In Its Fight With the Fed, the Bond Market Wins Every Time
The Federal Reserve continues to believe that the US labor market is exceedingly tight, and that in the end will prove decisive. Markets globally disagree, including but for more than economic circumstances in the United States. Once again, market versus Economist.
Chairman Powell stuck to his guns this week, raising the federal funds apparatus by 25 bps. This is, the FOMC claimed, consistent with how things really are. More than anything, a “strong” labor market, suggested entirely by the unemployment rate, will mean businesses competing for scarce workers driving up wages and therefore the whole of the economy. Consumer price inflation would merely be the confirmation all is well.
Here’s one relevant discussion:
“Last month, the unemployment rate edged below the 4 percent mark for the first time in more than thirty years, a development entirely consistent with the anecdotal reports in the Beige Book and elsewhere of an extremely tight labor market. Against this backdrop, and with the effects of the steep run-up in oil prices of the past year filtering through the economy, we are not surprised to be seeing some signs of a general pickup in wage and price inflation.”
I wrote that it is relevant not recent. This passage was lifted from the Greenbook prepared for the Federal Reserve’s policy meeting held in May 2000. Then, as now, policymakers were enthralled by these statistics as they saw them, more than enough to set aside any worries about that stock market thingy.
At the very same time markets, especially those that count (not stocks), were stacking up on the other side. The unemployment rate meant nothing, what did was massive imbalance threatening the economic status of the overall global economy.
Economists actually detest markets. They believe them irrational, suspect, and nothing more than the uncontrolled spasms of the easily excitable. Worse yet, they are pushed around by “evil speculators”, a charge almost always leveled when any market direction becomes too convincing in its opposition (like 2008).
A lot of it stems from one misunderstanding, a very big one. All Economic textbooks teach that central banks are central. Many of those were authored by scholars who would go on to become central bankers (funny how that worked out). From this view, no wonder policymakers don’t align themselves with market signals. For them, they tell each market what to believe.
Therefore, if it doesn’t believe the same thing at the same time, guess who Economists think is right? This is the part that should shame the discipline into some serious, deep soul searching but never does and probably never will (not willingly, anyway). In the context of markets versus Economists it has been no contest; if it was a boxing match the referee would’ve stopped it long ago for the pummeling Economists have taken.
It was one thing, as I’ve chronicled through the years, to ignore something like eurodollar futures in early 2007. Curious inversion in that market plagued the FOMC as it started to sketch out some rough edges of subprime. Eurodollar futures, you see, told them as anyone else it wasn’t going to be about subprime.
Nonsense, Bill Dudley replied again and again and again. Economists at the Fed consulted with their econometric models and the math worked out just the way Economists thought. Dudley then surveyed Economists at all the Wall Street banks who also consulted their models and the math still worked out just the way every Economist thought. And then the crisis happened in a way none of them thought it could.
The situation in May 2000 is perhaps the closest analog to what is unfolding right now. Powell may be held in high regard in some places still (though much less so after this week) but it is nothing in comparison to the “maestro” Alan Greenspan in his absolute prime. Greenspan in early 2000 was a bonafide rockstar, if for reasons of self- and institutional promotion above all else.
While the smiling image of the maestro permeated CNBC coverage and regular fawning stories about him appeared throughout the mainstream media, he never quite won over the “bond market.”
It is important to define our terms here; bond market can mean several different things. Credit markets on the whole are enormous and contain many classes. There is risky stuff like junk, safe stuff like Treasuries, and everything else in between. When I use the term bond market, I actually mean the securities and types closer to money equivalents. There are UST’s and relatedly eurodollar futures or interest rate swaps.
These are the very liquid, deep markets that are most directly attached to the banking system, and therefore are most direct in line of interpreting what banks are doing – as often opposed to what bank Economists might be saying on TV or via informal surveys conducted by Bill Dudley.
We care more about banks than central banks for that one grave misunderstanding. In the textbook, central banks dictate because of, as Ben Bernanke claimed two and a half years after May 2000, they possess the “printing press.” The modern wholesale-based offshore global reserve system, this eurodollar, doesn’t much have anything to do with whatever Bernanke was talking about.
In a credit-based monetary arrangement, what banks are up to at any one time matters a great deal. Thus, when the “bond market” suggests something odd or contradictory, where these very banks are putting their own resources on the line for reasons contrary to mainstream assessments, we really should pay attention. Alan Greenspan, as Jay Powell, moved one money market rate around a quarter point here or there and that is what moved, moves, the media.
But, why was Ben Bernanke talking about the “printing press” in November 2002 if the maestro controlled everything via his magic? Obviously, the economic system is incredibly complex, but it all started and starts with clear incompetence. The FOMC saw inflation breaking out throughout 2000 and into 2001, and therefore was acting upon that forecast.
The market foresaw an asset bubble which if it burst would become the single most important risk to not just the US but the overall world economy. The eurodollar futures curve had actually inverted the month before in April 2000. By then, some people not Economists could sense something wrong implied by at least the NASDAQ.
Curve inversion is often misunderstood, too. There are several elements to assess when one goes this way, but in the context of monetary policy it is really simple. The market disagrees with policymakers on its forecasts driving its actions.
