Powell On QE

Extract from the FOMC minutes 10/24/2012. Emphasis is mine:

MR. POWELL. Thank you, Mr. Chairman. So we have had Gary Cooper, the Most Interesting Man in the World, Bill Belichick, Woody Allen, and now Hamlet. [Laughter]

I support alternative B, to relieve the suspense. And as far as what is to be decided at the next meeting, it seems to me we should let it be decided at the next meeting. But I will say that if we have another good run of data, I think there would be a strong case to defer action. And I don’t see us as committed to act unless conditions warrant.

I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons.

First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?

Second, I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.

Take selling—we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month— it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market. And I would just say I want to understand that a lot better in the intermeeting period and leave it at that. Thank you very much, Mr. Chairman

After you’ve read this, do you think that Powell is in the least surprised by the consequences of raising rates? I don’t know what he will do, but I doubt that he will be deterred from whatever his strategy may be.

Silicon Valley Bank (SVB)

Last week, SVB was taken down by a classic bank run triggered, whether deliberately or not, by the VC community, with which the bank had close ties. Panic spread as portfolio companies and individuals rushed to take their money out of the bank. SVB was unable to meet the demands of depositors and was seized by the FDIC on Friday. Like many banks, SVB had significant unrealized losses on its securities portfolio, due to rising interest rates, and took a big loss as it sold securities to raise liquidity.

It seems like the FDIC attempted to sell the bank, but the effort went nowhere. Fearing a domino effect, the FDIC decided to extend its insurance to all depositors, removing the $250,000 limit. The Fed enhanced its “discount window” to allow banks to borrow against their securities portfolio at par, so they could raise liquidity without taking losses. While they were at it, the team also closed Signature Bank, a crypto-focused bank in NY state, on the same terms. All of this was entirely appropriate in my opinion. I’m bearish, but the last thing I want is a dysfunctional banking system. If that happens, even the bears don’t get paid. The Fed acted in its only proper role, as lender of last resort. The FDIC acted to spread any losses, after wiping out the share and bond holders, over the whole FDIC-insured banking system.

At the end of the weekend, the Fed is now free to continue hiking rates without crushing the banking system if it feels the need to do so. There is no need to line up outside your bank. From a macro point of view, very little has changed. The SVB head office and branches will open Monday morning under a new name (Deposit Insurance National Bank of Santa Clara).

This is not a bailout. Existing processes have been broadened in scope, but there is no repetition of the taxpayer-funded capital infusions of the past. This was the failure of a badly managed bank, arguably excessively focused on “woke” virtue signalling, combined with a tightly connected community as its customer base. The Feds acted swiftly to not only fix the immediate problem, but put in place processes to minimize repetitions.

Edit: the borrowing at par applies only to collateral acquired before Sunday 3/12. So no running out to buy underwater Treasuries. If you didn’t read the term sheet you can put them back now.

Edit: Name is now Silicon Valley Bridge Bank

Bank Runs

Silvergate Capital, a bank known for its ties to the crypto industry, said yesterday that it would voluntarily liquidate. Today Silicon Valley Bank, known as close to the venture capital industry, was closed by California regulators. Both are somewhat special cases, so aren’t necessarily a sign of general distress.

However, it is fair to say that banks are pressured on both sides of their balance sheets. On the asset side, interest rate increases have caused securities portfolios to drop in value. On the liability side, short-term Treasury securities offer a safe and highly liquid alternative to bank deposits, forcing banks to either raise the interest that they pay or accept the loss of deposits needed for liquidity. So far most banks have chosen the latter, but it is a risky choice, as evidenced by Silicon Valley Bank, which was forced to sell its entire tradable securities portfolio at a significant loss in an attempt to shore up liquidity. This situation illustrates the two ways banks can fail – on the asset side, losses on loans and securities reduce the bank’s capital so that it cannot continue or, on the liability side, withdrawals deplete the bank’s liquidity – cash if you like – so that it is unable to meet the demands of depositors.

So far the impact on the broad stock market has been negligible, probably balanced between fear of a financial meltdown and confidence that a tremor in the banking system would force Powell to pivot. GLWT.

Edit: From an anonymous VC to a portfolio company CEO: “Our view is that this is a sector-wide issue. We’re advising founders not to use a bank right now. We’re pooling together our portcos’ capital and executing a large batch transaction for Starbucks gift cards. Starbucks is likely more stable than banks (they’re on every corner and everyone drinks coffee).

To cash out, we’ll just buy a bunch of those dipped madeleines they have near the checkout. Best case we make back 98 cents on the dollar. Worst case, we have a few million cookies that have a long shelf life.”

Of course the portfolio companies will never see that cash – the cookies won’t make it past the break room at the VC outfit.

Something’s Going To Break

From past experience, we can be pretty sure that the bear market doesn’t begin until the inverted yield curve returns to a positive slope. Usually this happens because of a major disruption in the financial markets. Here are some of the opportunities for breakage.

