November 26, 2024 | Updated for FOMC | Yesterday we turned in the final draft of "Inflated: Money, Debt and the American Dream" to our editors at John Wiley & Sons (WLY). We edited 20,000 words from the original book and added a new chapter to deal with the Ben Bernanke, Janet Yellen & Jerome Powell FOMCs from 2010 through the election of President Donald Trump. We also added some great great new material from Jim Rickards, Judy Shelton and many others.
What did plunging back into the financial history of the United States for the past year tell us? Nothing has changed. Americans are part Calvinist prudes, part libertine punters who would rather speculate on the next thing than be concerned about the actual details of today. Think of the advocates of crypto tokens as the descendants of the silverites of the 19th Century.
Like silver coinage, crypto currencies represent an ideal index of mounting inflation and financial stress within the 175 year-old fiat dollar system, but offer no means of escape. Like private equity, as we discuss below, crypto currencies are merely a convenient receptacle for excess fiat liquidity. One thing that has not changed in the second edition of “Inflated” is the invocation from Frederick Hayek:
“I do not think it is an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order. A good money, like good law, must operate without regard to the effect that decisions of the issuer will have on known groups or individuals. A benevolent dictator might conceivably disregard these effects; no democratic government dependent on a number of special interests can possibly do so.”
Among of the most asked questions from our readers concerns the direction of interest rates and particularly long-term yields. We think a rapid retreat on short-term yields is pretty much a given, as and when an adequate economic pretext arrives, but longer yields are likely to rise due to the federal budget deficit.
The prospect of a liquidity-driven capitulation from the Fed is growing even as the federal debt mounts and LT yields rise. Note, for example, that the FOMC has reduced the rate on reverse repurchase agreements (RRPs) 5bp to the "floor" or bottom of the policy range. This is not a "technical" amendment folks and reflects the growing bias of the Committee towards ease. Watch what they do, not what they say. And remember, Congress did not give the Fed authority to pay interest on deposits of money funds and GSEs (h/t Bill Nelson).
Fed chairmen like Arthur Burns and Paul Volcker once lectured Congress about budget deficits, but not in the age of “big” liquidity and de facto fiscal policy by the FOMC. Buying trillions of dollars in securities and losing hundreds of billions in taxpayer funds is a fiscal operation, whether or not the Fed or Congress care to recognize it. Will President Trump hold Jerome Powell responsible for the results of the Fed's hedge fund?
The Fed will continue to lose money on its portfolio for years to come as trillions of dollars in mortgage-backed securities purchased by the Fed Board under Chairs Yellen and Powell linger. Since the 10-year Treasury is the indicator of solvency for US banks and also the reference for residential mortgages, the fact of a 4.3% yield is not welcome news. The Mortgage Bankers Association has just pushed down loan production estimates 10% for 2025 to just $2.1 trillion. That figure may yet fall lower if LT Treasury yields rise further.
There was a funny article in Bloomberg at the end of September lauding the US banking sector for dodging the bullet on unrealized losses, but this was before the 10-year Treasury backed up 75bp in yield through October. If as we suspect the Fed eventually drops short-term interest rates, the long end of the Treasury yield curve may rise, exacerbating the trillions of dollars of losses hidden inside many US banks, and also private equity and credit funds.
Speaking of unrealized losses, Robin Wigglesworth wrote a great piece in the FT earlier, detailing the mounting trainwreck in the world of private equity. PE managers are actually resorting to outright fraud in order to conceal the extent of the losses and, most important, continue paying themselves management fees.
When you don't need to report results publicly, it is easy to defraud credulous investors who must window dress their badly considered decision to invest in private vehicles. Wigglesworth notes that “the growing use of “payment-in-kind” loans — where interest payments are rolled into the principal rather than paid to lenders — is a sign that all is not well in private creditland.” No indeed.
Truth to tell, many of the investors in the world of private investing are just as insolvent as the large banks. “Quietude on ostensible defaults does not constitute good cashflow returns for private credit lenders,” opines Nom de Plumber from his Manhattan risk vantage point. “Payment-in-kind interest and principal may forestall defaults and loss severities, but do not return liquid capital.”
