Doug Noland: Walk the Walk

Michael Bond comments upfront: Why inflation-talk matters? With inflation running near 5% and 2% real GDP growth, the unmanipulated 10-year Treasury historically would be at 7% yield, basically nominal GDP. At 1.5% yield today, the real yield today is deeply negative and destroying purchasing power of savers at an accelerated clip.

No one believes financial assets can handle 4% yields let alone over 6%. At 7%, 30-year fixed rate mortgages would be 8.5%. To maintain, monthly payments new home prices would have to drop 40%.

To bring inflation down, the central bank traditionally slows the economy down by forcing interest rates higher. Today, it needs to first STOP pushing rates down via money printing. The first effect should be to blow the 30-40% froth off the top of the stock market bubble while easing interest rates up a percent or two. Then go from there.

Now for Doug’s “Walk the Walk” which in short means the Fed has to show us it can do something it has been unwilling to do for over a decade – stop propping up the markets.


Senator Pat Toomey: “Mr. Powell, under the Fed’s new flexible average inflation targeting the inflation target remains at 2%… Core PCE, the Feds preferred inflation metric, is running above 2% over the past five years, nearly 3% over the past two years, and 4.1% over the past year. So, it’s above target; it has been above target and it’s accelerating. Yet, the Fed has maintained an extraordinary emergency monetary policy stance. It looks to me like this framework appears to be a weakening of the Fed’s commitment to stable prices. Now I know you believe this is transitory. But everything is transitory. Life is transitory. How long does inflation have to run above your target before the Fed decides maybe it’s not so transitory?”

Jerome Powell: “Well, first of all, the test that we’ve articulated I think clearly has been met now. You’re absolutely right: Inflation has run well above 2% for long enough that, if you look back a few years, inflation averages 2%. So, I think we can say that it was not the case going into this episode. It had been many years since we had inflation at 2%. I think the word transitory has different meanings to different people. To many, it carries a sense of short lived. We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”

Powell: “Remember that every dollar of asset purchases actually adds accommodation to the economy. But at this point, the economy is very strong and inflationary pressures are high and it is therefore appropriate, in my view, to consider wrapping up the taper of our asset purchases – which we actually announced at the November meeting – perhaps a few months sooner. And I expect that we will discuss that at our upcoming meeting in a couple of weeks. Of course, between now and then, we will see another labor market report, another inflation report, and we’ll also get a better sense of the new Covid variant, as well, before we make that decision.”

Chair Powell (and the Fed) stepped away from the ledge. Their dismissive approach to inflation risk was both untenable and an increasing embarrassment. Institutional credibility has taken a major hit, while attempts to repair the damage will have the Fed “talking the talk” of a traditional central bank focus on stable prices and financial stability.

It’s been a while (1994), since inflation concerns spurred the Fed to tighten financial conditions. Will the Fed actually prioritize its stable prices mandate above other considerations, most prominently the level of securities prices? Will the Fed – or even can they – “Walk the Walk” in reining in consumer inflation at the expense of bursting securities and asset Bubbles?

There’s no doubt that neglect has left the Fed hopelessly “behind the curve”. Conventional thinking today has it that the Federal Reserve will be forced into more aggressive tightening measures, to the detriment of booming markets and the economic expansion.

Mohamed El-Erian: “The problem now is that such a late wake-up to the reality of inflation increases the risks of mismanaging its policy catch-up process, exposing the economy to a higher risk of an unnecessary, Fed-induced slowdown.”

December 3 – Bloomberg (Christopher Anstey): “Former Treasury Secretary Lawrence Summers said that Federal Reserve Chair Jerome Powell ought to signal the possibility of raising interest rates four times next year, in order to restore what he argues is the central bank’s lost credibility on fighting inflation. ‘I’d be signaling four rate increases next year – with two-sided uncertainty, depending on how the inflation figures of work out,’ Summer said… ‘That will be a jolt. But a jolt is what is required to restore credibility.’”

