitory Inflation Pressures.”

Traditionally, such cavalier attitudes toward inflation risks would provoke a stern bond market rebuke. But since QE’s introduction, bond market fixation shifted to prospects for additional QE. And with consumer price inflation essentially a non-issue, market yields responded positively to any development that could possibly usher in additional central bank bond purchases (i.e. market Bubble Dynamics, heightened money market liquidity risk, economic vulnerability, global instability, pandemic risks, etc.). The Fed well-recognized the risk of rising market yields and an associated tightening of financial conditions ahead of waning QE support (“taper tantrums”).

Powell and Fed officials this week adhered closely to their seasoned playbook. Major development of the week: Treasuries and global bond markets puked on the same old dovish gruel. Perhaps it’s a little premature to declare the long-awaited Reincarnation of the Bond Market Vigilantes. Yet I would caution against dismissing this week’s upheaval in the face of commentary that would have previously stoked market exuberance. The times, they are a changin. Regime Change.

Not many weeks ago markets relished in ultra-loose monetary policies forever. Not only would the Fed be sticking with zero rates and QE for years to come, our central bank would clearly resort to yield curve control in the unlikely event of rising Treasury yields. The Reserve Bank of Australia Friday moved to “control” their yield spike with a $2.4 billion purchase program – with notably little effect.

How enormous would Fed Treasury purchases need to be at this point to place a ceiling on yields – especially with additional Trillions of supply in the pipeline? Furthermore, would such huge additional liquidity injections prove counter-productive in a backdrop of heightened inflation concerns?

Powell: “Inflation dynamics do change over time, but they don’t change on a dime. And so, we don’t really see how a burst of fiscal support or spending that doesn’t last for many years would actually change those inflation dynamics.

Hope is not a strategy. We’re in a period of unmatched synchronized global monetary inflation. Short-term rates are near – or even below – zero internationally. Global “money” and Credit growth is unprecedented. Governments around the globe are locked in massive deficit spending. It is difficult to imagine global financial conditions being any looser.

In an environment of such extremes, it is imperative that central banks remain especially vigilant. But they aren’t because they can’t. Global central bankers are beholden to precarious market Bubbles. Policy tightening measures would incite a de-risking/deleveraging episode that would surely be quite challenging to control. After expanding its balance sheet by $3.4 TN over the past year – and stoking an epic mania and other Bubble excess in the process – how much additional QE would now be required to counter another major deleveraging episode?

Markets have just begun the process of coming to grips with a harsh reality: There are myriad historic speculative and Credit Bubbles, and central bankers are definitely not in control of the process. They have retained a semblance of control only through monstrous monetary inflation. And yet this week demonstrated it’s no longer so easy to manipulate market behavior with the usual pedestrian dovish comments. Markets now scoff at the notion of the Fed anchoring inflation expectations at a particular level. Moreover, even after Trillions of liquidity injections, central bankers are clearly not in command of marketplace liquidity. It is as if Fed credibility is evaporating right along with bond prices.

After beginning Thursday trading at 1.37%, 10-year Treasury yields were up to 1.45% in early afternoon trading. Then the results of a particularly poor (“disaster”) seven-year auction hit.

February 25 – Bloomberg (Elizabeth Stanton and Edward Bolingbroke): “Treasury’s $62b 7-year auction was awarded at 1.195% vs 1.151% when-issued yield…, the highest auction stop for the tenor since February… 39.8% primary dealer award was highest since September 2014 as indirect award slumped to 38.1%… Record low 2.04 bid-to-cover compares with 2.35 average for previous six auctions.”

In what must have sent chills from Wall Street to Washington – while swiftly radiating to London, Tokyo, Beijing and EM financial hubs around the world – the Treasury market briefly dislocated as yields spiked to 1.61%. Less than a month after a spectacular “meme stock” equity dislocation and near market accident, the behemoth Treasury market was revealed as anything but immune to “flash crash” dynamics and financial accident risk.

January’s equities upheaval left scars throughout the leveraged speculating community. In particular, losses were suffered in long/short and various “quant” strategies. This left many funds impaired by drawdowns (and prospective outflows) and the overall hedge fund industry with scaled down pain/risk tolerance. And while this doesn’t ensure a market drop, it does create vulnerability to commonplace market pullbacks escalating into a downside momentum dynamic. This week’s Treasury rout was a significant blow to many levered strategies, creating acute vulnerability to self-reinforcing “risk off” de-risking/deleveraging dynamics.

