TSP Smart: Doug’s premise below is the Fed is still targeting and talking the financial markets, not the real economy. The “at neutral” statement was simply due to Powell looking at the stock and bond market action, not inflation.
Inflation is a real economy factor. The belief the financial markets signal the effectiveness of policy is crazy talk (comical) after a decade of bubbling financial asset with the slowest economic growth in US history.
The financial markets adjusted rapidly to the “at neutral” statement because the markets don’t care about inflation, they care about what policy the Fed will implement. And lower (below inflation) terminal rates were signaled even if the Fed did not mean to. The Fed actually believes inflation will fall to 2% again although no realistic research supports this hope.
I see sustainable 5% inflation today until the excesses are squeezed out of the bubble economy. Wage growth and rents are rising through 6% today and are baked in for another year or two. If 40% of the CPI is at 6%, then 2% inflation is a ways off. Supply constraints could increase while demand fails to diminish keeping inflation much higher.
The current rally in stocks and bonds obviously will signal to the Fed that their policy is not at financial-economy neutral. And rising inflation will show they are not even close to neutral in the real economy. More tough talk coming from the Fed. Another leg down this summer is likely.
Indefensible Neutral Rate Doctrine
by Doug Noland
Bloomberg’s David Westin (Wall Street Week, July 29, 2022): “What do you economists do when you put together these neutral rates?”
Larry Summers: “I think Jay Powell said things that, to be blunt, were analytically indefensible. He claimed twice in his press conference that the Fed was now at the neutral interest rate – calling it 2.5%. It’s elementary that the level of the neutral interest rate depends upon the inflation rate. We’ve got on the most quoted measure a 9.1% inflation measure – if you extrapolate it off core it’s four or five percent inflation. There is no conceivable way that a 2.5% interest rate in an economy inflating like this is anywhere near neutral. And if you think it is neutral, you are misjudging the posture of policy in a fundamental way. So, I was very sorry to hear him say that and, frankly, surprised. He said back in 2018 that the Fed was approaching the neutral interest rate at a time when the inflation rate was 1.9%. How he could be saying the same thing today, when the inflation rate is where it is, is inexplicable to me, and it’s the same kind of, to be blunt, wishful thinking that got us into the problems we have now with the use of the term ‘transitory.’ So, I hope the rigor of the economic analysis at the Federal Reserve is going to step up.”
Powell provides an easy target these days. But when it comes to the “neutral rate” discussion, the entire economic community is implicated. The concept has never been on sound footing. As far as I’m concerned, the concept of calibrating monetary policy based upon some nebulous “neutral rate” is Indefensible. Analytical quicksand.
But let’s start with Powell’s assertion. While I believe interest rates will need to go significantly higher to crush powerful inflationary forces and inflation psychology (all bets are off in the event of a market accident), at least within the context of the Fed’s current framework, his claim of near neutrality was defensible.
The Fed’s current operating doctrine is to regulate system financial conditions chiefly through the financial markets (in stark contrast to the traditional model of regulating system Credit through adjusting bank lending conditions). In the contemporary Fed view, the primary monetary policy transmission mechanism works through market expectations for the path of short-term policy rates. Higher market yields, lower asset prices, and general risk aversion are expected to tighten financial conditions, reducing both economic demand and upward pricing pressures.
Monetary policy, of course, works with a lag. Powell referred to “financial conditions” 17 times during his May 4th press conference. The Fed’s view has been that it will not be necessary to raise rates aggressively to the point where key inflation measures are back to the 2% target level. Federal Reserve officials will instead closely monitor for a significant tightening of financial conditions that would precede waning growth and abating pricing pressures. A few aggressive rate hikes and tough inflation talk will quickly spur tighter market conditions, ensuring a downward inflation trajectory over the coming months and years. Or so they hope.
In this context, Powell’s “right in the range of what we think is neutral” was defensible. As of June 16th, the S&P500 was down 22.5% y-t-d. Treasuries (TLT ETF) had lost 24.0%, investment-grade corporate bonds (LQD) 16.7%, and high-yield bonds (HYG) 13.5%. High-yield CDS had doubled in 2022 to 588 bps, the high since May 2020. The corporate debt market was essentially closed for issuance in mid-June (the junk bond market remaining shuttered through July). Benchmark MBS yields had surged 285 bps y-t-d to 4.92% (high since 2009), with 30-year fixed mortgage rates up 270 bps to an almost 14-year high 5.81%. Housing markets had slowed notably.
Commodities prices reversed sharply lower in June, with the Bloomberg Commodities Index sinking 20% in four weeks from June highs. The Treasury five-year inflation expectations “breakeven rate” reversed sharply lower. The market began pricing in a rate cut in 2023.