“Slamming on the brakes” is undoubtedly out of the question. Moreover, there is now significant risk associated with the Fed’s attempt to revive its inflation fighting credentials. And count me skeptical a “jolt” will help with the Fed’s credibility problem. Mainly, I see a greater unappreciated risk: Faltering U.S. and global markets will be putting intense pressure on the Federal Reserve (and central bank community) to again stabilize markets with large liquidity injections. Will the Fed “Walk the Walk” on reining in inflation when bursting speculative Bubbles beckon for another bout of aggressive monetary support? Ten-year Treasury yields, this week dropping 13 bps to 1.35%, are not signaling a hawkish rate tightening cycle.

We’re now only 11 days from the start of the Fed’s final (two-day) meeting of 2021. Chair Powell and other Fed officials have suggested an openness to accelerating the taper – perhaps doubling the QE reduction to $30 billion monthly. This would end taper by March, presumably creating the possibility for an initial rate increase at the FOMC’s March 16th meeting.

Right now, 11 days seems an eternity. It’s been awhile since the FOMC faced a difficult decision. Their only bold moves have been pain-free openings of the monetary floodgates. It’s going to be a close call, but I doubt the Fed will double the pace of its taper. And I don’t see them signaling earlier rate increases. They’ll surely talk inflation. But I suspect their worries will be centered on Global Crisis Dynamics by December 15th. It would not surprise me to see the next move on QE to put taper on hold. And it may be weeks away, but I expect the next major move on the Fed’s balance sheet to be to the upside. I would bet on the Fed’s balance sheet surpassing $10 TN in 2022. I’ll place 50/50 odds on $12 TN.

Global crisis dynamics now accelerate weekly. What started in China and soon infected the “Periphery” has reached the “Core.” Chinese developers suffered a miserable week, as evidence mounts that China’s collapsing apartment Bubble is impacting confidence and the general economy. Meanwhile, the Turkish lira lost another 10% this week, with y-t-d losses up to 46%. Turkey faces brutal financial and economic crises. Who’s next? Global de-risking/deleveraging is gaining momentum, as contagion feasts on heightened risk aversion and waning liquidity.

If the backdrop wasn’t sufficiently perilous, there’s Delta and Omicron. Things are unfolding quickly, but the initial narrative associated with Omicron has been that “mild symptoms” leave little to be concerned with. My concerns became more elevated as the week progressed.

December 3 – Bloomberg (Amogelang Mbatha): “South Africa’s daily number of confirmed Covid-19 cases almost quadrupled from Tuesday as the omicron variant spreads across the country. The country recorded 16,055 infections in the last 24 hours and the positivity rate accelerated to 24.3% of tests from 16.5% on Tuesday… Hospitals reported an increase of 279 admissions in the past 24 hours, bringing the total to 3,202.”

December 3 – Washington Post (Amy Cheng): “Scientists in South Africa say omicron is at least three times more likely to cause reinfection than previous variants such as beta and delta, according to a preliminary study published Thursday. Statistical analysis of some 2.8 million positive coronavirus samples in South Africa, 35,670 of which were suspected to be reinfections, led researchers to conclude that the omicron mutation has a ‘substantial ability to evade immunity from prior infection.’ Scientists say reinfection provides a partial explanation for how the new variant has been spreading. The elevated risk of being reinfected is ‘temporally consistent’ with the emergence of the omicron variant in South Africa, the researchers found.”

The article quoted Juliet Pulliam, the director of an epidemiological modeling center at the University of Stellenbosch and one of the study’s authors: “Contrary to our expectations and experience with the previous variants, we are now experiencing an increase in the risk of reinfection that exceeds our prior experience.” And from Stellenbosch University professor Tulio de Oliveira: “Omicron is probably the fastest-spreading variant that South Africa has ever seen.”