February 26 – Bloomberg (Justina Lee): “One of the ugliest things about this week’s selloff is that there are so few places to hide, and that’s bad news for a breed of quant which seeks to spread out risk across assets. So-called risk-parity strategies posted their worst day in four months on Thursday…, while the $1.2 billion RPAR Risk Parity ETF plunged the most since the depths of the Covid rout in March. The investing style made famous by Ray Dalio allocates money across assets based on their volatility, so can struggle when things go haywire together. Thursday saw the S&P 500 slump 2.5% as benchmark U.S. Treasuries tumbled, the latest in a series of co-movements that have taken the 60-day correlation between their futures to the highest since 2016.”

The leveraged “risk parity” strategies this week were an obvious area under pressure to de-lever with stocks, Treasuries, corporate Credit and the precious metals suffering simultaneous price declines. Yet there are scores of strategies and products that have for years benefited from the reliability of Treasuries as a hedge against weakness in the risk markets. Why de-risk or purchase derivative “insurance” when one can simply use levered Treasuries holdings to hedge market risks?

But with inflation risk an issue and Federal Reserve yield control impractical, the game has changed. With Treasuries no longer a reliable hedge, a key source of Treasury demand has waned – which was especially notable during this week’s bout of market instability. Indeed, the week likely saw significant de-risking/deleveraging in the Treasury market – helping explain poor demand for the seven-year auction, market liquidity challenges along with Thursday’s flash of “flash crash” vulnerability.

Asset Bubbles create their own liquidity abundance. Rising prices foster leveraged speculation, leveraging that bolsters marketplace liquidity while begetting self-reinforcing asset inflation, speculative leveraging and liquidity abundance. And when the Fed’s balance sheet expands $3.4 TN in a year and M2 inflates $4.0 TN (institutional money funds an additional $570bn!), markets will understandably envisage liquidity abundance as a virtually permanent condition.

This week provided a major wakeup call: despite the Trillions upon Trillions of “cash” on the sidelines – and the Fed’s $120 billion monthly “money” injections – markets are at heightened risk for a liquidity accident. The world is plagued by highly levered market Bubbles. Fueled by zero rates and the global QE bonanza, global bond prices became divorced from reality. Now bond prices are sinking, an innately problematic development for levered markets. It would appear a period of major de-risking/deleveraging has commenced, implying challenging market liquidity issues ahead.

I’ll add that it is in no way obvious how interest-rate hedging can be expected to function effectively in the current environment. Globally, tens of Trillions of bonds have been issued at artificially high prices (low yields). If a meaningful segment of the marketplace now moves to hedge interest-rate risk, who has the wherewithal to take the other side of the trade?

It will be necessary for those selling rate protection to short Treasuries or other debt securities to hedge their exposures. This would seem to ensure market liquidity issues and could portend more serious market dislocations than Thursday’s fleeting yield spike. It was a notably rough week for mortgage-backed securities, Eurodollars and other instruments in the belly of the interest-rate hedging beast. I do not envy those responsible for managing portfolios of interest-rate derivatives.

Representative Warren Davidson (House Financial Services Committee hearing: 2/24/21): “Chairman Powell, thank you for your time, and I want to commend the Federal Reserve for the work that was done at the end of March to provide the liquidity and stability to our economy, to deal with the massive surge in demand for U.S. dollars, and we’re just so grateful that the U.S. dollar has become the world’s reserve currency and in time of crisis not just Americans, but people all around the world, want our dollar. It is indeed a source of our strength as a country to have a strong dollar that has become the world’s reserve currency. It does great things for our capital markets and frankly helps enable the deficit spending that we continue to do, because we certainly haven’t saved for bad times. We’re able to navigate them because we still can borrow. I wonder, sir, do you have a definition of sound money?”

Fed Chairman Powell: “We target inflation that averages two percent over time. That is what we consider to be…”

Davidson: “Well, that’s the policy, but I mean, when you think of sound money, what would you say constitutes sound money?”

Powell: “Where the public has confidence in the currency, which they do, which the world does. That’s really what it comes down to – that people believe that the United States currency is perfectly reliable and stable in value.”

