Watching Fed Chairman Jerome Powell testify to our esteemed but largely innumerate members of Congress, I was reminded that once government begins a massive intervention in a market two things happen. First, the bureaucrats are reluctant to give up their new found power and will endeavor to keep the intervention going long past its usefulness. Second, market participants will adapt and mold their behavior around this new dominant player.
The examples are not in a distant memory. Consider the sub-prime mortgage fiasco (which is again rearing its ugly head). Or the student loan meltdown currently underway. Recall that this is a market that came under Federal control only two years into the Obama Administration. We cringe as the pundits puzzle over rapidly increasing default rates in the face of political promises of forgiveness. Who could resist holding payments back in anticipation of an election year bonanza!
Sometimes the market distortions continue for so long and at such a scale that they form a new market attribute. This is where we find ourselves today.
This chart details the events. For the 50 years prior to the financial dislocation in 2008, the Fed was easily able to provide liquidity to the economy with assets equal to about 5% of GDP. In response to the crisis, that number rose to close to 25% of GDP and it is still near there today. The rational was sound. Goose up liquidity to rescue banks foreign and domestic. Buy long bonds to keep mortgage rates low in the hope that consumers could re-finance rather than default.
Excess reserves in the banking system rose from $1.9 billion in 2008, to over $2.6 trillion, an increase of 1,375 times. Most of those excess reserves were never deployed to support commercial loans or mortgages.
The immediate effect of all this was muted as the banks were grappling with a myriad of problems, not the least of which was finding a way to pay an astounding $243 billion in fines for misrepresenting the quality of the sub-prime loans they’d sold and for a wide assortment of other misdeeds. Fannie’s and Freddie’s control of the mortgage market rose to 90% of all origination’s.
The recovery, which should have been robust, fizzled out.
Despite that policy failure, the Fed is still sitting atop $3.7 trillion in assets. QE or quantitative easing is no longer a crisis-driven anomaly but just another wrench in their toolkit.
Powell’s style is that of a stern educator with the patience of Job, a reminder of the acerbic of Fed Chairs past: Greenspan and Volker. So he is perhaps well matched to clean up after the decade of Bernanke-Yellen QE bacchanalia. He was off to a good start.
And then the specter of an inverted yield curve appears.
With the Fed-controlled assets sitting all along the yield curve, what does inversion portend? What would the yield curve look like if those $3 trillion in bonds were in the hands of market participants rather than the government?
Therein lies the unique challenge for Chairman Powell. He needs to shrink his unneeded mountain of bonds while convincing the market that they are, in fact, unneeded. Once his own thumb is off the yield curve scale it will be easier to see the market sensitivities.
Powell also needs to continue the economy towards a return to normalcy in the face of unprecedented abuse from the very person who appointed him.
The recent easing was a mistake for three reasons. First, with the economy steaming along it was not needed. Second, it created the appearance of the Fed kowtowing to the White House. Last, he took a step backwards – away from normalcy.
As a reminder, this is what “normal” looks like:
- Total fed assets – $900 billion
- Excess banking reserves – $5 billion
- Fed funds rate – 3%
- Ten-year treasury – 5%
It may already be too late for a calm transition. The young folks on the trading desks today don’t remember what normal was like and they are afraid.
– Jim Anderson