Michael Bond: The market is coming to believe in Nirvana similar to accepting the belief in the “Permanently High Plateau” in the 1920s. Doug again nails the situation. But there is one area no one is talking about very related to the discussion of timing.
It is understood that monetary policy works with a long lag time… think at least a year. But Powell points out that today the market starts tightening on its own sooner based on policy statements and we see that.
So when does the “lag” clock start? We saw rising rates in early 2022, but the situation was massively stimulus then because inflation was running amuck. It was not until April of 2023 when the Fed Fund rate crossed above trimmed PCE inflation. Powell was calling policy neutral then. So…
Powell acknowledged that policy is now restrictive. So if we go back and say April was the start point, then the real effects will not be seen in the economy until April 2024 or later. This is all very fussy, but my point is policy remained easy even while they were raising rates.
And for those following me, you know that I see the trillion dollars the FHLB has pumped into the banks to replace fleeing deposits as having the liquidity effects of QE but with an interest rate attached. So I am not sure we have restrictive monetary policy yet. The markets are not acting like it.
And then there is the baked in rise in inflation by the end of the year. Higher for Longer. And Powell is telling us rates will not start down in 2024. Buckle in.
by Doug Noland
July 24 – Bloomberg (Liz Capo McCormick, Michael Mackenzie and Ye Xie): “Listen to Wall Street’s top economists and you’ll hear the same message again and again: The risk of a recession is fading fast. And yet, in the bond market, the traditional warning that a downturn is near — an inversion of the yield curve — keeps getting louder. Ed Yardeni, an economist who’s been covering the market since the 1970s, has an explanation. The yield curve, he posits, is signaling the slowdown in inflation that typically accompanies a recession but not the actual recession itself. He calls this the ‘Nirvana scenario’ — all the gain (an end to nasty price increases for consumers) without much pain (a spike in unemployment or a major hit to the stock market).”
“Nirvana,” “Goldilocks,” “soft-landing” and “immaculate disinflation.” It’s all talk befitting of loose conditions and market exuberance. “Permanently high plateau.” Yet the Fed is keen to wrap up its “tightening” cycle.
Evan Ryser, Market News International: “Financial conditions have been loosening at a fairly steady clip in recent weeks—the dollar, the stock market, et cetera. What does that mean for the Fed being sure that inflation will come down to target?”
Powell: “So, we monitor, of course, financial conditions—broad financial conditions. You’re right, it’s the dollar and equities but—and we’re, of course, very focused on rates and our own policy. We’re going to use our policy tools to—working through financial conditions—to get inflation under control. The implication is we will do what it takes to get inflation down. And in principle, that could mean that if financial conditions get looser, we have to do more. But what tends to happen, though, is financial conditions get in and out of alignment with what we’re doing. And ultimately, over time, we get where we need to go.”
Coming into Wednesday, I thought how Chair Powell handled the financial conditions issue would be the most important facet of this Fed policy meeting. He referred to “tighter Credit conditions” and “pretty tight Credit conditions in the economy.” “The overall picture is of tight and tightening lending conditions.”
There has been some tightening from egregiously easy bank lending. But “pretty tight Credit conditions” for the overall economy is quite a stretch. Indicative of easy Credit Availability, investment-grade spreads (to Treasuries) traded this week to near 17-month (pre-tightening) lows, with high yield spreads declining to 15-month lows.
July 27 – Financial Times (Harriet Clarfelt, Kate Duguid and Nicholas Megaw): “Rising stock prices and falling bond yields have made it so much easier for US companies to raise funds that much of the impact of the Federal Reserve’s interest rate rises has been neutralized… The degree to which the environment has improved in recent weeks is reflected in the National Financial Conditions Index, compiled by the Chicago Fed, touching its lowest point in 16 months… ‘The reality is that financial conditions have loosened — we have [effectively] unwound roughly 450 bps of rate hikes. Financial conditions are enough to take us back to March of last year,’ said Sonal Desai, chief investment officer for Franklin Templeton Fixed Income.”
The Fed Chair stuck with “Balanced Powell.” Relaxed and seemingly carefree – just as markets had hoped. “The inter-meeting data came in broadly in line with expectations.” “I would say monetary policy is working about as we expect.” “The overall resilience of the economy, the fact that we’ve been able to achieve disinflation so far without any meaningful negative impact on the labor market, the strength of the economy, overall that’s a good thing.” “It is a very positive thing that actually the unemployment rate is the same as it was when we lifted off in March of ’22, at 3.6%. So that’s a real blessing, that we’ve been able to achieve some disinflation.”
