This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
The rally in risk-free bonds is quickly rendering irrelevant the policy direction of the Federal Open Market Committee.
We’ve talked in past comments in The Institutional Risk Analyst about the structural shortage of risk-free collateral, even with bond yields down 50% from the November 2018 peak.
As fear of the economic effects of the COVID-19 virus grow, investors are seeking liquidity and high-grade credit.
Many of the financial and risk decisions that were made even six months ago now look questionable in view of the unfolding flu epidemic from China. But as we noted earlier, the risk to the US markets was always meant to come from offshore.
At present the forward risk is that the combination of QE by central banks and fear driven purchases of US Treasury paper may drive US interest rates to zero, further inflating the US bubbles in housing and financial assets.
The chart below shows the now negative cost of default for 1-4 family loans held by US banks, another way of saying home prices have risen strongly.
Some analysts continue to point to a future increase in unemployment or an economic slowdown as the likely pretext for lower interest rates. But the market already has discounted a slowdown. And lower market rates provide the impetus for another spasmodic surge in valuations for stocks, bonds and year estate – and all at the same time.
Traditional correlations are dead and gone, thus the question is only the timing of the next upward surge in dollar asset prices.
A sustained drop in interest rates may actually forestall an economic slowdown, again dashing the hope and expectations of many forecasting economists. Even as the fear trade drives dollar interest rates down, estimates for forward loan origination volumes are rising. Indications of growing froth in the housing markets such as the LGD chart above go largely unheeded by investors, but regulators are concerned.
Such is the level of consternation among regulators over the visible level of inflation in housing assets that lenders are being told to step back from certain housing markets, particularly in overheated coastal cities.
Worries that a sharp decline in home prices will occur as and when the next recession begins are driving the increasingly frantic directives coming from the Federal Housing Administration and the Federal Housing Finance Agency regarding capital levels in a stressed economic scenario.
Across the mall in Washington, however, no less a luminary than Fed Governor Lael Brainard is pushing for an even higher inflation target. Why? The Fed Board does not really say. Perhaps to goose asset prices ever higher?
Referring to the policy as “flexible inflation averaging,” Governor Brainard believes that the US central bank needs to set temporary inflation targets above its current goal of 2 per cent, to make up for periods when inflation runs below “target.” But what exactly is the target?
The fact that the Fed’s governing statute refers to “price stability” as the Fed’s policy target does not seem to bother Governor Brainard. Neither the former MD bank regulator nor the rest of the FOMC seem to have noticed that asset inflation in housing, stocks and bonds and other asset classes are presently running at low- to mid-double-digit rates of increase.
Another surge in the value of housing assets impends. Were US home prices rising at say 25 or even 50 percent annually, do you think Governor Brainard and other FOMC members would take notice?
Would such a circumstance constitute inflation or at least a rise in consumer living expenses that warranted recognition? That depends.
The Debt Avalanche
The fixation of the FOMC and other world central banks with statistical “inflation” stems less from a concern about weak employment, consumer price inflation and economic activity than from the growing pile of debt held by public sector obligors. Unless global central banks lean against the potential debt deflation by monetizing a certain amount of public obligations each year via QE, the situation will very soon become problematic.
The new update of the IMF’s Global Debt Database shows that total global debt (public plus private) reached US$188 trillion at the end of 2018, up by US$3 trillion when compared to 2017. Ponder how these figures will look at the end of 2020 after a year of dealing with the coronavirus.
“The global average debt-to-GDP ratio (weighted by each country’s GDP) edged up to 226 percent in 2018, 1½ percentage points above the previous year,” the IMF notes. “Although this was the smallest annual increase in the global debt ratio since 2004, a closer look at the country-by-country data reveals rising vulnerabilities, suggesting that many countries may be ill-prepared for the next downturn.”
China, of note, has seen the fastest growth in its debt load, this as the Chinese Communist Party has turned to ever larger and more ridiculous types of public spending to keep the nation’s 1.4 billion citizens cowed and under control. We are now into year five of the great debt deflation in China, which was signaled by the collapse of HNA Group and Anbang Insurance and the growing red ink in China’s overall payment flows. Again, ponder China's debt numbers in 2020.
We wrote in The American Conservative last week that much of China’s pile of debt is really just deficit spending in disguise:
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“The collapse of heavily indebted Chinese companies such as HNA and Anbang Insurance Group several years ago illustrated the growing pressure on the Chinese economy caused by hundreds of billions of dollars in subsidies to state companies and local governments that are treated as ‘debt.’” |
Yet even with the consternation over China, any correction in equity markets as a result of reduced expectations for growth due to COVID-19 will be quickly overwhelmed by the rising demand for dollar assets.
The world already had a propensity to hold dollar assets before the start of the year, but as 2020 progresses, the downward pressure on US interest rates will become intense. Should the US central bank, as well as the European Central Bank and Bank of Japan, be buying dollar assets via QE when the rest of the world is piling into risk free securities as well?
You can be sure that Governor Lael Brainard and the rest of the FOMC will never ask that question – at least not in public. That would involve an open admission of policy error, something that Federal Reserve is unable to accept. But to be fair, the concept of delegated infallibility is well established in Washington agencies, most notably Defense, Treasury and particularly FiNCEN.
We have long maintained that the decision first by the BOJ, then the Fed and ECB, to force interest rates negative via public asset purchases was inevitably deflationary. The diversion of interest payments from private investors to governments, and the reduction in carry on assets generally, reduces private leverage on capital and also current income. We suspect that the deflationary effects of QE cause consumers and investors alike to become ever more cautious.
The good news, of sorts, is that inhabitants of the dollar zone will continue to benefit from the spreading deflation in China and the rest of the world as the dollar soars. So long as the dollar remains the global means of exchange, the US under Donald Trump can seemingly issue infinite amounts of debt in competition with profligate communist China, which of course will hyperinflate endlessly to forestall political unrest.
The bad news, again in relative terms, is that real inflation on a personal level in the US will remain brisk, with prices for housing and financial assets continuing to rise and with it the true cost of living in dollars.
Even in the event of a global debt crisis and restructuring, perhaps by Italy and/or China in several years’ time, we suspect that the demand for fiat dollars will only grow.
Global central banks are deliberately engineering a shrinkage of the stock of risk-free assets via asset purchases or QE. This continued manipulation of credit spreads is perhaps the single biggest risk to the market in 2020.
We wonder when the FOMC will realize that it is easier to be a price setter rather than trying to physically manipulate the short-term money markets.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the 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.
