DID POWELL USED TO BE A LOT SMARTER?
2019-05-07 11am EDT | #Powell #FOMC #
I know some of you think me quite the bull. At times, it might appear I don’t worry about debt buildup and that I spend more time debunking popular end-of-the-world hedge fund narratives than agreeing with them. Yeah, I get it.
Sometimes I wish I could join the hedgies with their cataclysmic predictions. The dark side definitely sells better. And I certainly would appear much smarter if I would simply embrace the negative view.
Although I have long poked fun (good naturedly of course!) at the forecasts for another 2008 Great Financial Crisis, I wanted to highlight an interesting development that has me scratching my head wondering if I am being too cavalier. After all, it’s no longer just the Greenwich/Mayfair crowd sounding the alarm bell about debt. Yesterday, in their latest financial stability report, the Federal Reserve highlighted the alarming growth of private sector borrowing.
The Federal Reserve escalated its warnings about the perils of risky borrowing by businesses Monday, saying firms with the worst credit profiles are the ones taking on more and more debt. The Fed also left a question unanswered: Is it going to do anything about it?
The U.S. central bank’s latest financial stability report said leveraged-lending issuance grew 20 percent last year, and that protections included in loan documents to shield lenders from defaults are eroding. While the Fed board voted unanimously to approve the report, it didn’t indicate any course of action the governors might take to rein in the red-hot market.
This Federal Reserve report is a big deal. The language makes it clear they are worried about the rising amount of private sector debt.
And for good reason. Take a gander at this terrific chart from Bloomberg (G #BTV 6468 for BB users):
This chart doesn’t resort to the usual trickery of measuring debt in absolute dollars (it’s like man-scaping - it makes it look bigger than it actually is), but uses the much more appropriate debt as a percent of GDP figure.
Yet even with the proper measurement, the growth in corporate debt since the Great Financial Crisis is nothing sort of stunning. We have tacked on 900 basis points of GDP in debt!
The three R-stars
The other day I was chatting with my pal Aidan Garrib, macro strategist at Pavilion Global Markets and he articulated the dilemma facing the Federal Reserve so eloquently, I decided to steal his line. Aidan said there wasn’t really one R-star value, but three. The moment he uttered those words I instantly understood he had summed up the Fed’s problem perfectly.
Before we go further, let’s review - what is R-star? It’s the neutral rate of interest that balances the economy in the long-run. It’s a completely made-up number. An estimate for the interest rate that is neither stimulative or restrictive for a particular economy. But let’s face it, it’s something only economic PhDs get excited about.
Yet those PhDs set monetary policy based on their estimates for this magical R-star level. If they believe R-star to be higher, policy decisions get tilted on the side of tightening. If they believe R-star to be lower, that influences FOMC board members to keep rates lower. Central Bank decision makers’ estimate on the neutral level of interest rates is an important input in forecasting monetary policy. That’s why the Federal Reserve releases their infamous “Dot plot” that includes a R-star estimate by each FOMC board member.
Back to Aidan’s comment about there being three R-stars. What did he mean by that?
He was observing that there is a neutral level of interest rates for consumers, but that differs from the interest rate that would balance the manufacturing economy. Even more importantly, both of these differ from the level that would facilitate stable financial conditions.
To some extent this is nothing new. Rarely do all elements of an economy require equal level of interest rates. There are always areas of the economy where the rate is too loose while other parts too tight.
But I think it’s safe to say that the difference between these levels has never been higher.
Powell gave up on trying to balance the financial economy
When Powell first grabbed his seat at the head of the table as Fed chair, he was determined to squash what he viewed as a imminent bubble. He cranked rates and did not let up. Every FOMC press conference was met with equity selling as Powell failed to mouth the soothing words Wall Street wanted to hear. Rather, he highlighted the imbalances in the financial economy. Powell had sat through the Great Financial Crisis and was determined to not let another bubble develop under his watch.
Don’t believe me? The chart that best illustrates the dramatic change in Fed policy under Powell’s tenure is the 2-year TIPS yield.
Under Bernanke and Yellen the 2-year TIPS yield (the real yield after inflation) gyrated between 50 bps and minus 225 bps. Most of the time it was negative or close to zero.
Look closely at the red box. That’s the point when Powell got behind the wheel and steered 2-year real rates up to 200 bps.
And want to know the date of the high tick? It’s one day before the infamous Christmas-eve massacre when stocks went no bid.
After that, Powell changed his tune. No longer was he the bold-new-Chairman-willing-to-slow-down-the-financial-economy-to-stop-a-bubble. Suddenly he was the scared-and-trying-stay-out-of-Trump’s-crosshairs-FOMC-leader that was advocating patience with rate hikes.
Now some will claim Powell didn’t kowtow to Trump but rather reacted to a credit market freeze. I get it. Credit seized up. No doubt. But let me ask you something. Do you think if Trump had come out, and instead of lambasting Powell, said something to the effect that the financial economy was dealing with years of distortions and that he had faith his Fed Chairman was on the right path with his attempt to reset rates higher, do you really believe Powell would have backed off? I don’t. Not. For. A. Single. Second.
But Trump didn’t do that, so we will never know.
All that we can be certain of is that Powell is no longer tuning for the third R-star (financial conditions), but instead focused on the first two stars.
Financial economy will be the outlet valve
The interest rate needed to balance the “real economy” is significantly lower than that which balances the “financial economy.” Powell has been forced to choose. Either stop a bubble and crush the economy. Or try to let the economy grow and potentially create another bubble in the process.
At this point we know which way he has chosen.
Which brings me back to the original story about the Federal Reserve warning about the growing amount of corporate debt but offering no answer to the problem. They know the solution, but they are not prepared to do anything about it.
As the Federal Reserve allows interest rates to stay lower than the financial economy equilibrium point, more excesses will develop in the system.
Do I know if the Federal Reserve has already gone past the point of no return when private debt stops growing and starts to get paid back? Nope. Not a chance. And neither does anyone else. It’s still up in the air whether this debt expansion will continue.
But this private debt growth is a problem. A big problem. I am not sure that means you should rush out and short high-yield credit, but I know that private debt growth can’t continue expanding at this rate forever. Eventually it will slow, and god help us, even contract. That will have profound implications on financial markets.
The real question you should ask yourself is whether that day is here. Or whether Jay Powell was correct to worry about the bubble developing in the financial markets.
Was Jay Powell’s novice Chairman mistake raising rates too far too fast? Or was it giving in to Trump/Wall Street too early?
Many market pundits will tell you they know the answer. Good for them. I don’t know have a clue how they are so confident they know the right price for money and all the subtle interactions within the economic system.
But I am sure the rate of corporate debt growth is a worrisome development. Yet merely outlining a potential problem is much different than doing something about it. Be careful about assuming it will end tomorrow. Powell has abandoned the idea of tuning to financial conditions and the rate might still be low enough to encourage this debt to continue to grow.
I don’t know if it’s the cynic in me, but a little part wonders if Powell was a lot smarter before he started listening to everyone…
Thanks for reading,