Thursday, December 20, 2018

The Fed screwed up badly

In the comments section of an earlier post (, I said:

The interaction of the Fed and the market is a complicated dance, where one leads the other and vice versa. The bond market has been telling the Fed to back off on its plans for higher rates, and I think the Fed has been getting this message. At the same time the Fed has been trying to reassure the market that it has confidence in the economy and the outlook for inflation, but that at the same time it is not willing to do anything rash.

To extend this analogy to the disastrous market reaction to yesterday's FOMC announcement and Powell's subsequent comments, I would say I made the mistake of believing the Fed knew how to do this dance. Unfortunately, the Fed seems to be dancing with two left feet, and has in the process severely injured the feet of its dancing partner, the market. The Fed did not take the bond market's advice to back off on its tightening agenda. The Fed ignored the obvious signs of angst that are playing out around the globe, and it ignored the evidence pointing to declining inflation and declining inflation expectations. A pause was called for and warranted; instead the Fed preferred to tighten and to project a further two tightenings next year, in spite of the fact that the market was not prepared for any further tightenings. And on top of that, Powell said that the unwinding of the Fed's balance sheet was on "auto-pilot," as if nothing could go wrong in the interim.

To make matters worse, former NY Fed Chief Bill Dudley spoke to Bloomberg this morning and essentially seconded everything Powell said yesterday, i.e., the Fed was right to hike rates and there is every reason to think that more hikes are warranted. 

In short, the Fed now has convinced the market that it is more likely than not to over-tighten policy, and that, in turn, raises the spectre of another Fed-induced recession. (Very tight monetary policy is directly responsible for every recession in modern times, as I've repeatedly noted in this blog.)

If the Fed does not reverse course or otherwise clarify its intent, soften its stance, or display more concern for the market's angst, then the chances of a recession will increase significantly. It's hard to believe that Powell would insist on snatching defeat from the jaws of victory, but that's the message he has inadvertantly sent the market. 

There is still plenty of time for Powell to set things straight, because the key financial market and economic fundamentals are still intact. But in the meantime things are likely to get uglier.

Chart #1

Chart #1 shows what in my opinion is one of the most important financial indicators of all: 2-yr swap spreads. These have been excellent leading and coincident indicators of liquidity, systemic risk, and economic health. At current levels (~15 bps), swap spreads are exactly where you would expect them to be in a normal, healthy world. Eurozone swap spreads are on the high end of normal, however, but we know the Eurozone economy is struggling, and possibly flirting with another recession, if recent guidance from Fedex is a guide. As I mentioned yesterday, the US economy appears strong, and swap spreads support that view. They say that systemic risk is low, liquidity is abundant, and the financial and economic fundamentals are healthy. You couldn't ask for anything more.

Chart #2 

Unfortunately, Chart #2 shows that Credit Default Swap spreads are somewhat elevated. I think the main reason for this can be traced to the huge and recent decline in oil prices: it's a replay in a sense of what happened in late 2015, when collapsing oil prices created tremendous pressure on the bonds of energy-related companies. We can't rule out the negative impact of Fed tightening, but for now the main driver of wider spreads seems to be falling oil prices. That can be very painful for oil producers and related industries, but we survived worse just a few years ago, when oil prices truly plunged, from $110/bbl to a mere $30. More recently, the drop has been from a high of $75 to $46. 

Chart #3

Chart #3 compares the price of crude oil to the market's expectation for what the CPI will average over the next 5 years. Inflation expectations have fallen in direct proportion to the decline in oil prices, much as they did in late 2015. Inflation expectations are down mostly due to cheaper energy, and not, as one might fear, to the Fed being too tight. If the Fed were really squeezing market liquidity, 2-yr swap spreads would be high and rising.

Chart #4

Chart #4 compares the value of the dollar (inverted) to the level of industrial metals prices. There is a strong tendency for commodity prices to be inversely correlated to the value of the dollar, and that is easy to see during the period 1997-2014. More recently, from 2015 thru 2018, the correlation has declined significantly, as a much stronger dollar has resulted in only a modest decline in metals prices. I think this shows that the dollar is not "too strong," and that in turn implies that the Fed has not been too tight. If the Fed were intent on creating a shortage of dollars in order to slow the economy, the dollar would be much stronger and/or commodity prices would be much weaker.