• The average 30-year mortgage rate, as of today, is 7.13% according to Bankrate.com. Housing affordability has dropped to what Redfin deputy chief economist Taylor Marr calls the “lowest level in history.”
• Office occupancy in major city centers is ranging from 40-60% as a result of WFH practices. Pressure on bricks-and-mortar retailers from online shopping continues to build. The overall US CMBS delinquency rate jumped 18 basis points in February to 3.12%. (The all-time high on this basis was 10.34% registered in July 2012. The COVID-19 high was 10.32% in June 2020.) . Giga-investor Blackstone just defaulted on $562 million of CMBS.
• CPI/PCE inflation continues. While energy prices continue to be contained by withdrawals from the SPR, labor prices continue to increase. Fed chair Powell says that his primary measure of inflation is core PCE less housing, which implies a heavy weight on labor costs when evaluating inflation.
• The Fed continues to raise short-term interest rates to reduce business activity and therefore reduce inflation. So far with little success. Financial markets are busily fighting the Fed’s attempts to tighten financial conditions. History says this does not end well.
• There’s a war on, into which black hole the US continues to pump money and armaments. These will need to be replaced at great cost. Defense spending will be increased. The big risk is of further escalation, which could include the use of nuclear weapons.
• The primary source of inflation is deficit spending by government. Half of the government’s debt has a maturity of less than five years. The Fed’s rate increases are quickly running up the government’s interest bill, which of course will increase the deficit – that’s how the black hole works. Interest is already nearly as large a budget item as defense spending.
• China’s recovery from its draconian COVID policies is limping badly after a small initial surge. In addition, the US is actively hampering the development of technology in China and relations are a historic lows. There is a significant risk of another war, this time over Taiwan, where TSMC is the crown jewel of semiconductor manufacturing. All this means that China is unlikely to be the source of cheap manufactures goods that have helped quell inflation for the last twenty years or so.
• The US stock markets remain highly overvalued and not investable as the flood of liquidity during the COVID era has supported speculation. The options market has grown to be larger than the equity market of which it is supposedly a derivative, leading to extreme gambling activities such as 0DTE options..

Get the idea?

Good Advice But…

The cancel culture was a little more brutal back then. Cicero was beheaded by order of Mark Anthony.

Good News

Well the good news is that MMT advocate Lael Brainard has been removed from the position of Vice Chair at the Fed, effectively stripping her of any actual power. Oh and inflation came in pretty much as expected.

Honne And Tatemae

There are many financial conditions indexes, but in general terms they represent the cost and availability of credit and equity financing, interpreted as relatively “tighter” or “loose, easy”. Markets were surprised that Powell appeared unconcerned that these indexes showed that financial conditions were more or less unchanged by the Fed’s rate and QT actions. His unconcern was interpreted as conceding that the bulls were right in believing that rates would soon come down.

My interpretation was that he simply didn’t think it was a problem. One of the Fed’s primary concerns is to keep financial markets functioning normally, and the indexes show that they are. However, it is important to remember that the Fed is very well informed. The Japanese have words for this, “honne” and “tatemae”. “Tatemae” is the outward appearance of conformance to society’s norms and rituals, while “Honne” is what is really going on behind the scenes. In this case, the “Tatemae” is the traditional information bureaucracy – the BLS, BEA, and even the Fed itself – and the ritual announcements of  lagged and often politicized estimates of economic data. The “Honne” is that the Fed uses all kinds of information services and is very much in touch with the high-frequency data that is gathered by state governments, industry associations and many other private services. The recent callout of the BLS by the Philly Fed shows that the Fed has little faith in the BLS. Powell knows that the economy is either on the verge of recession or already in one regardless of the NBER’s view. He knows that deflationary collapses are underway in markets like housing and used cars. He probably also expects that taking down inflation, as happened in the GFC, will likely require a severe correction in financial markets, probably worse than the GFC. But I am of the opinion that  he is willing to be wrong about that, so if markets are right to “look through” the recession to a return to low inflation he would be perfectly OK with that. He did warn that no rate reductions should be expected in 2023, nor would he back off prematurely, but this was widely ignored.

Edit: This morning’s employment report demonstrates the useless, erratic nature of the BLS data.

Happy Days Are Here Again

Markets continue to behave as if 2022 never happened, inflation is dead, growth is strong, the Fed is impotent, we’ve had a soft landing and caution can be thrown to the winds. Stock prices have resumed their uptrend and new highs are soon to be seen. After all, the Dow is only down 7.5% from its all-time high close, and the S&P only 15%, dragged down by the big tech stocks, which are recovering fast from irrational selling, thanks to cost reductions from layoffs. VIX, the volatility index, is at levels last seen in early January last year, close to the December 2021 all-time stock market highs (18.06 as I write). Perhaps that is not a coincidence.

To me, this looks like an opportunity. Far be it for me to rain on a parade, but this looks like a bull trap.

Unwarranted

From the minutes of  the Fed’s 12/13-14 meeting:

Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the Committee’s reaction function, would complicate the Committee’s effort to restore price stability.

Per Bloomberg, financial conditions are now back in pre-QT, super low rate – i.e. bubble – territory.

This isn’t going to make Jerome Powell happy, is it? Could 0.50 be back on the table? Just to get the markets’ attention…

What If?

The stock and bond markets are depending on the recession to “force” the Fed to “pivot” back to money printing and ZIRP. The economy is addicted to free money and is slowing rapidly now that it has been withdrawn. The bond market has already priced in disinflation and Fed easing, and the stock market has been buoyed accordingly, proceeding from short squeeze to short squeeze since June of 2022.

But what if Powell has decided that the QE policies that have yielded only $1 of GDP growth for every $10 of fresh debt are toxic and the addiction must be broken, no matter what the symptoms of withdrawal might be? That his legacy will be having returned the economy from dependence on continuous stimulus to sustainable growth? To say nothing of reducing the Fed-induced income inequality that is being exacerbated by inflation? That would certainly earn him a niche in the financial Hall of Fame, perhaps next to Paul Volcker.