Everything was pointing to the type of significant tightening of financial conditions that would be consistent with downshifting economic activity and waning pricing pressures. Officials were communicating confidence that Fed doctrine was working effectively. Still, there was a major issue: global “Risk Off” de-risking/deleveraging was attaining powerful momentum.
EM currencies and bond markets, in particular, were under intense pressure, instability that only gathered steam in July’s first half. The dollar index surged 5% in two weeks to trade above 109 on July 14th for the first time in almost two decades. Between June 28th and July 14th, the Chilean peso dropped 12.2%, the Russian ruble 8.8%, the Polish zloty 8.0%, the Colombian peso 7.9%, and the South African rand 7.6%. Yields were spiking higher, as EM bond markets began to dislocate. EM CDS surged 63 bps in 12 sessions, peaking at 395 bps on July 14th. Up over 200 bps y-t-d, EM CDS traded to the high since pandemic crisis April 2020. So-called “frontier” EM markets were completely unraveling (i.e. Sri Lanka, Pakistan, Ghana, Egypt, Ethiopia, Kenya, Iraq…).
Meanwhile, China’s crisis took a turn for the worse. During the week of July 11 to 15, the Bloomberg China Real Estate Developers Index sank 10%, with Country Garden collapsing 27%. Country Garden bond yields surged 11.5 percentage points to a record 41.0%. China’s CSI 300 Bank Index sank 7.7%, the largest weekly loss since 2018. Chinese bank and sovereign CDS spiked higher, as fears mounted that China’s developer crisis was rapidly turning systemic.
European periphery bond markets were absolutely coming unglued in mid-June. Italian (4.17%) and Greek (4.69%) yields spiked to near-decade highs. And while ECB discussions of a “anti-fragmentation tool” took pressure off periphery bond markets, European CDS prices continued to spike, reaching multiyear highs on July 14th. The euro on that day traded below 1.00 (vs. $) for the first time in almost 20 years. As Crisis Dynamics accelerated, European bank CDS (i.e. Credit Suisse, Societe Generale, Deutsche Bank…) spiked to multiyear highs.
In short, de-risking/deleveraging had turned systemic. Global financial conditions were tightening dramatically. Contagion was intensifying, with Crisis Dynamics at the Periphery gravitating to the Core. After trading above 3.6% in late April, the five-year Treasury “breakeven rate” (inflation expectations) was down over 100 bps to 2.5% by mid-July.
From the perspective of rapidly tightening global market financial conditions, it was defensible for the Fed to assume that the policy rate had reached the vicinity of “neutral.” But this designation requires a key qualification: neutral specifically in the context of a “Risk Off” market backdrop.
But markets then did something they’ve grown accustomed to doing: at the brink of dislocation, they recoiled and mounted a decent rally. The ECB moved forward with its “anti-fragmentation” program, stabilizing periphery bond markets and financial markets more generally. The Bank of Japan refused to budge from either ultra-loose monetary policy or its bond yield ceiling. Beijing moved forward with a series of pronouncements to support its real estate markets and economy. And, at the Fed, there were ample hints of a dovish pivot.
After trading to 3.48% on June 14th, 10-year Treasury yields were all the way down to 2.58% by August 1st. A short squeeze and unwind of hedges surely contributed to sinking yields, a bond rally that helped spur a major equities market short squeeze. From June 16th lows to the August 5th close, the Goldman Sachs Most Short Index rallied 37%.
Meanwhile, myriad risk indicators signaled a significant shift in market conditions. High Yield CDS ended this week at 464 bps, down 123 bps from June 16th highs. Junk spreads to Treasuries ended the week at near two-month lows. Investment-grade CDS closed Friday at 80 bps, down 20 bps from July highs to a two-month low. Bank CDS also ended the week at two-month lows. A Thursday Bloomberg article: “Junk Bond Market Roars to Life With New Debt After Rally.” Thursday’s junk issuance ($2bn) exceeded all of July. And Friday: “US Companies Are Lining Up to Sell Bonds Again as Yields Fall.” At $56 billion, this week’s investment-grade issuance was the strongest since March. The bottom line: financial conditions have loosened meaningfully.
De-risking/deleveraging destroys liquidity. Both the unwind of levered positions and hedging-related selling/shorting burn through liquidity, with self-reinforcing panic selling spurring illiquidity and market dislocation. “Risk Off” is tantamount to much tighter financial conditions.
In contrast, short squeezes are a boon in terms of market liquidity. Derivative trading plays a key role. Sellers of derivatives protection – after selling into market weakness to dynamically hedge their exposures – become aggressive buyers in a rallying marketplace. On the margin, speculative and derivatives trading are the marginal sources of marketplace liquidity. “Risk On” leveraged speculation creates liquidity and fuels looser conditions, while “Risk Off” destroys liquidity and tightens financial conditions.