December 3 – New York Times (Apoorva Mandavilli and Lynsey Chutel): “If the finding holds up elsewhere, Omicron may be more difficult to contain than previous iterations of the coronavirus, lengthening the pandemic… ‘It is actually really striking how quickly it seems to have taken over,’ said Juliet Pulliam, the director of an epidemiological modeling center at the University of Stellenbosch in South Africa… Omicron cases in particular are doubling roughly every three days in Gauteng province, home to South Africa’s densely populated economic hub and now the epicenter of the country’s fourth wave of infections… In a mathematical analysis, they estimated the variant’s Rt — a measure of how quickly a virus spreads — and compared it to the metric for Delta. They found that Omicron’s Rt is nearly 2.5 times higher than that of Delta… The rise in cases in South Africa has been accompanied by a week-over-week increase in hospital admissions, already higher than seen in previous waves…”

December 3 – Bloomberg: “The omicron variant is now in at least 10 U.S. states, and White House chief medical adviser Anthony Fauci said there is ‘absolutely’ community spread… The states of New Jersey, Pennsylvania, Missouri, Maryland and Nebraska reported omicron infections on Friday, and cases are guaranteed to keep on rising in the coming days… Covid-19 infections in the U.S. have reached the highest level in two months.”

December 3 – Washington Post (Lenny Bernstein, Frances Stead Sellers and Fenit Nirappil): “The Minnesota man who contracted the omicron variant of the coronavirus met up with about 35 friends at a New York City anime convention and about half have tested positive for the coronavirus… Members of the group traveled to New York from a variety of states for the weekend convention that began Nov. 19 and tested positive after their return, said Kris Ehresmann, director of the Infectious Disease Epidemiology, Prevention, and Control Division at the Minnesota Department of Health… ‘We don’t know if we’ll see a lot of omicron, or we’ll see a lot of delta,’ Ehresmann said… ‘But we’re likely to see a lot of covid’ out of the convention, which drew 53,000 people and tightly packed crowds from Nov. 19 to 21.”

What the world has learned in a week: Omicron is highly contagious. It also appears antibodies from previous Covid infections have reduced effect on the Omicron variant. Over 10% of those hospitalized with Omicron in South Africa are children. There were earlier in the week encouraging comments from Israel regarding the efficacy of vaccines against Omicron, although some Israeli scientists are not yet convinced.

As of yet, there are limited infections in individuals either unvaccinated or without previous infections (estimates of up to 70% of the South African population likely to have suffered a previous Covid infection). It will take weeks before a clear picture of symptom severity, hospitalizations and deaths from Omicron develops.

Fragile global markets will struggle with weeks of Delta and Omicron uncertainties. Having missed its timing, the Fed must decide how comfortable it is to adopt a “hawkish pivot” into an unfolding Global Financial Crisis. They’ve dug themselves such a deep hole. If they uncharacteristically turn their backs on panicked markets, the great unravel could begin in earnest.

The VIX (equities volatility) Index traded Friday to the highest level (35) since January. High-yield and Investment-grade Credit default swap (CDS) prices rose to one-year highs. The spread between 10-year and two-year Treasury yields sank 22 bps to a one-year low. The five-year Treasury “breakeven” inflation rate dropped 20 bps to a six-week low 2.75%. The Bloomberg Commodities Index sank 4.4 points, or 4.3%, the largest weekly drop since March 2020. Natural Gas collapsed 24%. “Oil Posts Longest Run of Weekly Losses since 2018…”

The week was noteworthy for de-risking/deleveraging seemingly attaining important momentum. The global leveraged speculating community is increasingly frazzled and stunned by the prospect of a market rout into year-end. And there has surely been significant hedging over the past two weeks. Meanwhile, Omicron may be enough to subdue the over-confident buy the dippers.

The important December expiration of options and other derivatives comes two days following the Fed meeting. Markets have grown comfortable watching bouts of derivative hedging guarantee a rally and unwind of hedges into expiration. But things can always go the other way. Masses of outstanding puts and bearish derivatives create the potential for a self-reinforcing market breakdown. The Fed has painted itself into a corner. If they want to “Walk the Walk,” they’ll have to disregard market risk and unveil its newfound tough stance on inflation. I’ll believe that when I see it.

Original Post 4 December 2021


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