Originally sent to VIXCONTANGO subscribers on February 16th, 2019
Over the past 6 months I have had discussions with various subscribers about how to approach the next market crisis. They asked me how I think various trades will play out. My first immediate impression is that folks are very ready to fight the last war. All of the concerns I heard formulated read like a rerun of 2008:
- The commercial paper/money market will seize up
- The housing MBS market will seize up
- Corporate bond market will seize up and credit spreads will widen a lot (junk bonds will tank)
- Gold is going to moon because of QE4
Everybody assumes that in the next market crisis the FED is going to do exactly what it did in 2008:
- Lower rates to zero, potentially even do negative interest rates leading to money market and commercial paper market problems
- Do QE, buy Treasuries and MBS and expand the balance sheet a lot and thus send gold to the moon
Basically everybody assumes that the problems the US economy has today are the exact same problems it had in 2008. Also people assume that the policy tools the FED and the US government have today are the exact same that they had in 2008. The problem is the setup we have today is different and what will happen will also be very different.
The Last War
Let’s look at what caused the Financial Crisis in 2008:
- Massive housing oversupply – massive build out of McMansions for the smallest generation (GenX) in recent history.
- Massive housing bubble spurred on by low interest rates which were first driven by the FED and then by Chinese purchases of Treasury bonds
- Undercapitalized and highly leveraged banks (40/1 leverage ratio was widespread because of deregulation)
What the FED did then was to address the problem it had on its hands:
- How do you fix undercapitalized banks? Well, the traditional method since Abraham Lincoln and Samuel Chase invented modern banking was to stuff bank balance sheets with US treasury bonds. The FED went out and bought a ton of short-term treasuries from banks and fixed their capitalization and leverage ratios. Done in QE1
- There was no market for mortgage backed securities (MBS). The FED took those bad loans off the hands of the banks as well in QE1.
- Since the economy was tanking and the deleveraging process brought on deflation, the FED thought that interest rates need to be lowered to hike inflation expectations. FED overnight rates went down to zero very quickly. But 3-4 years later long term rates still didn’t go down as much as the FED wanted, so in QE2 and QE3 the FED had to target the long term rates by buying those treasuries.
As a result of all of this the FED quintupled the balance sheet from 800 million to 4.5 trillion sending gold up 5 times as well from $400 in 2005 (pre-crisis) to $2000. Note that the gold market moved higher 2 years ahead of the eventual FED balance sheet expansion announcements.
Are We Fighting the Last War?
Is the situation today the same as in 2008? Do we have the same problems?
Is there a massive housing oversupply and housing bubble? No
No, there isn’t. If anything we have a housing shortage. Millennial generation is much bigger than GenX and because of 10 years of no houses being built, there is simply no inventory. The FED successfully reflated home prices so we have a situation with high housing prices but also no supply. How are prices going to go down if nobody is selling? So where are millennials going to live? In apartments. Multi-unit housing development is exploding. You can sell an apartment for $200-300K and millennials can afford that. Millennials can’t afford a $500K starter home (unless they work at Google like my old neighbors). The new starter home is an apartment and the new 2nd home is the former starter home. But here is the bigger issue – the housing market is not going to tank anytime soon. If anything, rent and housing prices continue to outpace inflation and they will continue to do so because THERE IS NOT ENOUGH HOUSING SUPPLY. If there is no supply, there is no bubble.
Are banks undercapitalized? No
Nope, not a problem either. The FED has been keeping a tight leash on bank liquidity and we have Maxine Waters as House Financial Services Chairman. Bank balance sheets are not a problem.
Long story short, the FED is NOT fighting the last war.
Tools Available in 2008
When you consider what will happen in the future, you also have to consider the tools that are available. That is very important. Let’s look at the tools the FED and the US government had in 2008.
Small FED Balance Sheet
The FED had an 800 billion balance sheet on $15 trillion economy (about 5%). There was plenty of room for balance sheet expansion. If anything the balance sheet was ridiculously small in 2008. Now the FED has a 4 trillion balance sheet on a 20 trillion economy (about 20%). The FED considers this an “ample” balance sheet. In other words, in the next crisis the FED will not be able to ratchet up the FED balance sheet 5 times like it did the last time. There is much less room to move here without triggering inflation.