Chart #5

Chart #5 shows the market's projection over the past six months of what it thinks the Fed's target funds rate will average in December 2019. Of note is the huge decline beginning last month, from 2.93% to 2.55% today. This is completely at odds with the Fed's current expectation, as announced by Powell yesterday, that the funds rate will be 3% by the end of next year (i.e., two more tightenings in 2019). This is the market's way of telling the Fed that it is on course to over-tighten and thus risk a big economic slowdown or even a recession. You don't need an inverted yield curve (which is still modestly positive) to know that the market is worried about the Fed and the economy. This chart tells you all you need to know. If yesterday Powell had announced a pause and conditioned future tightening to the health of the economy and the state of global markets (e.g., trade tensions) the market would have reacted positively instead of negatively. 

Chart #6

As Chart #6 shows, there is blood in the streets. Fear and uncertainty are surging, and the stock market has plunged almost 16% from its all-time high of last September. At this rate we're likely to see more blood unless and until Powell walks back yesterday's comments. We're not yet in a full-blown panic.

On the positive side, all it takes is a few words to put things right. The damage done to date is not significant or permanent, and it is reversible.


Fred said...

Don't you think the market would crash if Powell said: "Oops, I screwed up badly and need to reassure you that I'm not incompetent." ?

WealthMony said...

I do not presume to have the knowledge or wisdom to advise the Fed, but as an investor with substantial assets at risk, I must say I am bewildered. The increases that the Fed has already imposed takes time to impact the economy, and the inflation rate is at or under the Fed's target. Oil prices are plunging. Where is the urgency to raise rates when the Fed has also projected lower GDP growth for 2019? Paul Gigot, of the WSJ, said a couple weeks ago that the Fed should not raise rates. Only Brian Wesbury wants higher and higher rates.

In addition to raising rates is the $50 billion per month roll off from the Fed's balance sheet. That's something I do not understand. If Scott would be so kind to explain how this impacts the money supply and market liquidity, I would greatly appreciate it.

From what I understand the Fed's balance sheet prior to the Financial Crisis was around $870 billion. During the crisis it added $4.5 trillion by buying Treasuries and Mortgage Backed Securities as an asset, and increased bank reserves by an equal amount as a liability. If bank did not use those reserves, how did they help pull us out of our economic mire? I don't understand that the Fed is selling $50 billion each month, but is just letting letting proceeds from maturities offset bank reserves. Are they sending these maturing proceeds to the Treasury? Exactly how does Quantitative Tightening reduce liquidity in the economy? An explanation would be greatly appreciated.

John A said...

If the Fed did not tighten, the markets would have realized they were acknowledging the economy was weakening, and they would have tumbled in response. If the Fed did tighten, the markets would have tumbled because of the tightening. There was no winning situation.

Fred said...

Lots of reasons to be grumpy about the economy going forward including all of Trump's best people abandoning the ship. I can't imagine what's it like to have to work for him. You can make all the arguments you like about the market being upset about he Dems taking control of the House but at the end of the day we're still stuck with a totally out of control President who, according to Tillerson, is an F'ing Moron.

Scott Grannis said...

WealthMony, re how Quantitative Easing and reducing the Fed's balance sheet work.

For detailed explanation, see a collection of my posts on this subject over the years:

The short answer is that when the Fed expanded its balance sheet by buying Treasuries and Mortgage Backed Securities, it "paid" for them by issuing bank reserves, which are not money but which are equivalent to T-bills: risk-free, short-term securities. This was done in order to satisfy the world's demand for safe assets. The Fed effectively transmogrified bonds into T-bills.

Now that the demand for safety has declined (at least until recently), the Fed is simply reversing the process by selling bonds in exchange for bank reserves, which it then extinguishes. This could be problematic only to the extent that the Fed reduces the supply of safe assets by more than the world is comfortable with. To date I have not seen signs that this is the case. The most obvious place to observe a problem would be in swap spreads, but those remain quite low and suggestive of plentiful liquidity conditions. In addition, bank lending continues to expand. Conclusion: to date the Fed hasn't disrupted the financial markets, but now the market worries that it might well be a disruptive factor in the near term.

Scott Grannis said...

John A, re the Fed facing a no-win situation.

I disagree. I think the Fed could have announced a pause in its tightening program, and cited the unusually high level of global angst and market turmoil as a rationale. After all, there is no evidence that inflation is rising or becoming more likely: inflation expectations are falling, actual inflation is below target and falling on the margin, the dollar is not collapsing, and non-energy commodity prices are range-bound. I think the market would have looked at such a reasoned move as a responsible one. Why should they try to fix something that is not broken?

