This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
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“Investors must now attempt to reconcile this contradiction between soaring asset prices and an economy whose productive potential and consumer demand have both collapsed.” - Gordon Li, CFA TCW |
No matter how many books we open and articles we peruse, there is really no replacement for the opening lines of A Tale of Two Cities to describe the current predicament. Charles Dickens wrote in 1859:
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair…”
Although things may seem a trifle upside down at present, as the citation from Gordon Li at TCW suggests, there are signs of hope. For example, just about every company in the world of mortgage finance seems to be for sale thanks to the beneficence of the Federal Open Market Committee.
Witness the unnatural fact that nonbank mortgage servicers and lenders have outperformed the S&P 500 for several months. First we saw Rocket Mortgage (RKT) take the plunge into public ownership, an exercise that seems motivated as much by estate planning as the bull market in residential mortgages that continues to build. As we noted previously, the new mortgage securities issuance numbers from SIFMA are over $400 billion per month and growing.
More recently, we saw United Wholesale Mortgage take the plunge via a SPAC transaction led by no less than Alex Gore. UWM, for those unfamiliar with mortgage finance, specializes in the wholesale channel, a murky world of low margin business where independent mortgage brokers sell “warm leads” to aggregators like UWM.
Whereas firms like RKT and PennyMac Financial (PFSI) focus on call center and refinance as primary channels, UWM has just one focus, wholesale. In good times it’s great, in times of weak volumes not so much. If RKT is the bluefin tuna of the mortgage world and PFSI the swordfish, hard-working UWM is the monkfish.
Now in the dreadful days of 2018, neither RKT nor UWM would have even dreamed of going public. But in the fantastic world of QE in 2020, anything is possible. Fed Chairman Jerome Powell merely puts his finger on the great scale of financial valuations and, viola, we turn complete dross into a beautiful golden cloth.
By skewing the risk curve, the FOMC is able to convince investors that deepest black is in fact shining white.
And Chairman Jay Powell made this possible! All hail Jay! All Hail Jay!
https://www.youtube.com/watch?v=A9sd10CHAP8
Our friends at Grant’s Interest Rate Observer remind us of the FOMC’s August 27th statement, where Powell & Co promised to “use its full range of tools to achieve maximum employment and price stability goals.” Think how fabulous to see the FOMC inflate the economy and keep prices stable, all at the same time! Yet we do note that the Federal Housing Administration reports that American home prices are rising about 1% per month nationally.
Jim Grant, who most recently published a biography of Walter Bagehot, likes to remind us too of the auto-quotation from the famous writer: “John Bull can stand many things but he can’t stand 2%.” Bagehot continued:
“People won’t take 2 percent; they won’t bear a loss of income. Instead of that dreadful event, they invest their careful savings in something impossible – a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea, a corporation for shipping skates to the Torrid Zone.”
Much like the opening lines of A Tale of Two Cities, people generally only quote the first several lines of famous pronouncements. Only when you include the entire statement, however, can we appreciate the full import of the Bagehot view of markets. Bagehot’s observation, in fact, predicted QE and the FOMC’s obsession with making credit progressively cheaper, to the detriment of savers.
When Bagehot wrote those immortal words, banks had to offer attractive rates to entice investor to deposit gold in their vaults. Gold in the vault allowed banks to increase leverage by issuing paper. If rates got too low, Bagehot suggests, then John Bull would sell paper and take his gold, leading to deflation in banks and the financial markets.
When Bagehot wrote those lines 150 years ago, gold was money and paper was a derivative. Since the New Deal when FDR confiscated gold in 1933, however, the role of money in the US has inverted, with worthless paper dollar now legal tender and the unit of account. George Selgin writes in Alt-M:
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“[T]he recovery that followed FDR's assumption of office was fueled almost exclusively by growth in the Federal Reserve's gold holdings. As the following FRED chart shows, those holdings almost tripled during the four years following the nationwide bank holiday, allowing the M2 money stock to concurrently grow to 150 percent of its pre-holiday level. The result was a ‘Great Expansion’ of real GNP that more than offset the ‘Great Contraction’ of the preceding three years.” |
The trouble, of course, is that almost a century later, there is no easy fix for the deflation that now menaces the US economy and the rest of the world. The FOMC indeed has managed to skew risk preferences and asset prices, but still insists that more need to be done to fulfill the mandate of price stability and full employment.
Meanwhile, the deflationary impact of COVID continues to ripple through the global financial system.
David Kotok at Cumberland Advisors writes this week:
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“Negative interest rates impact all yield curves and eventually force them into a parallel shape…. Essentially, the starting point of the negative interest-rate policy is to cause the negative-rate yield curve to slope into more-negative rates as one extends maturities. The reverse happens with positive-rate yield curves. This creates a tension, and currency-hedged adjustments and derivatives eventually resolve that tension. As that resolution occurs, all yield curves gravitate toward a parallel slope. Furthermore, the yield spreads between various currency yield curves become the currency futures differentials.” |
Ponder that reality while considering your asset allocation choices in the days and weeks ahead.
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.