To
many economists, the biggest mistake the Fed has made has been a lack of
aggression in raising interest rates. After all, they reason, the
U.S. job market is as strong as it has been since 2007 and the economy, even if
sluggish, is at least back on an even keel. These same observers
cheered the Fed’s decision to raise the Fed funds rate in December by a quarter
percentage point.
Yet
there is even more reason to worry that the raising of the Fed funds rate last
month may have been a policy blunder of major proportions. In this commentary we’ll briefly examine the
distinct possibility that the Fed has put the U.S. financial market on the cusp
of another troublesome year ahead.
Many
investors and analysts believe that the quarter percent rate hike enacted by
the Fed at its December meeting is inconsequential. Some analysts, however, believe
otherwise. One such analyst is Bert
Dohmen, editor of the Wellington Letter. In a recent article he points out that in
order for the Fed to achieve its goal of raising the benchmark interest rate to
0.25% from virtually zero, it has to drain reserves from the banking system. It does this through “reverse repos,” which
means it sells Treasury bonds to banks and receives payment via the bank’s
reserves. In short, it amounts to
decreasing the amount of liquidity in the banking system.
On
December 31, 2015, the Fed did almost $475 billion of reverse repos, according
to Dohmen. “Of course, this is not
permanent,” he writes, “but usually measured in a few days or less. But it does reduce the ability of banks to
lend to each other for that time. The
above was a record amount, exceeding the prior record of $339.48 billion on
June 30, 2014, 1.5 years ago. On Jan 5,
2016 the fed did a reverse repo of almost $170 billion for one day.”
He
points out that the Fed must continue doing this in order to keep the Fed Funds
at or above 0.25%. In doing so, the Fed
is draining liquidity from the financial system at a time when liquidity is in
great demand. E.D. Skyrm, managing director of
Wedbush Securities, has calculated that starting at zero, the Fed’s rate hike
to 0.25% is “infinite” in percentage terms. He further estimates the Fed needs to drain
between $310B and $800B in liquidity to achieve this.
As
if that weren’t enough, comments by St. Louis Fed President Bullard this week
suggest the Fed is completely oblivious to the effects that rate increases are
having on the financial market.
Incredibly, Bullard suggested that four more rate increases were likely
in 2016, underscoring the Fed’s total blindness to the global market crisis.
The
Fed, duly chastised by its dilatory response to the 2008 crisis, claimed for
years that it would vigilantly prevent another bubble from forming in the
credit market. Yet there is growing
evidence that it has failed miserably in that duty as well. Credit analysts Edward Altman and Brenda
Kuehne, in an article entitled “Credt Market Bubble Building” (Business Credit, March 2015), observed
last year that a bubble was building in the high yield corporate debt
market. They pointed out that the
corporate high yield (HY) and investment grade (IG) sectors had been
refinancing and increasing their debt financing continuously since 2010 when
the Fed began ramping up its loose money policy. They also wrote that “new HY issuance topped
$200 billion in 2012 and almost matched that in 2013,” adding that corporate
debt issuance was even more substantial in Europe in 2013-14.
“In
a nutshell,” Altman and Kuehne concluded, “market acceptance of newly issued
high-yield junk bonds has been remarkable, with record amounts issued at
relatively low interest rates. This
reinforces that a seemingly insatiable appetite exists for higher yields in
this low-interest rate environment.”
Further, the authors found that HY corporate bonds in 2015 carried a
higher default risk than those outstanding in 2007. The outcome of this can be clearly seen in the
following graph of the SPDR High Yield Bond ETF (JNK), which is testing levels
not seen since the depths of the 2008-09 credit crisis.
And
so it would appear that after feeding another credit market bubble with its
persistent zero interest rate policy of the last few years the Fed is
committing a far more grievous error by raising rates at the worst possible
time.
