The power to create is the power to destroy
May 2, 2021 – Weekly comment
Several analysts have mentioned the Kansas City Fed’s Jackson Hole Symposium as a likely venue for an announcement that the Fed can begin tapering. The exact date hasn’t been announced, but typically it occurs in late August. By that time we will have had two more FOMC meetings, in mid-June and late July. As mentioned during the week, I went back to a Greenspan Jackson Hole address of 1999 which has bearing on the current environment, not in terms of policy change, but in terms of core concerns of the central bank. In 1999, a big part of that was asset values.
From 1994 until March of 2000, stocks rallied as the promise of the internet permeated the public’s consciousness. The dotcom bubble. Through this period the FF target ranged from 4.75% to 6.0%. From the middle of 1999 to May of 2000, the Fed raised rates from 4.75 to 6.5%, followed by the unravelling starting in Dec 2000, which took the target rate all the way down to 1.75 by the end of 2001.
From 1996, when Greenspan uttered his famous “irrational exuberance” line until the 1999 Jackson Hole speech, Greenspan was concerned about asset values, which generally trended higher even though interrupted by the Asian currency crisis in 1997 and the Russian / Long Term Capital crisis in the following year. From the mid-July 1998 high to October low, SPX lost a bit over 20% and made it all back by the end of the year.
The real declines came after what is shown on the above chart. From the September 2000 high until Sept 2001, SPX lost 38%, then bounced, but the ultimate low in October 2002 at 768 was only about half the value of the year 2000 high.
Here are a couple of excerpts from Greenspan’s speech. The crux of the address concerns equity valuations and confidence. It touches upon discount rates and the wealth effect. These are the issues that currently seem relegated to the dustbin of history.
The translation of value judgments into market prices is, of course, rooted in how people discount uncertain future outcomes. An individual’s degree of risk aversion may vary through time and possibly be subject to herd instincts. Nonetheless, certain stable magnitudes are inferable from the process of discounting of future claims and values.
One of the most enduring is that interest rates, as far back as we can measure, appear trendless, despite vast changes in technology, life expectancy, and economic organization. British long-term government interest rates, for example, mostly ranged between three percent and six percent from the early eighteenth century to the early twentieth century,and are around five percent today. Indeed, scattered evidence dating back to ancient Rome and before reflects the same order of interest rate magnitude, not a one percent interest rate nor 200 percent.
[For the past ten years, the US 10y yield has only briefly tickled the bottom end of this 3-6% range, in 2013 and in late 2018]
It has become evident time and again that when events are unexpected, more complex, and move more rapidly than is the norm, human beings become less able to cope. The failure to be able to comprehend external events almost invariably induces fear and, hence, disengagement from an activity, whether it be entering a dark room or taking positions in markets. And attempts to disengage from markets that are net long–the most general case–means bids are hit and prices fall.
History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance.
To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes
[ I.e. the Fed’s job is clean up…not to second guess the market]
As we make progress, hopefully, toward understanding asset-pricing mechanisms, we need also to upgrade our insights into the effect of changing asset values on GDP–the so-called wealth effect.
And differentiating between gains that arise from enhanced profitability and those that reflect changes in discount factors may also be useful. The former may be more likely to be sustained, given the tendencies of discount factors to revert back to historic norms.
In the current episode of runaway stock values dominated by big tech, few of these considerations seem to enter into the Fed’s deliberations. Of course, the financial press encourages this omission, as evidenced by this quote from CNBC Friday: “Smaller tech companies offer bigger opportunities for growth and returns over the long term. But if investors are looking for investments with the safety of US government bonds and the prospect of at least some future growth, there is no investment class like the tech giants.”
The last snippet of Greenspan’s speech is particularly interesting, because in late 2018 we got a taste of what happens when discount rates revert back towards norms, a Q4 decline of 20%. I would say that the “so-called wealth effect” is exerting tremendous influence on the economy currently. If so, then a sudden loss of confidence or a reset of the discount rate will have an outsized effect on activity, but still might not arrest a general increase in inflation expectations.
In many ways, Powell has become Bizarro Volcker. Volcker, against tremendous political pressure, kept short end rates extremely high to crush inflation. Powell is keeping rates near zero, with a huge political tailwind, to push inflation higher. As Seinfeld explains to Elaine, “Bizarro Superman is Superman’s exact opposite who lives in the backwards bizarro world: up is down, down is up, he says hello when he leaves, goodbye when he arrives.” Volcker used to smoke a cigar in a rumpled suit when he appeared before Congress. Powell talks about social equality.
Volcker: “It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. If the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.” Soooo last century.
Bizarro Volcker (last week’s press conference) “So it seems unlikely frankly, that we would see inflation moving up in a persistent way that would actually move inflation expectations up while there was still significant slack in the labor market.” Also: “So one of the areas is asset prices, and I would say some of the asset prices are high. You are seeing things in the capital markets that are a bit frothy. That’s a fact. I won’t say it has nothing to do with monetary policy. But it also has a tremendous amount to do with vaccination and reopening of the economy.”
