LET’S LEAVE NOW; DON’T WANT TO MISS THE FLIGHT
In the big picture, Janet Yellen’s tenure as head of the Federal Reserve has been stable and successful. Unemployment has declined steadily. Inflation is not quite at target, but talk of deflationary risks has subsided. My belief was that the market always tests a new Fed chair, but since February of 2014 when Yellen began her term, stocks (SPX) have never gone lower (although there was a test in early 2016), and the highest the ten year yield ever got during her chairmanship has been 280, a couple of months into her term. Greenspan was quickly tested with the 1987 crash, and Bernanke, of course, with the great financial crisis. Yellen pretty much sailed through without any major squalls. Many analysts have said that Friday’s Jackson Hole speech, a defense of strong regulation of the financial system, makes it unlikely that Trump will re-nominate her, given the administration’s deregulatory zeal. I’m not so certain of that. While I personally think that higher rates, higher volatility, and higher risk premia in general, act as cushions in a dynamic economy, stability in the financial world is generally applauded as a worthy goal. In any case, the next Fed chair will almost surely encounter rougher seas.
I would just like to take a couple of quotes from the speech.
And yet the discussion here at Jackson Hole in August 2007, with a few notable exceptions, was fairly optimistic about the possible economic fallout from the stresses apparent in the financial system. [acknowledgment that many financial experts were wrong].
The vulnerabilities within the financial system in the mid-2000s were numerous and, in hindsight, familiar from past financial panics. [the Fed mistakenly didn’t get in front of the situation].
Preeminent among these domestic and global efforts have been steps to increase the loss-absorbing capacity of banks, regulations to limit both maturity transformation in short-term funding markets and liquidity mismatches within banks, and new authorities to facilitate the resolution of large financial institutions and to subject systemically important firms to more stringent prudential regulation. [this is the solution; risk premia by definition decline]
To be sure, [current] market-based measures may not reflect true risks–they certainly did not in the mid-2000s–and hence the observed improvements should not be overemphasized. [the Fed should now avoid overconfidence]
Greenspan’s bias in the late 1990’s was this: The Fed may perceive dislocations and risks in the market, but will not unilaterally stand against the decisions of millions of investors. The blind buying of many tech stocks is sure to lead to a shake out and large losses, but the Fed will simply provide the clean-up and liquidity if/when the bubble bursts.
Yellen is, instead, falling back on the macroprudential approach. Depend on the regulatory framework to ensure that there is plenty of capital at financial institutions in case of problems. Use regulations to keep financially large players from pursuing too much risk. This cautious policy framework shouldn’t be surprising. It’s been written that Yellen arrives at the airport three hours before flights.
The questions now are 1) whether the low rate regime has let risks amass under the surface and 2) with the US being a smaller percentage of the global economy can crises overseas overwhelm the US financial structure? After all, the US exported the mortgage crisis to the rest of the world. Since 2008 the US economy has grown about 26%, China’s economy has more than doubled and the size of the shadow banking system there has supposedly grown faster by magnitudes.
There’s one other little quote that’s of interest in Yellen’s speech:
In addition, algorithmic traders and institutional investors are a larger presence in various markets than previously, and the willingness of these institutions to support liquidity in stressful conditions is uncertain.
This all gets back to my topic of a couple of weeks ago. It’s not the trade, it’s the size. She is not blind to risks, just wants to make sure there’s plenty of cushion in the form of capital and regulatory structure in TBTF in case things go awry. Perhaps partially as a result of this institutional bias from the Central Bank, markets themselves are not correctly pricing risks and have removed shock absorbing cushions in the form of spreads and implied volatility. Maybe we’ll discover an alternate reality with the next Fed chair.
Whatever the longer term ramifications are of Central Bank philosophy, the short term outcome from Jackson Hole was fairly clear. The euro ended at a new high for the year. DXY made a new low; $/yen close to new lows (DXY chart below). Yields eased with tens down about 3 bps on the week to 216.6. New ytd lows in some measures of the curve. Red/gold euro$ pack spread (2nd to 5th year) closed just over 52 bps, essentially cut in half from the high last December. 2/10 and 5/30 made new lows on the week at 83.4 and 99, not quite at the year’s low made after the June FF hike of 79.0 and 93.2. Spot VIX fell 3.0 over the week, from 14.26 to 11.28. Bitcoin leapt to new highs.
The real rate as defined by the 10 year inflation-indexed note closed solidly in the middle of the range defined by Yellen’s chairmanship term, ending at 41 bps.
The early part of the coming week is likely to be defined by damage estimates regarding Hurricane Harvey. Clearly there will be large costs, met in part by resources of the US Federal Gov’t. In the context of already lower than expected cash balances of the US treasury going into the debt ceiling fight, I would think that short term t-bill issuance will explode –after ‘last-minute’ heroics to fund the gov’t.
Employment report is Friday, with NFP expected 180k. Treasury auctions 2’s and 5’s on Monday and 7’s on Tuesday.