Davidson: “Okay, so as a store of value. It clearly isn’t stable in value. It is not. What is a store value? The U.S. dollar really, is it diluted as a store value when M2 goes up by more than 25% in one year? Does the printing of more U.S. dollars somehow diminish the value of the dollars that others hold?”

Powell: “You know there was a time when monetary aggregates were important determinants of inflation and that has not been the case for a long time. So you’ll see if you look back, the correlation between movements in different aggregates – you mentioned M2 – and inflation is just very, very low, and you see that now where inflation is at 1.4% for this year…”

Davidson: “Yeah, you keep using that, you keep using it to talk about inflation. And I don’t think that’s the only proxy for whether the dollar is a store value and an efficient means of exchange. It is clearly still the world’s reserve currency, but we’re putting it under a pretty big stress test by diluting the value of the dollar. And I think one of the indicators of that is when the U.S. government issues debt for all this spending that we’ve done as a country, it isn’t really funded, is it? There’s not a true market demand for this much debt. It’s not being lent. When there’s borrowing there’s actually a lender. How much has the Federal Reserve had to purchase to bridge the gap between market demand for Treasuries and the actual need to finance the spending?”

Powell: “That’s not at all what’s happening. We don’t have to purchase any of this. We purchased it because it is providing accommodative financial conditions and supporting the economy in keeping with our mandate. There’s plenty of demand for U.S. Treasury paper around the world.”

Davidson: “So, all of it would sell – you’re competing, so are you bidding up the price then? Is it your contention that you’re inflating asset prices by increasing this purchase?”

Powell: “No. I think that we could sell all of our debt. The reason we do it – by the way, we issue debt – we issue United States obligations in the form of reserves when we buy Treasuries, so we’re not actually changing the amount of obligations outstanding on the part of the Treasury — what we’re doing is we’re substituting an overnight reserve for a Treasury bill. It has no effect on the overall outstanding obligations to the United States when we do that.”

Davidson: “Right. So, the growth of the Federal Reserve’s balance sheet – you don’t think that has anything to do with the disconnect between Wall Street and Main Street? Let’s just take as an example the confidence people have expressed in bitcoin and other cryptocurrencies and you know well-respected proven investors like Ray Dalio – who said ‘cash is trash’ – isn’t it because the U.S. dollar is being destroyed by fiscal and monetary policy?”

Powell: “It’s hard to say that it’s being destroyed. Another way to look at the dollar, you mentioned the dollar, you can ask domestically what can it purchase and that’s a question of inflation. You can also look at it in terms of a basket of other currencies and…”

Davidson: “I understand, but if you look at it, if you look at it, sir… the key to this is the Fed has done a horrible job at predicting asset Bubbles. They have. And if the pensions are going up because the market prices are going up, people with marketable securities have their basket of wealth going up and wages aren’t. Teachers, for example, they have a great pension but their current consumption isn’t going up. So, CPI lags what’s going on in the investment. I think it’s a big concern and I would just implore you and the other members of the Fed to pay attention to monetary inflation, not just price inflation.”

Noland comment: It is a disturbing flaw in Powell’s (and conventional) thinking to equate sound money to relatively contained consumer price inflation. After all, asset inflation and Bubbles are this era’s greatest threats to monetary stability and sound money more generally. Unfettered “money” and Credit is the root cause. Massive monetary inflation and fiscal deficits are categorically incompatible with sound money. And unsound money is incompatible with social and political stability.

Inequality, speculative Bubbles and manias, resource misallocation, wealth redistribution and destruction, and deep economic structural impairment are all consequences of years of unsound money. And it’s back to this fundamental flaw I’ve been railing against for too long: it is impossible to resolve Monetary Disorder and the fallout from unsound money through additional monetary inflation. It’s destined for catastrophic failure, and it was another week when inklings of a failing system were observable to those with discerning eyes.

It may be archaic and relegated to the dustbin of history. But one cannot overstate the peril associated with entrenched unsound money. An insidious corruption of price mechanisms over time jeopardizes the very foundation of Capitalism. And as Capitalism decays Democracy flounders. Society frays, while insecurity, animosity, anxiety, and the forces of distrust are left to fill the void. And as we continue to witness, the consequences of unsound money incite only more perilous inflationism.

Original Post 27 February 2021



Categories: Doug Noland