Reliance on some “neutral rate” to calibrate monetary policy is deeply flawed doctrine. The Fed’s assumptive 2.5% neutral rate may have seemed reasonable during the recent “Risk Off” backdrop. In the current squeeze rally environment, however, it is Indefensible – or, in the words of Mohamed El-Erian, “comical.” To be sure, Fed talk of reaching the neutral rate only stokes risk embracement and resulting loose conditions, thus countering previous tightening measures.
Friday’s much stronger-than-expected (528k added) July payrolls data underscores another Fed dilemma. Bubble markets are more fragile these days than the underlying economy. Over 900,000 jobs were created during the past two months. According to Tuesday’s “JOLTS” report, there remain 10.7 million job openings. It’s also worth noting Friday’s much stronger-than-expected June Consumer Credit data. At $40 billion, the increase in Consumer Credit was second only to March’s $47 billion splurge.
August 2 – MarketWatch (Andrew Keshner): “Americans added $312 billion in debt during the second quarter — an increase that New York Fed researchers called ‘pretty sizable.’ In a sign of the continuing toll from decades-high inflation, Americans loaded an extra $46 billion on their credit cards during the second quarter and their balances saw the sharpest increase in more than 20 years, according to the Federal Reserve Bank of New York. Credit card debts grew 5.5% from the first to second quarter and 13% year-over- year. The annualized increase was the sharpest cumulative increase in more than two decades…”
This year began with the strongest growth in household borrowings since 2006 (Q1 8.3% annualized). An inflationary economic backdrop develops powerful self-sustaining momentum, where rising prices spur strong Credit growth – the requisite monetary fuel for even higher prices. For good reason, outspoken analysts such as Summers and El-Erian rebuke the Fed for not having the appropriate analytical framework, resolve and singular focus to do what is necessary to wring inflation out of the system.
Ten-year Treasury yields traded this week as low as 2.51%. Treasuries refuse to price in either persistently high inflation or a sustained Fed tightening cycle. Yield curve inversion gained further momentum this week, with the 2-year/10-year Treasury spread ending Friday trading at negative 40 bps. This was the largest inversion since the piercing of the “tech” Bubble in early 2000.
There was a lot of boisterous recession talk when the curve first inverted back in early-April. Recent job growth acceleration has challenged conventional yield curve analysis. Instead of recession, low 10-year yields and the inverted curve are discounting the likelihood of an unfolding global market accident.
Ominously, 10-year Treasurys have not been intimidated by hot inflation, a hot jobs market, or a Fed pressured to impose more aggressive tightening measures. Yields are instead consistent with the unfolding synchronized bursting of scores of global Bubbles. Could the situation in China be more alarming? Country Garden yields surpassed 50% this week, as the historic developer meltdown runs unabated. Vanke CDS surged another 255 to 747 bps – up from 300 bps in June and 100 bps in September.
August 5 – Wall Street Journal (Wenxin Fan and Joyu Wang): “China touted its military exercises around Taiwan as proof of its ability to blockade the self-ruled island in the event of a war, as the operations in response to a visit by U.S. House Speaker Nancy Pelosi entered a second day. Chinese warplanes and warships carried out maneuvers off Taiwan’s coast on Friday morning, Taiwan’s Ministry of National Defense said. During the operation, China’s military crossed the median line in the Taiwan Strait, a notional boundary that Taipei says demarcates areas of de facto control, the ministry said.”
I can’t accept that collapsing Chinese Bubbles and such a belligerent approach with Taiwan are coincidental.
August 5 – Wall Street Journal (Peter Landers and Chieko Tsuneoka): “China’s firing of missiles near Japan has left little doubt that Tokyo would be pulled into any potential war over Taiwan—and would be part of the U.S.-led alliance likely to defend the island. China’s military launched five missiles that landed inside Japan’s exclusive economic zone on Thursday, Tokyo’s Defense Ministry said… U.S. Secretary of State Antony Blinken, on a visit to Cambodia, cited those launches in calling China’s moves a ‘significant escalation,’ and he said the moves against Japan were ‘understandably causing them, and all of us, grave concern.’ The… inclusion of targets near Japan sent an unmistakable message, said Masahisa Sato, who heads the ruling Liberal Democratic Party’s foreign-affairs committee. ‘If you’re talking about surrounding Taiwan or imposing a blockade, of course in that case it means you’re bringing Japan into it as well,’ said Mr. Sato, a former army officer.”
Fed policy, the markets, the U.S. and Russia, China and the U.S., China and Japan, Russia and Europe. The whole world seems on a collision course. Little wonder Treasuries are readily dismissing inflation and Fed tightening, apparently content to count down the months until rate cuts and the restart of QE.
Original Post 6 August 2022
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Categories: Perspectives