Bloomberg’s David Wighton notes that “returns from venture capital have shriveled since the bubble burst at the start of 2022. UK venture capital funds lost 25% of their value last year, according to figures for members of the British Private Equity and Venture Capital Association.”
The trouble with private equity, of course, is that it is private. Without a public market price to validate the claims of managers, investors have no way to test the supposed valuations or returns reported by the long list of conflicted professionals involved. Given that President Trump has vowed to tax the “profits” within the endowments of some of the largest US universities, for example, the pretense surrounding PE returns may soon end as endowments fess up on concealed portfolio losses.
At the end of October, the State of Florida announced its intention to sell up to $4 billion in private credit loans. Nom de Plumber notes that it will be interesting to see if and how this open-market sale of illiquid private credit assets occurs. “For once, Florida may be staying ahead of a storm,” he advises with tongue in cheek.
Of note, Elizabeth McCaul, a member of the ECB’s supervisory board, said that some firms involved in private credit “have grown to such a scale and have reached such a level of interconnectedness that they now exhibit systemic characteristics.” Could President Trump be faced with calls for bailouts of PE funds in the New Year?
The size of private credit shops makes “their stability integral to the health of the broader financial system,” McCaul declared, although without naming any specific firms. It is important to remember that banks fund much of the world of private credit via "secured" commercial loans to managers. These loans often feature double-digit coupons, one reason why yields on bank loans have risen -- at least in theory. But will relatively new bank loans to private credit firms turn to ashes?
Whether we are talking about banks or private equity, the prospect of higher LT interest rates means that financial stress in the global dollar system is rising. Even though the yield on bank loan portfolios has jumped several hundred basis points since 2022, average yields on securities have barely moved, as shown in the chart below for the banks in the WGA Bank Top 100 Index.
Source: FFIEC
The average yield on $2.9 trillion in MBS held by US banks was just 2.8% in Q3 2024. Fannie Mae 2.5% MBS are trading at 83 cents on the dollar, suggesting a market-to-market loss of more than $500 billion for this category of bank assets alone. The Treasury 2.875% bonds of 2043 are trading at ~ 78-13 this morning.
There are many large banks in our surveillance group with yields below this level, as we noted in our profile of Bank of Hawaii (BOH) last week. Indeed some of the largest US banks in our surveillance group have loan and securities yields significantly below the Peer Group 1 average.
If yields on the 10-year Treasury note move above 4.5%, the alarm bells will start ringing in Washington. If yields touch 5%, then the entire US banking industry will be in distress and the Federal Reserve Board will have already resumed QE with a focus on longer-dated maturities. And all of this may happen before Donald Trump has even taken the oath of office in January 2025.
Treasury Secretary-designate Scott Bessent earlier announced a "3-3-3" plan inspired by the late Japanese Prime Minister Shinzo Abe, which most resembles a policy proposal from President Joe Biden. Abe adopted a "three arrows" plan that featured aggressive monetary policy along with fiscal stimulus and structural reforms aimed at lifting Japan's economy from stagnation and persistent deflation.
"U.S. Treasury was able to save the country during the Civil War by expanding the deficit… They saved the economic well-being of the country during the Great Depression by spending. And then we were able to save the world during World War II. So we have to get this down, or we have no room for maneuver," Bessent said in a speech.
Of note, the Abe "three arrows" plan of two decades ago was a dismal failure and led to the Bank of Japan engaging in more yield curve control (aka "financial repression"). Our bet is that the Bessent "3-3-3" plan likewise will be a failure and that the Fed will be forced to restart QE sooner rather than later to rescue commercial banks, funds and of course the US government from overmuch debt. Now you know why we have avoided bank common stock since 2022. Happy Thanksgiving to all!
In our next comment, we will don the Raging Bull hat and provide a detailed check list of what needs to happen before the GSEs, Fannie Mae and Freddie Mac, are released from conservatorship. Suffice to say if the well-regarded Treasury nominee gets started on release immediately after confirmation by the Senate, Bessent still may not have enough time to get the job done in a little less than four years. And this assumes that the US financial markets somehow avoid a real-world mark-to-market in the meantime.
First Half 2025
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