High Interest Rates
The FED went into the 1990 recession with 8% interest rates. Into 2000 with 6% interest rates. Into 2008 with 5%. Both on the FED rate and the 10 year. Going into the next recession the FED is going in with 2.5% interest rates. As you can see from that chart, the FED had to lower rates about -5% to get the economy running up and running quickly. Next time around, they don’t have -5% to go down. They can only go down -2.5%. Which means that the economy isn’t going to be able bounce as hard. It is one thing to refinance 8% mortgage down to 4%. People’s mortgages go from $3500 to $2500 with no underlying inflation. That is a big boost. When you go from 4% to 2% mortgage, you go from $2500 to $2000. Still a boost but much smaller boost particularly if you have inflation.
Low Debt to GDP Ratio
The US went into the 1990 recession with a debt to GDP ratio of 53%. Into the 2001 recession with 54%. Into the 2008 recession at 62%. Guess where the debt-to-GDP ratio is today? 104%. Clearly there is less room for massive fiscal spending today. The interest expense is going up dramatically. It was at $324 billion in 2018. That 50% more than 2008 (220 billion). This is $100 billion per year that can’t be spent on the economy. Interest expense is almost as much as Medicaid spending! The burgeoning interest expense is going to put a real constraint on the amount of fiscal spending available in the future. What that means is that you can’t do tax cuts anymore without paying for them. What that also means that you can’t do military or infrastructure spending without paying for it. The never ending magical money pot provided by the US government that markets have been tapping since 2008 is rapidly coming to an end.
When you look at these numbers above it is very easy to panic. You see a lot of pundits and articles screaming and pointing at these charts and advocating for imminent doom and gloom and hyperinflation and so forth. Well, it has been 10 years without doom and gloom and hyperinflation. I am showing you the same numbers everybody else is showing you. Where we differ greatly is the interpretation.
There is only one question that you need to answer when you look at these numbers:
What can the government do without triggering inflation?
Would massive expansion in the balance sheet trigger inflation? Not if the balance sheet was scarce to begin with.
Would massive government spending trigger inflation? Not if the money is spent in Afganistan. 6 trillion of the debt under Obama/Bush went into the Middle East. How is that going to trigger inflation in the US? Now if you throw the same 6 trillion on the US, yes you will have inflation.
So what matters really is NOT HOW MUCH money is being spent, but WHERE it is being spent. The real question is what can the FED/US government do in the next crisis that does NOT trigger inflation? Inflation is really what limits their policy responses. In 2008, they had a lot of artillery at their disposal because they were fighting DEFLATION. If you are fighting deflation, you basically have a blank check. That is not the case today. However, the FED and US government are not completely out of tools. Somebody like Peter Schiff who says the FED/US is out of tools is exaggerating. The FED does have tools. The tools are simply smaller than what they were in 2008 and thus need to be deployed more efficiently.
The Next Crisis Response
The FED has been providing an enormous amount of information on what is going to happen next. If anybody is paying attention. We covered how money markets are NOT going to cease up, how people are NOT going to be defaulting on their mortgages and how banks are NOT going to collapse. We covered how the FED is NOT going to be able to ratchet up their balance sheet 5 times and how the US government will NOT be able to borrow 10 trillion again. But they will not need to.
What is the next battle the FED is fighting? INFLATION. That was the headline of my market outlook for 2019. This is very different than 2008, when the FED was fighting DEFLATION.
In 2008, the FED fought deflation caused by a decade long demographic lull (peak years of GenX). In 2019, FED is fighting inflation caused by a demographic crush of millennials coming into their peak years. And the FED has to fight inflation without triggering a spike in the federal outlays for interest expense. Going forward, the FED has to be super-efficient.
