Sleepy Hollow | In this issue of The Institutional Risk Analyst, we take stock of the state of things now several weeks since the political transition in Washington. Despite some dire predictions, the world has not ended and, indeed, the Federal Reserve Board is continuing to buy over a hundred billion in securities – that is, duration – out of the market every month.
The fact of quantitative easing (QE) forever has not only inflated stocks such as Tesla (NASDAQ:TSLA) but has caused its colorful CEO, Elon Musk, to “invest” $1.5 billion of his shareholders’ money, the treasury funds of the company, in bitcoin. Not only has the fact of QE forever lifted stocks, but it has also changed the behavior of investors. Passive and crypto are in, fundamentals and short-selling are out, when the central bank is overtly depriving private investors of returns to the financial benefit of the US Treasury.
There was a fascinating conversation on CNBC yesterday with Carson Block of Muddy Waters Research, a shop that offers diligence based investing. The guest made the case that the fact of passive investing has caused a decrease is short selling, a logical conclusion in our book. But more than this, by targeting the Fed funds rate as a policy tool, the FOMC has forced investors to give up on short-selling strategies in all but the most extreme cases like GameStop (NYSE:GME).
CNBC anchor Becky Quick asked Block whether the rise of passive investing was not the result of the democratization of investing, a lovely sentiment. But no, there is nothing democratic about the members of the FOMC manipulating asset prices to support the political goal of full employment.
Thou shall be long forever, is the message from the FOMC, meaning that we shall take long-term value from investors to boost short-term employment for those who do not invest. This was the Faustian bargain struck 50 years ago in Washington via the Humphrey Hawkins law, full employment instead of guaranteed employment.
The imperative of full employment has led to the economic endpoint of zero or negative interest rates. Those investment managers and lenders who ignore this imperative to full employment do so at their peril. Of course, nothing lasts forever, especially when the equity market’s emotional center is still governed by the bond market.
No less a person than Mohamed El-Erian warns that the bubble shall continue unless and until the FOMC “loses control over long-term bond yields.” But has the Fed ever really been in control of long-term yields? Or is that merely a convenient illusion? Our view, informed by long chats with Ralph, is that the offshore bid is the key factor in the analysis. Equity managers don’t generally understand the world of fixed income or currencies, but they do understand that rising Treasury bond yields are bad for client returns and commissions.
The bond market seemed content to tolerate massive US deficits when a Republican was in the White House and that party controlled a majority in the Senate. With the Democrats apparently in control, that calculus may not hold true in the face of tens of trillions in new debt during the four years of the Biden Administration.
To us, the imponderable question looking us all in the face is the fact that the FOMC may not be able to further expand QE from current levels. Or put another way, with reference to the chart from FRED above, volatility may continue to grow and long-bond yields could continue to creep higher, especially if Democrats in Congress begin to act unilaterally.
Once the FOMC does visibly lose control of the long end of the curve, then the proverbial game may be up. Treasury Secretary Janet Yellen told CNN on Sunday that: “There's absolutely no reason why we should suffer through a long, slow recovery." Such is the hubris of Washington in February 2021, but that may not be the case in the future. Doubling down on more "stimulus" spending after four years of runaway fiscal deficits under President Donald Trump may finally provoke the bond market.
“Inflation is not dead. It is not gone. It has not been tamed,” writes Brian Wesbury, Chief Economist at FT Advisors. “We can see the impact of this affecting markets. The 10-year Treasury yield has risen from roughly 0.6% in May 2020 to 1.2% today. The gap between the yield on the normal 10-year Treasury Note and the inflation-adjusted 10-year Treasury Note suggests investors expect an annual average increase of 2.2% in the consumer price index (CPI) in the next ten years, and those expectations are rising.”
One of the key factors that the FOMC considers in its monetary policy deliberations is expectations, particularly about future prices. Based upon our work in the world of housing finance, it is pretty clear that the Fed has succeeded in convincing people that home prices are going to rise for the next several years.
In the nuclear winter created by the FOMC, home price affordability is a bad joke – at least so long as the FOMC is buying $60 billion per month in mortgage securities. Remember when Fed Chair Yellen expressed surprise that more young people were not buying homes?
The joke's even funnier now, Madam Secretary, as home prices gallop along at double digit annual rates thanks to QE. Yet as we noted in our comment on MSRs last week (“Update: Commercial & Residential Real Estate, MSRs”), once the Fed buying of Treasury bills and agency MBS stops, the prices of assets with both positive and negative duration will quickly normalize.