Chair Yellen Spills the Punch Bowl
“Across the globe, investors have one thing in mind. How far will interest rates rise and is the great bull market in bonds finally over?”
Henry Ford's missing punch bowl
New York | The proverbial punch bowl has been spilled all over the floor. Not surprisingly, the departure of Janet Yellen as Chair of the Board of Governors of the Federal Reserve System is bad news in many quarters. The speculative policies that helped gun assets prices around the world are now ending – at least for now. An eight year bull market in bonds is also seemingly at a conclusion. Quantitative easing or “QE” went on for years longer than necessary, thus Yellen’s successor, Chairman Jerome Powell, must clean up a particularly large mess.
Cleaning up other people’s messes is, of course, the key job requirement for being Fed Chairman and, particularly, President of the Federal Reserve Bank of New York. Names like Volcker and Corrigan return to front of mind, but the past three Fed chairs have not deigned to dirty their hands with mere banking. The mess cleaning task of the Fed is similar to the role played so wonderfully by Sally Hawkins and Octavia Spencer in The Shape of Water, our vote for the Oscar this year BTW.
Besides conveying dying broker dealers and insurance companies into new hands, the merger of dying zombie banks with the living, and most important, preserving the Treasury’s access to the debt markets, the Fed is now tasked with cleaning up a mess in Washington. This last responsibility is about to become particularly difficult as we rocket into the future with a Republican Congress that refuses to raise revenue out of fear of losing the next election.
Before Chair Yellen actually walked out the door, the Fed’s Supervision & Regulation function announced supposed sanctions against Wells Fargo & Co (WFC). The bank engaged in widespread acts of fraud against customers, apparently for years. The sanctions are an embarrassment and amount to a single gentle slap on the backside by the Fed. For starts, by telling a $2 trillion asset zombie bank and the largest loan servicer in the industry that they cannot get bigger, you are doing the CFO a favor. After all, it's about equity returns.
The Fed has the power but not the will to act. For example, replace the CSUITE of WFC and force the bank to sell 50% of its assets. Then the Fed would be doing its job, as it would do without hesitation with a smaller institution. But by slamming dying zombies into healthy banks for fear of damaging confidence, the Fed created the governance problems at WFC. And the US central bank dares not challenge the bank monstrosities it has created over the years, in part because they are all primary dealers in US government bonds.
None are more surprised about the market's turn of affairs than the inhabitants of Wall Street, both the perpetrators themselves and their loyal scribes in the world of financial journalism. The idea that markets for stocks, bonds and real estate might need to correct a bit after galloping along for five years at multiples of the official inflation statistics is a revelation to many -- but certainly not all. We still have “positive fundamentals,” you understand.
Most of the senior pundits in the financial press have asked the right questions at one time or another, but as former Citigroup Chairman Chuck Prince lamented, on Wall Street you dance until the music stops. Or as they used to tell teary eyed fans at the end of his concerts, “Elvis has left the building.” No, Chair Yellen will not be playing an encore. And the timing of Chair Yellen’s departure is particularly unfortunate for the overbought and overheated financial markets.
Washington has just done a reprise of sorts, repeating the market movements seen after the 2016 election. The yield on the 10-year bond is rising towards a five-year high, attracting cash from absurdly over-stretched equity markets. The chart below shows the 10-year Treasury bond and the S&P 500 Index. The arrow indicates the November election and subsequent discontinuity that included a surge in interest rates and stock prices. Was the post-election uptick in stock prices supported by “good fundamentals” or the proverbial animal spirits?
Our friend and The IRA reader Dick Hardy down in Atlanta worries that the ratio of the 10-year Treasury bond and the SPX are nearing a worrying divergence. “Note the head and shoulders pattern developing, and note that if one draws a trend line off the 09 low and 14 low the trend has been broken. A break below 90 (the approximate head and shoulder neckline) would be an ominous sign. Might want to put this one on your watch list,” he writes.
With most markets fully correlated, we may all be staring into the eye of a perfect storm in formation. First, Congress has just passed tax reductions that promise to greatly increase Treasury funding needs in the near term. Indeed, the position taken by Secretary Stephen Mnuchin and his predecessors about the US Treasury issuing primarily short-term debt seems to be evolving with each passing day. Look for those 10s and 30s to be reopened more frequently in coming months as the reality of Argentine style fiscal policy in Washington collides square on into a receding bond market and a weak dollar.
