QE Unwind and Charge of the Horsemen

This is one of those times I am glad I am not paid by the word. I was in the car on a long drive this evening and heard the soporific tones of NPR’s Kai Risdahl going through the day’s financial results.  

“Down day for the Dow today, closing off one-tenth of a percent.”

“Down day for the Nasdaq as well, closing one-tenth of a percent lower”

“The S&P 500 fared no better, closing down four points, just under two-tenths of a percent.”

Really? I mean...really NPR? Couldn’t you have just saved us all a little time and said, “everything basically unch...again.”  

There was a time earlier this year (and for the prior decade, I guess) when I would wake up, fire up my laptop to get the overnight price action. For the past three months I just hit snooze, read the Wall Street Journal, and figure prices will come to me if they are worth looking at.

Today I spent some time thinking back to 2006 as a part of a piece I am working on about the potential downside of a victory by the populist candidate in the upcoming Mexican presidential election. Turns out markets were hustling pretty good back then! There was a fare degree of vol….but that had done nothing to shake the complacency of years of monetary quaaludes and financial accumulation. There was vol….and there was the BTD mentality...but it took until at least 2007, arguably right into the weeks just prior to the Lehman bankruptcy in 2008, before it was really all over. Investors had to have their throats slashed. There was no possibility of a soft landing.  

“We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know at some moment the black horsemen will come shattering through the terrace doors wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time. So everybody keeps asking--what time is it? But none of the clocks have hands.”  

In late 2006 my boss taped that quote to the wall above his desk. In a good-natured act of part-mockery, part-admiration, we found a clock with the company logo on it, broke off the hands, and nailed it to the wall above his terminal. Both the quote and the clock sat in that same place in 2008 when colleagues were literally stopping at the bank on their way home to withdraw cash in case it wouldn’t be open the next day.

Right, so “The Great Unwind”. This chart caught my eye in the financial paper of record earlier this week:  

I would have lost a nickel on this one--I was a little shocked that the ratio of the change in central bank assets to GDP was at the highest levels of the decade early this year...and is only just not starting to come down. But look at the slope of that line...steep. We all remember back in 2012 when the Fed was ready to sound the all clear….only to see the growth and inflation go down the chute again in 2013. Perhaps the steep negative slope of monetary accommodation and the wheezing of the global economy weren’t uncorrelated events..but it is also self-evident that correlation was not forecasted by the monetary authorities in charge of the printing press at the time.

So while it is boiler plate Fed-speak, it came as a mild surprise to hear the Atlanta Fed Governor Rafael Bostic say this yesterday in a speech on the subject of balance sheet “normalization”:

“On balance, the limited market reaction to the rollout of the Fed's new balance-sheet policy leads me to conclude that financial market participants do not view it as a significant tightening of conditions or a hindrance to economic growth….I don't expect financial market conditions to be significantly affected in the coming months by balance-sheet reductions.”  

There’s so much wrong with that statement I don’t really know how to approach it. In the interest of journalistic integrity, let's stick to the facts.  Or failing any facts, let’s stick to what the Fed has told us already about the impact of QE on long-term rates. Back in April, a gang of economic pirates at the Federal Reserve said, “Avast, ye scurvy dogs, ye olde term premium rests at the bottom of the sea in Davy Jones’ Locker, 100 basis points below the point where Captain Ben skewered the hull of the wee ships sailed by risk-averse landlubbers.”  

Ok, maybe not just like that, they were economics PhDs...but they did highlight how balance sheet normalization will cause an unwind of their estimated 100bps in compressed term premium wrought by the Fed’s QE programs, which doesn’t even count knock-on impact from the ECB, BoJ, and BoE asset purchase programs that may or may not be wound down over the same period of time.

I think the steam in the economy and increased supply effect from balance sheet normalization will eventually steepen the curve--right now the market has voted in favor of a repeat of 2013, where tighter conditions will lead to a slowdown in growth that will force a reversal to more accommodation.

The same economic wonks (the nerds, not the governors) at the Federal Reserve are forecasting a  fed funds path that looks like this...

The Fed governors decided to split the difference with those forecasts and those of the market in the September SEP.  

Given the growth and wages data I noted earlier this week, and some good reasons to believe that inflation is being sandbagged by some one-off effects, I think there is good reason to price in a path close to the “dots”...say nothing of the nerds’ “dots”!

So yeah, I can hear Al Edwards laughing already….ice age, I get it…but his latest piece did mention that a more hawkish Fed led by Warsh would be his choice to try and defuse this credit driven time bomb. Yet the Fed at large, as illustrated by Bostic's speech yesterday, prefers to stay at the party a little longer. I still believe as my old boss did...you can’t defuse it...people won’t leave the party until the black horsemen crash through the window, slash the throats of the guests, and pillage the house.

But maybe, just maybe….a steeper curve would convince a few party-goers to call it a night.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista