September 19, 2024 | In past comments in The Institutional Risk Analyst, we’ve noted that the recent propensity of the Federal Open Market Committee to err on the side of more liquidity has created significant problems for the markets. In 2020, for example, the market for Treasury debt nearly collapsed despite "big" levels of reserves. Now the Fed has gone explicitly political, pushing an excessive 50bp rate cut just ahead of a presidential election. What could go wrong?
Chairman Powell panicked in 2019 and began a vast increase in liquidity that ultimately drove a huge uptick in inflation two years later. Now, Powell seems to be desperately trying to block the election of former President Donald Trump. If President Trump wins in November, he’ll be more than justified in demanding Jerome Powell’s immediate resignation. Trump cannot legally remove Powell as a governor without impeachment, but he can certainly appoint another Fed Chairman.
Readers of The IRA will recall that when President Harry Truman declined to reappoint Mariner Eccles as Chairman in 1948, Eccles remained on the Board to support Chairman Tom McCabe's fight for Fed independence. We note that important period in the revised edition of "Inflated: Money, Debt and the American Dream":
"Though not reappointed as chairman, Eccles remained on the board and fought for the Fed’s independence during the remainder of his term as governor until he resigned in 1951. McCabe was pressured repeatedly by President Truman and Snyder to continue supporting artificially low interest rates, publicly and privately. Yet he, Eccles, Sproul, and the other members of the FOMC stood their ground and defended their responsibility for controlling inflation, which was a plausible threat from 1946 to 1950. But more important, McCabe and other Board members wanted to end the direct purchases of Treasury debt and create a dealer network to finance government needs."
Kudos to Fed Governor Miki Bowman for her dissent on the FOMC’s decision. Not only is any possibility of a recession fading rapidly, but the FOMC has not really even begun to reduce the level of reserves in the system in 24 months of supposed tightening. This added liquidity in the money supply, added to the brisk rate of increase in the federal deficit, means that real liquidity in the system is growing at close to 10% annually.
Q: What does the FOMC see in the “data” that would justify such reckless action? The chart below shows reserves, the Treasury general account and reverse repurchase agreements.
As we noted last week (“Powell FOMC Folds on Inflation”), since the US Civil War, fiat dollars (aka "greenbacks") and Treasury debt have been functionally equivalent. Menand & Younger (2023) remind us that Alexander Hamilton perceived that government debt had a “capacity for prompt convertibility” to currency, potentially rendering transfers “equivalent to a payment in coin.” In other words, they note, claims on the sovereign exist in a superposition of states between money and debt. This conveyed a special status on direct obligations of the federal government compared to all other financial assets, especially "at a time when money was in short supply."
For financials, this latest lurch in monetary policy under the Powell FOMC suggests that our view of the macro outlook is correct. The Fed has made some subtle tweaks to the Basel III proposal that are beneficial to banks with large retained portfolios of low coupon MBS. Indeed, low coupons actually outperformed higher coupon MBS yesterday, contrary to our expectations.
"Fannie Mae to-be-announced coupons of 5% and lower outpaced their Treasury hedges, with 3% coupons performing best," reports Scott Carpenter of Bloomberg. "Unlike higher coupons, lower ones are less negatively convex and may have reacted more favorably than higher coupons as the half-point reduction was larger than many expected."
We’ll be discussing these and other changes affecting financials in our next comment for subscribers to the Premium Service. But for now, Chairman Powell has set the US on a course for a liquidity driven rally in stocks and home prices over the next several years, but look for that maxi reset in home prices and financial assets on or before 2028, as we discuss in our latest book.
Next week, WGA Chairman Christopher Whalen will be discussing the political and practical prospects for Fannie Mae and Freddie Mac to be released from government control. The event will be held on Monday in New York City and is sponsored by Odeon Capital. Please contact your Odeon Capital representative for more details.
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