Doug Noland: “You have to shock the markets”

In a week of notable headlines, I’ll start with the Bloomberg headline, “Mester Says Shrink Fed Balance Sheet Fast But Don’t Roil Markets.” Notions of “Doing No Harm” and “Don’t Roil Markets” are wishful thinking. There’s the long-established principle that central banks must move early to quash inflationary impulses – to ensure that a central bank doesn’t fall “behind the curve.”

History teaches that to allow inflation to gain a foothold ensures the containment challenge rises exponentially over time. Unleash inflation dynamics – in the markets and/or the real economy – and getting it back under control will invariably inflict magnitudes of harm, pain and market “roil” necessary to alter behavior and quell inflation psychology.

But don’t take my word for it. We have the good fortune of having one of the great Credit and macro thinkers of our age still with us – and providing astute analysis – at the age of 94. For those unfamiliar with the esteemed Henry Kaufman, he was a Fed economist before becoming a Wall Street legend in the seventies as chief economist and head of bond market research at Salomon Brothers (my analytical framework owes a great debt to Dr. Kaufman). Kaufman Knows Inflation.  

Henry Kaufman was interviewed this week for an article by Bloomberg’s Erik Schatzker: “I don’t think this Federal Reserve and this leadership has the stamina to act decisively. They’ll act incrementally. In order to turn the market around to a more non-inflationary attitude, you have to shock the market. You can’t raise interest rates bit-by-bit.”

“The longer the Fed takes to tackle a high rate of inflation, the more inflationary psychology is embedded in the private sector — and the more it will have to shock the system.”

“‘It’s dangerous to use the word transitory,’ Kaufman said. ‘The minute you say transitory, it means you’re willing to tolerate some inflation.’ That, he said, undermines the Fed’s role of maintaining economic and financial stability to achieve ‘reasonable non-inflationary growth.’”

“If he were advising Powell, Kaufman said he’d urge the Fed chair to be ‘draconian,’ starting with an immediate 50-bps increase in short-term rates and explicitly signaling more to come. Plus, the central bank would have to commit in writing to doing whatever is necessary to stop prices from spiraling higher.”

There’s no “draconian” in our central bank’s playbook. Markets were heartened by Powell’s suggestion that inflation will likely be coming down on its own by mid-year, as well as by the general reassuring tone (echoed by Brainard) that the Fed is focused on doing no harm. To the ears of acutely vulnerable Bubble markets, “no harm” implies no Fed appetite for risks associated with a meaningful tightening of financial conditions.

In last week’s “Issues 2022” piece, I attempted to put the new year into some historical context. Inflation is running the hottest in four decades. Commenting on Volcker’s decisive move to crush inflation, Kaufman stated: “It required a lot of fortitude in 1979 to do what the Fed did.” In Volcker’s day, the Fed would impact financial conditions through the banking system, for the most part with subtle adjustments to bank reserves (that would impact bank short-term funding costs – and lending and financial conditions generally).

Under Alan Greenspan, the Fed transitioned to the securities markets as the primary mechanism for system stimulation. It was both seductive and powerful. Greenspan realized he could stoke speculation, leverage, higher market prices and overall looser financial conditions, uttering not many syllables. But this approach was ominously “asymmetrical” – maximum stimulus to sustain booms, but minimal effort to rein in excess. And the larger Bubbles inflated, the more aggressive the requisite rate cuts to hold Bubble deflation at bay. Out of rate cuts, Bernanke resorted to massive “money” creation. Massive degenerated into monumental. The Fed’s balance sheet has inflated $5.0 TN in 121 weeks, now having inflated 10-fold since 2007.

Decades of mismanagement are coming home to roost in 2022. The risk of collapsing “Everything Bubbles” precludes aggressive tightening measures. The Fed surely grasps that it will not be forcefully hiking rates, though officials hope that through a concerted effort to talk tough, the markets will get the message and moderately tighten for them.