Perhaps
the biggest danger for central banks this year is hubris. The Fed
spent the better part of last year insisting that benchmark rate would be
raised at some point in 2015. It also consistently (and correctly, I
maintain) passed on raising rates in meeting after meeting. Only
when December’s policy meeting came around did the Fed finally see fit to raise
the benchmark interest rate. There was essentially no justification
for raising the rate; it seemed merely a case of the Fed feeling obligated to
keep a promise it had made months earlier. In other words, the Fed
was merely trying to save face.
Robert
Campbell, in the latest issue of his Campbell Real Estate Timing Letter,
made an observation about market forecasters that could easily be applied to
central bankers. He wrote:
“It’s
[a] natural tendency for humans to stock to a given forecast come hell or high
water. Instead of adjusting to changing conditions, most investors
get married to their outlook for the markets – which only proves they would
rather be right than change their positions according to changing realities and
make money. I know it sounds crazy but it’s human nature: most
people would rather defend a bad idea (or investment position) – and prove they
are right – than admit they made a mistake (and change and be happy).” [www.RealEstateTiming.com]
Is
it just possible that the Fed is oblivious to the bear market now underway in
the equity market, along with the threat of additional weakness being imported
from overseas? Could it actually be serious about wanting to
incrementally raise interest rates (thereby tightening money availability) in
2016 when the data argues it should be doing everything to make liquidity more
plentiful? While the jury is still deliberating those questions, the
preliminary evidence would answer both questions in the affirmative.
Fed
Chair Janet Yellen has been painted as a monetary dove by many Fed watchers,
yet her actions since assuming control of the Fed have been anything but
dovish. Despite the many threats posed by the global economic
crisis, the Fed is acting as if the U.S. is perfectly insulated against any ripple
effects from global weakness. She appears blithely unaware that her
misguided monetary policy stance risks undoing the equity market rebound her
predecessor helped engineer in the years following the credit crisis.
Wouldn’t
it be ironic if in 2016 the Fed’s lack of sensitivity to the threat posed by
the global crisis turns out to be its downfall? The Fed appears to
have painted itself into a corner with its monetary policy
decisions. Rates are too low to be used as an effective weapon against
a further deflationary threat from overseas. To lower the Fed funds
rate from here would be to admit that it made a mistake in raising it in the
first place. It’s unlikely the Fed would do this since it fears
anything that would potentially undermine its credibility and smack of
indecision. Moreover, it’s unlikely that the Yellen Fed would risk
the appearance of being unduly aggressive by increasing liquidity at this early
stage of the crisis. History shows the Fed, like most institutions,
to be a reactionary creature. If the Fed under Bernanke was late in
aggressively loosening monetary policy in 2008 when the credit conflagration
was in full flame, why should we expect anything different from Yellen.
The Fed isn’t the only central bank that seems to be underestimating
the potential danger of the global crisis.
European Central
Bank (ECB) President Draghi famously pledged his bank would do “whatever it
takes” to reverse the deflationary undercurrents within the euro zone. Yet the ECB has failed to live up to that promise
to date. Although the ECB recently
lowered its deposit rate from -0.2 percent to -0.3 percent and extended its
60-billion-euro monthly asset purchase program, the ECB hasn’t shown the
necessary urgency commensurate with the magnitude of the crisis. The result of the bank’s efforts to date has
been an anemic euro zone economy and a lack of confidence among the region’s
investors.
The
lack of urgency among central bankers and investors alike is troubling since it
means – from a contrarian’s perspective – that the global crisis likely has a
lot further to run before it abates. In
the meantime, traders and investors should continue to maintain a defensive
posture and avoid new long commitments due to the continuing internal
weakness.
Robert Moriarty’s New Book
My
old friend and colleague, gold mining stock analyst extraordinaire Bob
Moriarty, has written an entertaining new book.
Although a work of fiction, it’s based on his real-life exploits as a Marine
fighter pilot during the Vietnam War. Bob’s
avid followers will want to read this exciting and quick read, entitled “Crap
Shoot” which is available for download at Amazon.com.
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