But hasn’t the economy maintained more momentum than expected? Aren’t higher policy rates having significantly less impact on overall financial conditions than anticipated? And doesn’t economic resilience – and persistently tight labor markets in particular – heighten the risk of second-round inflationary effects? Many of Powell’s comments struck me as inappropriate for the head of a central bank confronting serious inflation and financial stability risks.
The Nasdaq100 ended the week with a y-t-d gain of 44.6%. The Semiconductors (SOX) have returned 53.2%. The Goldman Sachs Short Index has surged 36%. The Nasdaq Industrial Index sports a 2023 gain of 28.8%, the S&P100 25%, the Dow Transports 24.7%, and the S&P500 19.3%. It’s a full-fledged “A.I. Everywhere” and “Magnificent Seven” mania.
The backdrop beckoned for a tougher Powell. He should have directly addressed the significant loosening of conditions, and at least acknowledged signs of market excess. This was certainly not the time to corroborate expectations from such a highly speculative marketplace.
Powell: “The federal-funds rate is at a restrictive level now. So, if we see inflation coming down credibly, sustainably, then we don’t need to be at a restrictive level anymore. We can move back to a neutral level and then below a neutral level at a certain point… And you’d start cutting before you got to 2% inflation too. Because we don’t see ourselves getting to 2% inflation until—you know, all the way back to 2 until 2025 or so.”
Indicative of his hear, speak, and see no evil press conference, Powell punted on what is certainly a pertinent question: “Are you concerned then about a trend of series of big unions, these contracts, pushing wage inflation up?”
Powell: “Not for us to comment on contract negotiations. Not our job. Not our role. You know, we monitor these things, and we’ll keep an eye on them. But really, that’s something that’s handled at that level.”
Rising compensation is today a predominant risk to price stability. The Fed’s inability to tighten financial conditions, weaken demand, and cool the hot labor market accommodates “knock-on” secondary inflationary effects.
Powell: “So there’s a long-running debate about the lags between changes in financial conditions and the response to those changes from economic activity and inflation, right? So, we know that in the modern era financial conditions move in anticipation of our decisions, and that has clearly been the case in this cycle. So, in a sense, the clock starts earlier than it used to. But that doesn’t necessarily change the process from that point on, and it’s not clear that it has.”
This is critical subject matter. In his original quote, Friedman stated that “monetary changes” have long and variable lags. Powell in June: “So it’s a challenging thing in economics. It’s sort of standard thinking that monetary policy affects economic activity with long and variable lags. Of course, these days, financial conditions begin to tighten well in advance of actual rate hikes.”
Explaining contemporary dynamics, we can say that monetary policy has highly uncertain and variable effects on financial conditions. Meanwhile, financial conditions, which exert immediate and powerful influence on market perceptions and pricing, have longer and more variable effects on economic activity. More than ever before, the transmission mechanism between monetary policy and the real economy travels through the vagaries of wildly speculative financial markets.
And I would strongly argue that central bank interventions over time have pervasive effects on market perceptions and prices, creating distortions that impair market function. More directly, long periods of artificially low interest rates and repeated market liquidity bailouts (Trillions of QE) crystallize market expectations for ongoing rate cuts and additional rounds of QE.
Powell notes the tightening “clock starts earlier.” More importantly, the loosening clock these days is set off before rate policies have exerted their typical restrictive effects. And this has become fundamental to Bubble Dynamics. The bond market has been conditioned to respond to loose conditions and resulting stock market (and other) excess by pricing probabilities for crisis-response rate slashing and QE purchases. In short, acute system fragility ensures bond yields remain artificially depressed and financial conditions loose irrespective of Fed tightening measures.
The reality is that the Fed has lost further control over monetary management. The March banking crisis confirmed that the so-called “Fed put” would be employed more quickly than ever – irrespective of Fed “tightening.” The resulting short squeeze and unwind of hedges effectively concluded system tightening, unleashing a torrent of liquidity into a highly speculative marketplace.
That financial conditions are now dictated by market Bubble Dynamics comes with major ramifications. I would argue that inflation risks remain elevated, boosting odds that the Fed will be forced to extend rate hikes. And with the inmates running the asylum, the risk of a market melt-up and crash scenario is alarmingly high.
I also expect heightened global market instability. Trillions of speculative leverage globally is positioned based on relatively certain policy and interest-rate differentials. When the major central banks move predictably and in unison, the levered players can operate with the necessary degree of policy clarity. But with markets now increasingly calling the shots, there becomes a problematic degree of uncertainty.