We know where Powell stands. Inflation is due to bottlenecks, base effects and re-opening. It will not be sustained. They knew where Volcker stood, “By the time I became chairman and there was more of a feeling of urgency, there was willingness to accept more forceful measures to try to deal with inflation.”
What we have now is almost like the WeWork model on a national scale (thanks AG), where the company committed to long-term lease obligations and let clients drink free beer and sign short-term leases. The Federal government is locking in long term debts, sending out stimulus checks for free beer or whatever other goodies the public wants to buy, confident that the capital will keep flowing in. As Sam Zell said on a CNBC interview in early September of 2019, this model has never worked. “Might as well just change the name to Savings and Loan. “Find me an example of creating a company that loses 50 cents on every dollar of revenue and explain it to me.” WeKnow TM that WeWork imploded. The US stimulus model might lead to similar results in terms of inflation. It’s well known that primary inputs are exploding in price with copper and lumber and plastics near or at all time highs. The Fed knows it.
I’ll just leave it with one more Volcker quote: “When I hear complaints about less liquidity, remember there is such a thing as too much liquidity.”
OTHER MARKET THOUGHTS/ TRADES
When the Fed was tapering in 2018, they shaved the balance sheet by $10 billion every three months, in equal percentages of Treasuries and MBS. This time they will simply be growing the balance sheet less rapidly. Due to strength in housing, I would think this time the Fed would shave MBS purchases more quickly than treasuries. Since tapering in the current environment would simply be buying less, and since they have indicated that tapering comes before hiking the FF target, the reduction schedule should be more aggressive than $10b per quarter; perhaps more like $30 billion per quarter. September of 2021 to September of 2022?
Last week, Clarida made these comments:
“If inflation at the end of the year has not declined from where it is in the middle of the year that will be some good evidence,” that the Fed’s current outlook is wrong, Clarida said.
“We would expect those (increases) to be transitory and as the year progresses and as we go into next year, if they are not then we will have to take that into account,” he said.
On Friday, MNI ran a piece with this quote from former NY Fed chief Dudley:
“The chances of a soft landing in this regime is virtually nil,” Dudley said. “They’re going to be late and that’s by design. So when they start tightening they’re going to have to go relatively quickly.”
Late on Friday, there was a buyer of 60k EDM2 9962.5/9937.5 put spreads for 2.5 to 2.75 and then a 30k lot block buy of EDM2 9962/9925 put spread for 3.0. The prelim CME open interest report shows all trades done in the 9962/9937ps in size of 109k. In any event, the idea is predicated on a Fed hike in about a year, a significant move forward on most people’s timelines. Dudley’s warning that the Fed will be late and then have to be more aggressive seems to have struck a nerve.
There has also been significant accumulation of 3EU 9800/9900 risk reversal (buying the put) and on Friday, a similar trade to what originally kicked off the major interest in blue midcurves. This was buy 3EU 9837/9812ps (7.75s) vs sell 9862/9887cs which settled 8.0 ref 9845.5s (traded about 25k). Of course when the similar 12.5 bps put spread vs call spread was originally done in 3EH (which has of course expired) the blues were trading around 9945 and the lower strike was the 9912/9900 put spread. Currently the first blue is EDM24 which trades 9861.5. Clearly the market has already had a significant adjustment, but has a lot more to go if the Fed is wrong about “transitory”.
| 4/23/2021 | 4/30/2021 | chg | ||
| UST 2Y | 15.7 | 16.0 | 0.3 | |
| UST 5Y | 81.3 | 85.4 | 4.1 | |
| UST 10Y | 156.5 | 162.8 | 6.3 | |
| UST 30Y | 225.0 | 229.7 | 4.7 | |
| GERM 2Y | -69.0 | -68.2 | 0.8 | |
| GERM 10Y | -25.7 | -20.2 | 5.5 | |
| JPN 30Y | 63.6 | 65.7 | 2.1 | |
| CHINA 10Y | 317.5 | 315.6 | -1.9 | |
| EURO$ M1/M2 | 8.5 | 7.5 | -1.0 | |
| EURO$ M2/M3 | 39.5 | 40.0 | 0.5 | |
| EURO$ M3/M4 | 68.0 | 72.5 | 4.5 | |
| EUR | 120.99 | 120.20 | -0.79 | |
| CRUDE (active) | 62.14 | 63.58 | 1.44 | |
| SPX | 4180.17 | 4181.17 | 1.00 | 0.0% |
| VIX | 17.33 | 18.61 | 1.28 | |
https://www.federalreserve.gov/boarddocs/speeches/1999/19990827.htm
https://www.inspiringquotes.us/quotes/j8DJ_rwDsozl5
So many of the financial crackups in all countries—all Western countries—that have happened around the last 30 years have been around housing. We really don’t see that here. We don’t see bad loans, and unsustainable prices, and that kind of thing.” Powell at the presser, fighting the last war.