Average Inflation Targeting
The first thing the FED is going to do is make its own job easier. It will move the goalposts. FED will start tolerating inflation overshoots. Vice Chairman Clarida alluded to this a couple of times in his speeches but yesterday we had former New York FED Chairman Dudley say it outright: The FED is looking to change its approach on inflation. Dudley said:
Right now, they have what’s called a bygones policy, and what that means is that if they miss on one side, they don’t try to miss on the other side to make up for it. I think the Fed is going to change that policy subtly over time. They are going to talk about, ‘We want to hit 2 percent inflation on average.’ And that’s going to imply to people that if they miss on the low side for a while, that they’ll be willing to miss on the high side for a while.
So the FED will tolerate CPI of 3% for a while if we had a CPI below 2% for a while. They will target a long term average of 2%. This theoretically is not that big of a deal and should not lead to hyperinflation. Many inflation observers think inflation has a momentum and that the FED won’t be able to stop inflation at 2% but so far it seems the FED thinks it can do just that. Let’s assume that they can do that.
In the immediate term, Dudley’s statement means that the FED is done with rate hikes for now. If that wasn’t crystal clear after Powell’s U-Turn. But Dudley provides the rationale for Powell’s U-Turn. Dudley’s statement also means that the FED will not be cutting rates for a while. FED rates are likely to stay at 2.5% for a while. Why? Well, if the FED rates are less than neutral and you have an economy operating at peak capacity, by definition inflation will remain strong. The FED can’t cut with core inflation readings above target. FED is not going to raise, but it can’t cut either.
QE with Positive Interest Rates (Yield Curve Control)
The fact that inflation will remain strong does not mean that there aren’t financial stability risks on the horizon. In fact, the FED is well aware that inflation is likely to start obliterating corporate earnings. Inflation also might keep long term bond yields/mortgage rates high thus putting pressure on the housing industry. The FED previously used QE only AFTER interest rates were at zero. But the FED may not have the luxury of cutting rates to zero before a QE intervention is needed because of inflation.
The San Francisco FED issued a paper to address this issue just last week. The paper is called “The Effects of Quantitative Easing on Interest Rates” and in the paper the authors outline how the FED QE policy in 2008-2012 period really was very haphazard and not targeted well. And as such not very efficient in achieving its policy goals. For example, in the paper they said that buying short term treasuries did not necessarily mean long-term rates went down as much as the FED wanted. That is a total “Duh, of course”, but it is one thing for me to say it, it is another thing for FED research staff to say it. They also said that the FED buying MBS directly had exactly the intended effect to lowering mortgage rates dramatically and improving financial stability in that sector. In other words, the next round of QE is going to be highly targeted towards the specific rates that the FED wants to suppress or specific loans/industries the FED wants to bail out.
So if the FED deems long-term rates a problem in the future, guess what? The FED will be buying 10-year or 30-year treasuries directly. That is called “yield curve control”. That is exactly what the Bank of Japan is doing right now. They just stand ready to buy at a certain interest rate and take everything from the market. So if mortgage rates are high and the housing industry screeches to a halt, the FED will start buying 30-year bonds. Look at the FED balance sheet. Majority of their Treasury security holdings are shorter term maturities, basically 2-year bonds. They don’t own much above 10-year in duration. Look for the FED to start monetizing long-term debt next time around if long term rates aren’t where the FED wants them. The FED might want to take the 30-year down to 2.5%, for example, now that 2 and 10-year are already there.
Add Corporate Bonds To FED Balance Sheet
But that is not all. What is the number 1 risk the FED identified in its inaugural Financial Stability report? Corporate bond yields are too low. Powell repeatedly is saying how corporate leverage is out of control and credit spreads are too low. Powell is after all a former Carlyle partner and he knows corporate leverage from inside out. I initially thought that Powell wanted to raise rates to burst the corporate bond bubble. He may have intended that but he may have been forced to get religion by Trump and Cramer. He might have been forced to accept a bail out the corporate bond sector instead. You never know what is going on behind the scenes. Clearly there was massive change of course by the FED over the holidays. Instead we will get a Carlyle partner bailing out Carlyle’s bad loans!
There is another aspect to this. Once earnings decline, credit spreads tend to widen out. Markets tend to ignore the FED cutting rates and instead focus on the widening credit spreads. Everybody is looking at those and screaming “panic”. How does the FED get control of that situation? Mute that market signal. It is like whac-a-mole. If some rates shoot up and panic the market, the FED whacks them.