As expected, the ECB raised rates 25 bps this week to 3.75%. President Lagarde scrapped her tough inflation-fighting persona for flighty meeting-by-meeting data dependency. Impressionable markets were quick to price in the likely end to the ECB’s tightening cycle. In contrast to the U.S., European financial conditions are dictated more by traditional bank lending than market-based finance. Tighter European bank lending is not to the same degree offset by market loosening, ensuring greater near-term economic vulnerability. This creates considerable uncertainty regarding prospective policy and interest-rate differentials.
But when it comes to policy uncertainly, the Ueda Bank of Japan is king of the mountain.
July 28 – Financial Times (Kana Inagaki, Leo Lewis and Hudson Lockett): “The Bank of Japan has eased controls on its government bond market, altering a cornerstone of its ultra-loose monetary policy and prompting a surge in the country’s benchmark bond yields to the highest level in nine years. In an unexpected move, the BoJ said it would offer to buy 10-year Japanese government bonds at 1% in fixed-rate operations, in effect widening the trading band on long-term yields. The central bank added that it was technically maintaining its previous 0.5% cap on 10-year bond yields, but this level would be a ‘reference’ rather than a ‘rigid limit’. The move triggered confusion about whether the central bank would make further moves to unwind its easing policy, which has come under pressure this year from inflation that has hit four-decade highs. But the BoJ held its overnight rate at minus 0.1%, saying more time was needed to sustainably achieve its 2% inflation target.”
It’s reasonable that the Bank of Japan and its new Governor felt compelled to not let a meeting go by without doing something. So, it tinkered with YCC (yield curve control), cleverly achieving some flexibility without unleashing a panic. Markets nonetheless feel crossed, with Ueda adjusting a policy after signaling no move would be forthcoming. Worse yet, there was a leak the day before the meeting. Ueda only dug a deeper hole, stating the YCC tweak “didn’t represent a step toward normalization” and the “BOJ still sees a long way to achieving price goal.”
With Nasdaq up almost 2% Friday – and the bond market posting solid gains – it’s easy to dismiss the importance of BOJ policymaking. Not so fast. The Nikkei newspaper scoop that the BOJ was to discuss its yield curve control policy broke during Thursday afternoon U.S. trading. Already under pressure, market yields jumped higher. After closing Wednesday at 5.58%, benchmark MBS yields surged to an intraday high of 5.86% on the YCC report, before closing the session up 23 bps to 5.81%.
I’m reminded of a quote from none other than Paul Newman: “If you’re playing a poker game and you look around the table and can’t tell who the sucker is, it’s you.” I can imagine the bond market, these days increasingly contemplative, warily scanning the table.
Powell is essentially telling us he’s fine with loose conditions and a stock market Bubble. Definitely no need for either a jump in unemployment or a recession. Emboldened labor unions and a backdrop conducive to rising compensation expectations are not in the Fed’s purview. The Fed Chair is nailing the key elements of “immaculate disinflation.”
The bond market over recent decades became so conditioned to champion loose conditions that it lost sight that it’s the big loser from entrenched inflation. No amount of “easy money” has been too easy. No deficit too big. No stock market Bubble too extreme. Only faded memories of the old, revered vigilantes.
I’ve been waiting for the backlash. We witnessed last September in the U.K. how quickly bond market deleveraging can spiral out of control. I believe today’s loose conditions and booming stock market raise the odds of upside growth and inflation surprises. This would really gum up Fed policymaking – and bond market stability.
While we’re thinking this through, we can consider the possibility of inflationary Chinese stimulus. I don’t see why speculative fervor won’t return to the commodities space, reversing some disinflationary benefits as speculation shifted decidedly back to financial assets. And there’s the unfolding train wreck in Japan that at any time could unleash global deleveraging.
When I ponder the world, a few choice words come to mind. Nirvana is not among them. It’s frightening to see a major stock market Bubble inflate at this phase of the cycle. We’ve all become numb. On a weekly basis, there are developments that provide reminders of how dramatically the geopolitical backdrop has deteriorated.
July 28 – Reuters (Josh Smith and Hyunsu Yim): “Chinese and Russian officials stood shoulder to shoulder with North Korean leader Kim Jong Un as they reviewed his newest nuclear-capable missiles and attack drones at a military parade in the capital, North Korean state media showed… The widely anticipated parade in Pyongyang the previous day commemorated the 70th anniversary of the end of the Korean War, celebrated in North Korea as ‘Victory Day’… Their appearance at events with the North’s nuclear-capable missiles – banned by the U.N. Security Council with Chinese and Russian support – was in contrast from previous years, when Beijing and Moscow sought to distance themselves from their neighbour’s nuclear weapons and ballistic missile development.”
Original Post 29 July 2023
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Categories: Doug Noland