Q: What is the duration of a security with a negative yield? Hold that thought.
Noted financial author Nassim Nicholas Taleb has little patience for economists. “Charlatans & economists use logical flaw: because a pilot is expert, they are experts,” notes Taleb in a recent tweet. “But pilots are selected via skin-in-the-game mechanisms. Plumbers, dancers, dentists, mathematicians, snipers, pastry chefs are experts. Economists BS for a living.”
Nowhere is this obvious distinction between economists and everyone else better displayed than in the performance of the Federal Open Market Committee over the past decade and especially the last year. Watching the 10-year note sink towards 1% in a matter of hours, we are confronted by the market volatility that both former Chairmen Ben Bernanke and Janet Yellen predicted in their statements to Congress. QE and other policies were the cost of fighting deflation, they said. But then we lost the war.
Financial markets have shown volatility in both prices and correlations between different economic sectors since 2008, yet members of the FOMC have stubbornly clung to outdated notions about the workings of the global economy -- ideas that are not even seriously considered by private researchers. The result is extreme swings in markets – and FOMC policy directives -- with political volatility that ultimately undermines the confidence of investors and consumers in the central bank.
The point about “confidence” is particularly important and goes to the FOMC’s credibility with investors and markets. The FOMC believes that what is does or does not do with interest rates, for example, can change consumer sentiment and therefore behavior in the economy. Many of the rules that seemed to govern things like consumer spending and inflation, to name but two key factors, have broken down. But on the FOMC, it almost as though the clock were turned back to 1980.
Ponder the supposed link between interest rates and inflation. For literally years now the members of the FOMC have stated repeatedly that getting inflation up to a 2% level is the target of US monetary policy, including QE and low rates. Yet none of the PhD economists that populate the committee have taken notice of the fact that the apparent link between interest rates and inflation expectations has been broken for nearly half a century.
“Economists have two theories of inflation: the monetary theory — too much money chasing too few goods, championed by Milton Friedman and his followers, and the Phillips curve theory, which posits a structural relationship between the unemployment rate and the inflation rate so that when the unemployment rate falls, the inflation rate necessarily increases,” notes Dan Thornton, retired Vice-President and Economics Adviser at the Federal Reserve Bank of St Louis in a letter to the Financial Times. “Neither of these theories have had any validity or predictability.”
Sadly, this news has still not reached most members of the FOMC. But even more broadly, the FOMC continues in the inane belief that it controls interest rates in the US or even globally. From 2015 onward, when the FOMC ended its extraordinary purchases of US Treasury bonds and mortgage securities, the committee proceeded in the belief that if could actually raise interest rates despite the deflationary conditions that persist around the world. Clearly this view has now been discredited -- or has it?
By December 2018, the combination of raising the target for Fed funds and shrinking the US central bank's bloated balance sheet almost cause the US financial markets to seize up. Even President Donald Trump has learned to inveigh against the dreaded "QT" or quantitative tightening. Stock prices fell dramatically and the issuance of new securities – perhaps the most important indicator of economic health – basically went to zero. Only by performing a 180-degree change in policy was the FOMC under Chairman Jerome Powell able to avoid financial and economic disaster, but the Fed’s remaining credibility was badly dissipated in the process.
The events of the past six months have made clear that the entire policy narrative constructed under Chairmen Ben Bernanke, Janet Yellen and Powell was in error. The trillions of dollars in asset purchases made by the FOMC did not address the threat of deflation. More, none of these policy machinations seem to have affected either the reality of inflation or expectations of future price gains. Indeed, the FOMC seems to have made deflation worse and has also damaged expectations about inflation and the basic stability of key market segments such as housing.
In a comment last month in National Mortgage News, we noted that since 2008, the equity in American homes has soared by almost $10 trillion to just over $32 trillion. Yet credit creation tied to residential mortgages in the US declined in the 2013-2016 period and then grew at a far lower rate than the economy or housing prices more generally. As with the once trusted connection between employment and inflation, for example, the tie between interest rates and housing credit seems broken. But again, nobody on the FOMC (or in Congress) seems to have noticed.
When it became clear that low interest rates alone would not lead to an increase in the purchases of new or existing homes, the FOMC shifted to a secondary position, focusing instead on the increase in home prices to show that low interest rates were "helping" housing. This change in Fed posture was essentially an embrace of the "wealth effect," another widely discredited economic theory that says when people see increased paper wealth in stocks or even a house, they will feel richer and spend more.
Some members of Congress advocate an annual audit of the Federal Reserve Board, this ostensibly to see if the central bank keeps proper books and records. But instead the Fed ought to be subject to annual audits of its policy choices and rationales to see if FOMC members can actually explain to the American people what they think and say, and why. At present, the FOMC seems to be completely lost when it comes to formulating a “data dependent” plan for US monetary policy.
For example, the idea of voting members of the FOMC embracing the “wealth effect” as serious public policy is bad enough, yet the willingness of committee members to speculate on ever more radical and vague policies further undermines the credibility of the US central bank. New York Fed president and FOMC member John Williams, who advocates negative interest rates if needed, said in a March speech that a “wait and see” approach to interest rate reductions is fine when rates are much higher. But when rates are already this low, Williams confides, it’s better to “vaccinate.”
What does John Williams mean when he makes these metaphorical references to preventative medical procedures? Nobody knows. We wonder, do Williams and other members of the FOMC understand that bonds with negative yields of necessity have increasingly negative duration?? But it is increasingly clear that global investors and markets are less and less impressed by the flow of conflicting comments and policy pronouncements coming from the FOMC.
“Monetary policy isn’t a job with Jay Powell. It’s an adventure,” The Wall Street Journal concludes in an editorial. Fasten your seat belts and assume the crash position.
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.