The FED’s job is to suppress rates in economic distress after all. They have just slowly expanded their footprint over the years. In 1913, it started by controlling overnight rates. In 2008, they added Treasury bills and notes up to 2-5 years. In 2019, it will be 10-year bonds and corporate bonds. The FED is slowly taking over interest rate control over the entire economy as it seeks to manipulate all risk signals.
Summary of the Next Policy Response
Because the FED is fighting inflation, the FED will NOT be able to cut rates to zero. It will instead do QE while rates are still positive. This QE will be very targeted and it will target long-term Treasuries and corporate bonds. Corporate bonds will be a new balance sheet item the FED has never had before. The FED will expand its existing portfolio of long-term Treasury holdings.
Scope of next FED QE
What and how much the FED will be buying? The total bond market is about 40 trillion. Treasuries are 15 trillion. Mortgage is 9 trillion. Corporate debt is about 8 trillion, etc.
Let’s look at Treasury debt first. As of Sep 2018, total treasuries outstanding are 15.7 trillion. Of those 2.2 trillion are Treasury Bills (up to 1 year), 9.1 trillion are Treasury Notes (1 to 10 years) and 2.1 trillion are Treasury Bonds (20 and 30 year). The part that the FED will likely want to target are the 30-year mortgages to restart the housing industry. If somebody in the private market has 30-year debt at 3.5% and inflation is 2.5% they will be holding onto that. It is still yielding more than inflation. The FED won’t be needed to buy that. Where the FED will have to step in is all the long bonds that have yields below inflation. Normally investors will have to sell those and move their money somewhere else. But if inflation is 2.5% and you are holding a 2.2% 30 year bond, you can’t get rid of that. That is where the FED will monetize. Most of the long-term debt is above current levels of inflation. So I think the treasury debt the FED will monetize is all the sub 2.5% issuance from 2013 and 2016. I think there is at most 1 trillion of that. At most. If I were to guesstimate there is probably about $500 billion that might need a bailout. I think the most likely scenario is the FED simply monetizes the new debt that is coming out of the Treasury that international buyers will not want to buy. I think that is why the FED is stopping QT. They want to start repurchasing the debt Trump is issuing. But that will most likely happen without the FED significantly expanding the balance sheet. At least not this year and next year. The FED was going to do $600 billion of QT in 2019. If they stop the QT, that means the FED can monetize $600 billion of new capacity that the Treasury needs in 2020. Long story short, by stopping QT the FED will monetize the Trump tax cut.
In the corporate debt market, you have about $8 trillion of debt. $2.5 trillion is investment grade. 2.5 trillion is BBB rated which currently people consider to be overpriced. Then you have high yield and leveraged loans. The talk is around BBB bonds and leverages loans. If we have issues blow ups there, the FED will rescue them. After 2015 Oil Crisis, I think the FED is ready to start buying junk bonds to bail out energy companies if oil prices go down. This is effectively monetizing the shale build up. I don’t think oil is going to $25 again, but if it was, the FED would be ready to step in and take over the bad loans.
The average default rate in the corporate bond market is 1.5%. A-rated issues have default rate of 0.20%. In the junk bond market, the default rate is around 3% (some say 4%). In the C rate issues, the default rate is 25%. Recovery rate for junk bonds is 40%.
Long story short, let’s assume 10% of the non-high grade corporate bond market needs a bailout because inflation is higher than the yield offered or there is simply default prospects because corporate earnings are getting slaughtered by inflation or low oil prices or whatever. 10% is a very high default percentage but let’s say we have a stagflation economic scenario where that is necessary. 10% of 5 trillion is $500 billion. That is how much the FED needs to monetize in the corporate bonds space.
To summarize, the next FED QE will bail out:
- $500 billion in long term treasuries
- $500 billion in corporate bond issues
The scope of the next FED QE as I see it right now is about 1 trillion. That means the FED will have to expand its balance sheet from $3.5 trillion (projected currently) back to about $4.5 trillion. Back to Financial Crisis era levels.