The guest commentary below is from Jesse Felder.
“Somehow we need to go to an economy that is using its resources, operating at full employment, but doing so in a way that isn’t reliant on bubbles.”
This quote, uttered before she became Fed chair, is worth studying for at least a couple of reasons. First, because it demonstrates just how easy it is to see the problem from a distance and also how difficult it becomes to address once you become deeply involved with it. And second, because it underscores the limitations of monetary policy and the fact that central bankers, even though they are cognizant of these limitations, continue to try to defy them.
As my friend Dr. John Hussman adroitly discussed last week, “Extraordinary monetary policy has one function, and it is to amplify yield-seeking speculation when investors are inclined to speculate. That and that alone, is how quantitative easing has impacted the economy in recent years.”
The Fed influences the financial markets by controlling short-term interest rates, via the Fed Funds rate, and the supply of risk-free securities, via Quantitative Easing. When they took the former to zero for the better part of a decade it inspired investors to reach for yield they could no longer get from a savings account or something similar. And when the Fed also started buying up risk-free treasury bonds, it forced investors to move into corporate credit and other risk assets.
Add to this massive increase in risk appetite a trend of deregulation, or at least lack of enforcement, in the world of corporate credit and you get a recipe for the biggest boom in corporate leverage in history, characterized not just by the amount of debt or the degree of leverage employed but also by the loosest lending standards and weakest covenants in history.
It’s amazing to see that, despite some of the lowest spreads in history based on some of the lowest interest rates in history, that median interest coverage today among corporate America is even worse than it was during the depths of the financial crisis. It’s a testament to just how crazy the current credit cycle has gotten. It may be, to use Hyman Minsky’s term, the most Ponzi of all the Ponzi finance stages of all time.
All of this new credit has enabled a massive debt-for-equity swap in which American companies, as a whole, have used new borrowing to buy back their own shares. As my friend, Teddy Vallee, pointed out last week, there is a very close relationship between corporate spreads and stock buybacks. Policies at the Fed and in Washington that have led to a compression in spreads have, in this way, enabled massive inflows into equities on the part of the companies themselves.
This phenomenon has been so large and pervasive among public companies in America that it has represented essentially all of the net demand for equities for the past decade. It’s no coincidence that the Fed expanded its balance sheet by $4 trillion over the past decade and almost that exact amount has been manifest in stock buybacks.
This is the main reason why, despite the weakest economic recovery on record, this has been one of the strongest bull markets in history. The massive, price-insensitive buying on the part of corporations has driven prices and valuations to record highs even as the fundamentals, as measured by revenue or earnings growth, have been near historical lows.
The Fed understands these dynamics. Janet Yellen’s remark at the top of this piece is testament to that. The relationship between consumer confidence and stock prices is really just too hard for anyone to ignore. In many ways, the stock market has become the economy largely as a result of extraordinary monetary policy that explicitly targets markets in trying to manage the economy.
Donald Trump, too, has clearly embraced this tail-wagging-the-dog ethos. Create policy to prop up stock prices in order to preserve consumer confidence hence spending and the overall economy. This, however, is a very dangerous game. Again, Janet Yellen warned as much before she became Fed chair. Trying to build up the economy on yet another, “big, fat, ugly bubble,” is merely repeating the very mistake of the last cycle and smacks of desperation.
And to the extent that the current debt-driven bubble was created by monetary policy, the recent reversal of these policies should be effective in bringing it to its inevitable end. Risk-free rates have risen for the first time in a long time. Investors are already responding by shifting their preferences away from risk and towards risk-free assets once again; it’s the beginning in a complete reversal of the reach-for-yield that kicked off the bull market.
As Teddy Vallee pointed out above, this tightening of credit should feed through to stock buybacks. As Goldman Sachs points out above, without buybacks equity demand will collapse. Falling equity prices will dent consumer sentiment. In fact, they have already. As Leuthold Group points out above, the “present situation” component of consumer confidence is now in a downtrend after peaking at one of its highest levels on record. And once consumer confidence turns south, history shows no amount of Fed easing can prop up the bubble any longer. “Live by the s̶w̶o̶r̶d̶ bubble, die by the s̶w̶o̶r̶d̶ bubble.”
This is a Hedgeye Guest Contributor piece written by Jesse Felder and reposted from The Felder Report blog. Felder has been managing money for over 20 years. He began his professional career at Bear, Stearns & Co. and later co-founded a multi-billion-dollar hedge fund firm headquartered in Santa Monica, California. Today he lives in Bend, Oregon and publishes The Felder Report. This piece does not necessarily reflect the opinion of Hedgeye.