Unfortunately, there are some in the Fed (like Bill Dudley for example) who still believe in the Phillips Curve theory of inflation, which holds that very strong growth inevitably leads to rising inflation (in other words, the Fed should always try to keep the economy from "overheating" in order to keep inflation under control). This theory has been roundly discredited by many, but it lives on.

Tin said...

The Fed action isn't the problem, the problem is Powell's garbled babbling about 2 more hikes and leaving QT on autopilot. The man has a singular talent for driving down the market (7 straight Fed Days, an all-time record-- And yesterday was the All Time Record Losing Fed Day.)

John A said...

@Scott: "I think the Fed could have announced a pause in its tightening program, and cited the unusually high level of global angst and market turmoil as a rationale."

But, would markets have actually *believed* that rationale? I doubt it. They probably would have just realized that the Fed *really* thinks the economy is slowing, and as I said, tanked anyway. Just because the Fed says some rationale, doesn't mean markets will buy it. People are always trying to read in-between the lines, and rightfully so.

honestcreditguy said...

why not cite inflationary pressures have been reduced and point at the 10 year that he testified is the big indicator for next move in last congressional testimony, its below where he wanted it...

fwd pe of spx is now around bubble number there....
risk sectors are even lower....

I'm going on record and blaming this on the Dimon Trump smarter dumber exchange in Sept and the Kashoggi oil top....

steve said...

The reason the Fed hiked is DT's insistence that they NOT hike! They had to appear independent and did they ever. That said, Powell may be in over his head judging by his erratic remarks. The market perceives we're rudderless and that AIN'T good.

Tom L said...

Scott - Looks like the Fed was reading your posting

New York Fed President John Williams says the central bank is ready to “reassess and re-evaluate our views.”
“What we’re going to be doing going into next year is re-assessing our views on the economy, listening to not only markets but everybody that we talk to,” Williams tells CNBC.

Thanks for all your insights this year - and happy holidays!

brave chicken said...

Fed rates too high and S&P earnings way too high and global political chaos -- what could possibly go wrong next year?

Tom Nugent said...

The Fed's great role is lender of last resort as evidenced by the Fed's savior role on Tuesday, Oct 20th, 1987. To relate an anticipated 1/4% increase in the Fed funds rate (in the old days they would do 1/2 to 3/4% as standard fare) to a 900+point swing on the day of the announcement stretches my imagination. This selloff is directly attributable to the unwinding of speculation and forced liquidation of many hedge funds and unwinding of margin positions in the face of rising financing costs. Watching the markets trade it feels more like Black Monday or the flash crash rather than the legitimate beginning of a bear market.

Scott Grannis said...

Tom: Indeed, this is now looking like a full-fledged panic attack. PE ratio for the S&P 500 is down 30% from its Jan. '18 peak. The market will soon be very "vulnerable" to good news.

Anonymous said...

Interesting. If this is just a panic attack it will be interesting to watch how the stock market leads, and where it will be, into the next actual GDP contraction.

Benjamin Cole said...

Great posts by Scott Grannis.

I think there are a couple genuine worries out there, and markets are reacting.

Trump is Trump. But China is China as governed by the Communist Party of China. The CPC is reasserting itself into every facet of China society, most importantly the business scene. China is not progressing to a more democratic or liberal nation as we all hoped. It is a risky place to have your supply chain. How do you like those apples?

Property markets. It seems like recessions always start in property and property feeds on credit. Some people say the endogenous supply of money is very important and they may be right.

I think the Fed has been too tight and has been too tight since about 2006. Central banks need to reassess. Economies change. The threat today is no longer from high inflation but rather from slow growth.

Speaking politically, another recession could make Bernie Sanders president.

ckhajavi said...

Scott - I know everyone wants to come up with an explanation when the market falls but aren’t you the least bit concerned that we are running a trillion dollar deficit in a healthy environment - the market is now much lower than when the tax cuts were introduced suggesting the market beleives we got a sugar high and now reversion back to lower gdp which equals lower tax revenue just as the treasury is borrowing like mad - this is clearly going to crowd out the private market to some extent - maybe we are finally hitting a wall on this debt driven expansion and the only solution will be the fed deciding to start cutting again as they realize the system can’t handle higher rates - maybe I’m babbling here but something seems very wrong to me and Im not just going off the price action in the stock market

Al said...

Swap spreads loOK beatiful. This is a Christmas gift. Buy buy buy!

ronrasch said...