The Bloomberg Commodities Index rose 2.2% this week, increasing early-2022 gains to 4.4%. WTI crude surged $4.92 for the week to $83.82, quickly back within striking distance of October’s $85.40 high. Gasoline jumped 5.2% this week, with Natural Gas surging 8.8%. There are powerful inflationary biases percolating throughout energy and commodities markets.

Faltering speculative Bubbles (i.e. equities, crypto, corporate Credit, etc.) and associated de-risking/deleveraging would spark a problematic tightening of financial conditions. My sense, however, is that today’s environment has important differences to previous backdrops, where market “risk off” was immediately perceived as bearish for energy and commodities prices (and inflation generally). Inflationary forces have made decisive headway throughout the global economy (including energy and commodities).

There is more than ample monetary tinder available, and investment interest in the commodities markets could actually grow as the appeal of financial assets wanes. Besides, 2022 appears poised for another year of enormous growth in government indebtedness globally. While all bets are off in a crash environment, I would expect inflationary pressures to prove resilient even in the face of weak securities markets. Indeed, a crisis of confidence in financial assets could exacerbate the unfolding shift to commodities and real things as more secure stores of wealth/value.

As for the stock market, there was a dynamic this week that was reminiscent of the bursting “tech” Bubble back in 2000. In trading Monday (and again on Thursday), there were notable correlations between sinking technology stocks and the cryptocurrencies – and some key financial conditions indicators (including various CDS prices). It was as if fear was starting to take hold – the market was beginning to connect the dots between a collapsing crypto Bubble, the desperately overheated technology industry, and latent systemic risk. In short, we started to see some of the correlations I would expect at the incipient stage of market panic.

At the late stage of the nineties’ tech Bubble, there was recognition that the big technology companies were extraordinarily overvalued. Yet the bulls were undeterred. After all, revenues and profits were growing so rapidly that overvaluation was viewed as short-lived. Not appreciated was that inflated stock prices were but one facet of industry Bubble Excess. Speculation, speculative leverage, and the attendant loosest financial conditions (at the time) imaginable were spurring massive spending (over- and malinvestment) by fledging Internet, technology and media companies.

When the speculative market Bubble burst and financial conditions tightened suddenly and dramatically, scores of companies were left without access to new finance. Investment in technology and communications equipment and services collapsed. Even for many established companies and industry bellwethers, revenues and earnings dropped significantly. It is this dynamic that helps explain how stock prices tend to collapse up to 80 or 90% in major bear markets. Price-to-earnings ratios sink, while earnings collapse.

And speaking of Bubbles and bear markets, Chinese stocks were again under pressure this week. In particular, many developer stocks and bonds are well on their way to losses unimaginable just a few short months ago.

China Crisis Dynamics gained important momentum this week. While this is a significant global development, market focus is elsewhere. And that’s how things tend to play out. The initial phase of instability garners much attention. But then policy responses and a semblance of stability nurture the perception that the situation has been largely resolved. Meanwhile, Credit stress builds and broadens, methodically gravitating from the “Periphery” toward the systemic “Core.”

China developers, the “AMCs,” and LGFVs – we’re literally talking about Trillions of suspect liabilities…

…We’re only two weeks into 2022, yet there are already threatening convulsions at key fault lines: the mighty U.S. tech and crypto Bubbles; China’s collapsing apartment Bubble turning more systemic; and a geopolitical backdrop fraught with risk. If things start to unravel, how reliable is the Fed (and global central bank) liquidity backstop? For years now, dependable and predictable Fed responses to market instability have been fundamental to (cheap) pricing for risk protection derivatives.

There’s still a solid argument for the dependability of the Fed’s liquidity backstop. But surging inflation has significantly clouded the predictability of both the timing and scope of Fed QE responses to market instability. I expect this to increasingly be a key factor in higher pricing and waning liquidity throughout the derivatives universe. This will become a pressing issue as market Bubbles falter.

Original Post 15 January 2022

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