Financial Conditions vs Financial Stability
November 29, 2020- Weekly Comment
The Fed minutes were released on Wednesday from the November FOMC. A few sentences summarized the underlying tension between financial conditions and financial stability:
A few participants indicated that asset purchases could also help guard against undesirable upward pressure on longer-term rates that could arise, for example, from higher-than-expected Treasury debt issuance. Several participants noted the possibility that there may be limits to the amount of additional accommodation that could be provided through increases in the Federal Reserve’s asset holdings in light of the low level of longer-term yields, and they expressed concerns that a significant expansion in asset holdings could have unintended consequences.
A few participants expressed concern that maintaining the current pace of agency MBS purchases could contribute to potential valuation pressures in housing markets.
Of course, this framework of differentiating between conditions and stability is not overtly identified in the minutes, but I believe it’s a subtext that increases economic vulnerability going forward. Recently, every Fed official that has given a speech or interview emphasizes the importance of increased fiscal support, the result of which will necessarily be increased debt issuance. The first sentence excerpted from the minutes above, essentially provides guidance that the Fed will continue to hold long rates down by monetizing government debt that the private market is unwilling to absorb. The next sentence represents a push-back.
Former NY Fed chief William Dudley defined financial conditions in terms of “five key measures: short and long term Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices.” Obviously, every one of these criteria currently falls under the umbrella of highly supportive conditions. The minutes refer to spreads being back to pre-pandemic levels. Stocks are near all time highs, the dollar’s value is declining. The risk, as noted by some members, is that attempting to juice financial conditions from these levels will foster future financial instability.
As William White, former chief economist of the BIS notes, “Every [previous] crisis was met with monetary easing that caused debt and other imbalances to accumulate over time, and that caused the next crisis to be bigger than the previous one. The next crisis then needed more punch from central banks. But since interest rates were never raised as much in upturns as they were lowered in downturns, the capacity to deliver that punch was decreasing.” White’s view is that risks of instability are high. Also worth noting is that Fed staff considers risks currently tilted to the downside. Later in White’s interview (linked below) he is asked about the possibility of a tipping point. “One of the conclusions of the complexity literature is that the trigger itself is irrelevant. If the system is unstable, anything could be a tipping point, even if the instability goes on without incident for years.”
The final sentence that I highlighted from the minutes borders on naivete. The current pace of MBS purchases is MEANT to foster activity in housing markets. Push mortgage rates lower and you’ll generate transactions. This, at a time when many Americans are either trying to escape high costs and violence of major cities, or have found that work-from-home arrangements mean geographical independence. It’s obvious that prices in some jurisdictions will be pushed higher, maybe to unreasonable valuations! It’s also clear that the same dynamic has lifted stock prices.
In order to address potential instability brought on by bloated government and corporate debt, many have concluded that higher inflation is a key policy goal. Reaching this goal by definition means reducing the purchasing power of the dollar, and if that’s the stated objective, then it’s no wonder that bitcoin and prices of economic inputs should increase. I saw several articles mention that copper had hit a seven-year high last week. Below is a long term chart of both DXY (dollar index) and Bloomberg’s Base Metals index.
Note that in 2011 both base metals and DXY hit extremes. Trend lines drawn from those points reveal that both DXY and base metals have recently broken these trends. This example among others, suggests that the Fed will be successful in generating inflation. The question is whether it will be too successful.
A couple of other observations: Given the low level of yields, many asset managers concluded that bonds no longer were likely to provide much of a cushion in case of a stock break. Some even substituted gold for bonds as a hedge. Last week gold was dumped as risk-on sentiment strengthened. From the previous Friday close to Friday’s low gold fell $100 ($1871 to $1774). VIX dipped below 20 for the first time since February, though it ended the week at 20.84. The minutes repeatedly refer to a goal of asset purchases as “restoring smooth market functioning.” Clearly, there’s been mission creep, as Powell echoed Draghi by saying on November 17 that the Fed will use all available tools to support the recovery, “as long as it takes.”
There’s a decent amount of economic data out this week, culminating in Friday’s employment report. Chicago PMI and Dallas Fed Mfg on Monday, Mfg ISM on Tuesday, ADP and Beige Book on Wednesday. Powell appears before the Senate Banking Committee on Tuesday as well.
The assassination of the top Iranian nuclear scientist on Friday could prompt an escalation in hostilities in the region as Iran responds. In September of 2019, a large attack on Saudi oil installations caused WTI crude to surge around $10, from 55 to nearly 65, though it quickly fell back.
| 11/20/2020 | 11/27/2020 | chg | ||
| UST 2Y | 16.5 | 15.2 | -1.3 | |
| UST 5Y | 38.0 | 36.7 | -1.3 | |
| UST 10Y | 82.8 | 84.1 | 1.3 | |
| UST 30Y | 153.0 | 157.4 | 4.4 | |
| GERM 2Y | -75.1 | -75.5 | -0.4 | |
| GERM 10Y | -58.3 | -58.8 | -0.5 | |
| JPN 30Y | 62.5 | 64.8 | 2.3 | |
| EURO$ Z0/Z1 | -0.3 | -0.5 | -0.3 | |
| EURO$ Z1/Z2 | 10.5 | 9.5 | -1.0 | |
| EURO$ Z2/Z3 | 14.5 | 15.5 | 1.0 | |
| EUR | 118.56 | 119.61 | 1.05 | |
| CRUDE (active) | 42.42 | 45.53 | 3.11 | |
| SPX | 3557.54 | 3638.35 | 80.81 | 2.3% |
| VIX | 23.70 | 20.84 | -2.86 | |
https://ggc-mauldin-images.s3.amazonaws.com/uploads/pdf/20201116_OMS_cbanks-White.pdf