Scott thank you for your outstanding analysis. Good to see signs of the Fed backing off.

Brad Reid said...

From Chairman Powell's Q&A session, one of the most interesting exchanges led to him replying that the committee recognized that as the unemployment rate has steadily dropped over the years from its high point after the 2007/9 debacle . . . to its current sub 4% reading, that there has been no attendant increase in inflation. In your opinion, will this influence the FRB's thoughts going forward on the Phillips Curve? A follow up question: If new hires add to the supply of goods and services in an economy, get paid, and then create a new "supply" of demand for other goods and services, why would anyone expect this to be inflationary? Is the "growth causes inflation" theme being challenged? Brad

The Cliff Claven of Finance said...

"If yesterday Powell had announced a pause
and conditioned future tightening
to the health of the economy
and the state of global markets
(e.g., trade tensions) the market
would have reacted positively
instead of negatively."
I disagree with the above comment.
No one knows what the market would have done "if" ...
More importantly, investors have been in a bad mood
for a month, where almost all news is interpreted
negatively, rather than logically.
If the Fed had NOT raised ST rates,
perhaps investors would have been more depressed,
thinking the economy must be weakening for that
to have happened, and stocks would have gone down anyway?
What looks like a stock market correction started with
very high valuations, except for the P/E Ratio, which is,
unfortunately, the only valuation ratio tracked here.
Whether the "correction" is really the start of a bear
market depends on whether a recession is coming.
Unfortunately, the economy usually looks good
in the months before a recession starts ... except
for the stock market ... which is a leading indicator
of a recession.
I'm not the fed Chairman, so it doesn't matter
that I think there was no need to raise ST rates
... but the Fed is also reducing its assets --
which is the opposite of its former policy ...
that SUPPORTED a rising stock and bond market.
Just my two cents.

Anonymous said...

A comment on output data being representative of a strong economy.

Yes. Industrial Production and physical transportation related indices show the status of current economic activity and are relevant, but only to the extent that the output being manufactured and transported will be consumed.

In other words, and I'm sure Scott knows this, output adds to inventory that may or may not be consumed. If that previously manufactured aggregate output is not consumed then we will have to retract output to re-equilibrate aggregate supply and aggregate demand.


Scott Grannis said...

Cali Coast, re "output adds to inventory that may or may not be consumed."

Yes, it's possible that production (supply) can exceed eventual demand, and that producers can over-estimate future demand, resulting in an inventory buildup that would be followed by a production cutback. But as a supply-sider, I find a lot of wisdom in the great economist F. Say's dictum (paraphrasing here) that "supply creates its own demand."

In the Keynesian world, demand is the driver of the business cycle. But in the Supply-Side world, supply is the driver. You must first produce if you are then to consume. To be sure, on a micro level, some producers will tend to over- or under-estimate demand. But on a macro basis, total consumption is limited by total production. Collectively, we cannot consume more than we produce.

ckhajavi said...

Stocks are extremely expensive on a price to sales basis Scott - margins are well above the mean hence the pe is low - margins have always mean reverted and if this time proves no different the stocks are cheap argument is out the window - the market is saying margins going down -
Maybe the market is wrong - it often is but the stocks are cheap argument doesn’t hold water given market cap
To gdp and price to sales - pe only one variable

Scott Grannis said...

Re swap spreads and credit markets "seizing up." I think both these gentlemen are exaggerating current conditions, perhaps egregiously so.

2-yr swap spreads both here and in the Eurozone have actually declined as the stock market has dropped. US 2-yr swap spreads are now a very low 13 bps, Eurozone spreads now 47. CDS spreads are up in the past few months, but have declined a bit in the past two days. They are not in any kind of danger zone, and most of the rise can be attributable to lower oil prices putting pressure on oil producers. So with the exception of swap spreads, which are the most important gauge of the market's financial health and which are very low (and thus indicating great liquidity conditions), credit spreads are up in recent months but are not anywhere near the levels that might be characterized as "seizing up." Another measure of credit market health is the TED spread, which has moved up in recent months to a current 40 bps. This is somewhat elevated relative to the 15-25 bps which might be considered normal, but it is far below the 300+ level reached in late 2008. The TED spread hit 63 bps early last March. Credit markets actually did "seize up" in late 2008, when 2-yr swap spreads reached 170 bps and 5-yr IG CDS spreads reached 275 bps (they are currently 92 bps).

Smart_Margauz said...
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