Of particular interest is the decision by the Chinese government to reduce outflows of yuan and how this political shift will impact foreign asset prices. Press reports suggest that epitomes of leveraged growth such as HNA Group seem headed for default, although we still don’t know who actually owns the company! Speaking of AML violations, let's ponder the fact that global regulators and counterparties have no idea as to the overship of HNA, the largest shareholder of Deutsche Bank AG.
Reports that HNA and other Chinese investors may be forced by Communist Party leader Xi Jinping Beijing to lighten up on foreign real estate certainly provides food for thought. Will the forced assets sales by some of the more egregious examples of excessive leverage in China cause a general liquidation of the Yellen bubbles in stocks and bonds? As one New York real estate publication The Real Deal warned, "Brace yourself for a yard sale."
The unwind of large bubbles does not necessarily happen quickly. The Great Crash of 1929 was actually the final crescendo of a period of financial boom and bust that began to end with the collapse of the FL real estate market in the mid-1920s. John Kenneth Galbraith, writing in his classic 1954 book “The Great Crash, 1929,” describes how parcels of land in Florida were divided into building lots and sold for a mere 10% down payment. In effect, Americans of the early 1920s were trading fractional options on FL real estate.
Charles Ponzi, the great American fraudster and namesake of the financial pyramid scheme, was actively involved in selling parcels of land in Florida in the 1920s. He leveraged a steadily growing flow of investors until 1927, when the tide of new investors peaked and the FL property market began to crack. Sound familiar? Bitcoin is merely the modern day extension of the alluring logic of Charles Ponzi, albeit enabled by the Internet.
The Great Crash of the stock markets in 1929 was not the final act, however, and would lead to the catastrophe of the banking crisis of 1933. As recalled in Ford Men: From Inspiration to Enterprise, a decidedly selfish Henry Ford helped to crater the US banking system by threatening to withdraw his cash from Detroit's banks. From early 1933, financial institutions from Chicago to New York closed for months and even years -- all thanks to Henry Ford’s enmity for his former business partner, Senator James Couzens, and most people generally.
Scores of private banks and businesses failed in the forced deflation from early 1933 onward. When President Franklin Delano Roosevelt made his famous March 1933 inauguration day utterance about Americans having “nothing to fear but fear itself,” every bank in New York was closed. Millions of Americans were quite literally standing in the streets of major US cities. The terrible year 1933 was quite a bit worse than the crisis of 2008.
Out of the experiences of the Great Depression and World War II, the Fed and Washington generally have evolved a progressive attitude towards “pump priming” consumer demand that has led us to the current juncture of zero rates and infinite duration. Most of the industrialized world, including China, is drowning in bad debt, but this fact goes unremarked.
Several years ago, the big idea coming from Chair Yellen and her comrades on the Federal Open Market Committee and other global central banks was to lever up the economy with even more debt. This increase in global leverage included the purchase of trillions of dollars in stock funded with record amounts of corporate debt.
Just to add some spice, the Yellen Fed purchased two trillion dollars worth of mortgage paper -- bonds that will sit on the Fed’s books for many years to come. Indeed, should we start to see mortgage agency bond issuance with 4 and even 5 percent coupons not so far down the road, the duration of the Fed’s MBS position will explode -- even as the nominal principal amount very slowly runs off. But at least holders of mortgage servicing rights (MSRs) can look forward to big positive marks in Q1 2018.
The pressing question facing investors is whether interest rates will follow the pattern seen a year ago, when Treasury yields feel as the market retraced the increase in yields seen after the election of Donald Trump. The key market benchmark flirted with 2% yields in September last year. With each uptick in interest rates, the massive amounts of investor cash sitting on the sidelines returns, acting to counterbalance the market’s bearish tendencies.
The difference between last year and 2018, however, is that now the Treasury is seeking to fund trillions of dollars in red ink to fund a badly advised peacetime pump priming effort. Don’t get us wrong. Structural tax reform is great. But the US badly needs to raise some revenue pronto or will run the risk of looking ridiculous to the entire world.
The danger here stems not from the colorful occupant of 1600 Pennsylvania Avenue but from the fact that the larger building down the street that sits atop Capitol Hill appears to be empty -- of courage or even practical perspective. Market prognostications aside, the lack of political will among America’s leaders when it comes to matters of money is the biggest risk facing the world in 2018.