Financial and money curves especially are supposed to be upward sloping. Time means risk, and risk requires compensation. More time, more risk, more compensation. If an interest rate or bond yield for the same kind of security, like US Treasuries, is lower for a longer-dated security that doesn’t mean investors (banks) aren’t getting compensated, it means they are expecting to be paid in other ways than what might be associated with normal, healthy economic processes.
The end result is the market saying interest rates will be lower in the future, which, if you remember your Friedman, means tight money in the real economy. In terms of federal funds and the modern, activist central bank’s interest rate targeting scheme, they have it all backwards (loose money now and tight money in the future, the central bank futilely raising its target during the former and lowering it during the latter).
The Treasury curve had become inverted in the hugely important 5s10s space on the last day of January 2000. The 2s10s followed several days into February.
Since Greenspan via his models had become concerned about the unemployment rate therefore the economy becoming “too good”, the FOMC had been voting since the summer before, 1999, to “tighten” by raising the federal funds target. Curve inversion, again, said that the market expected over the intermediate term ahead even the maestro would be forced into realizing his forecast error; the unemployment rate did notdenote the most significant risk to the economy.
This is exactly what happened, quite rapidly as it turned out. The FOMC would vote to chase the unemployment rate on May 16, raising the fed funds target by another 25 bps. It was to be their last “hike” that cycle.
In one more eerie coincidence, the policy committee actually blamed T-bills, as they have again in 2018, for a large part of the curve inversion and what was happening as market practice. The federal government’s fiscal “surplus” at the end of the nineties had reduced the supply of securities. The Federal Reserve requires the purchase of especially bills for earning assets and market liquidity functions.
The Manager of the System Open Market Account, as it was called at the time, was Peter Fisher.
“MR. FISHER. As a number of you noted at the last meeting, with over $3 trillion in marketable Treasury debt outstanding it seems clear that we ought to be able to find sufficient assets to grow the SOMA balance sheet from the existing stock. However, the amount of marketable Treasury securities outstanding with remaining maturities of more than 10 years, exclusive of SOMA holdings, totals only $433 billion. And that amount will decline as a consequence of both Treasury buybacks and System purchases. There is also strong demand for these long duration assets in foreign and domestic private portfolios, as reflected in the inverted yield curve.”
Though the overall budget situation was vastly different back then, the opposite of today, Fed officials discussed how the situation with regard to supply was creating the inversion in the yield curve – and therefore it wasn’t something they should pay much attention to a technical quirk as opposed to a serious alarm about economic conditions.
And they didn’t. They kept discussing instead the unemployment rate and the risky inflation outlook policymakers believed as inevitable.
Several confused and volatile months followed, punctuated by enormous uncertainty on every side. Two days into the New Year, 2001, the maestro was doing exactly what curve inversions had predicted, what he had publicly denied often vehemently. This was because in private they outright rejected each and every risk being presented, a surefire case of tunnel vision based on emotions drawn from the one number that just so happened to suggest successful monetary policy.
Robert McTeer was President of the Dallas branch at the time, and his May 2000 summary discussion of conditions in the Eleventh District perfectly illustrates their collective dissonance.
“MR. MCTEER. Labor shortages are still the most common anecdote. It has even spread to academia where “raiding” parties are trying to recruit away faculty members. In Austin, where shortages of high-tech labor have persisted for a longer time than in other parts of Texas, some employers have been giving quarterly rather than annual salary increases, as Bill Poole reported for his District.”
Even though in their assessment labor was in short supply, McTeer would admit right after the above statement, “In spite of the pressures on wages, there are few examples of businesses passing on higher input prices unless the increases are related to higher energy costs.”
That wasn’t the only contradiction coming from Texas.
MR. MCTEER. Last month's weakness in retail sales could be the start of a new trend, but it is too early to judge. Housing demand probably has begun to deteriorate, but a rush to buy in anticipation of further increases in interest rates may have masked the underlying deterioration. April’s down-drift in the stock market could produce a notable reverse wealth effect for the remainder of the year. This morning's CPI number serves as a hopeful suggestion that we may not be guilty of doing too little too late or be behind the curve. Our gradualist approach has served us well and I see no compelling reasons to depart from that strategy.
Since the yield curve inversion was chalked up to Treasury supply factors and the Fed’s imposing SOMA provisions, nothing to worry about there, either. No one mentioned eurodollar futures because I don’t believe Fed officials were aware of what they were or how important they had by then become.
In summation, the unemployment rate’s myriad market-based detractors were for policymakers unserious distractions from their true mission – controlling the economic success they believed they had crafted by steering just the one money market rate up and down (actually down in ’98 and then back up beginning ’99).
By the time Bernanke was talking about the printing press toward the end of 2002, the dot-coms were still busting, the economy had gone all the way through a mild “unforeseen” recession and the recovery from it wasn’t actually a recovery. Had they relied on the bond market rather than poorly constructed, though impressively complex, models they might not have made that mistake.
It didn’t seem as if it cost the world much in 2001, just a mild recession, but it paved the way for policymakers to make the same mistakes based on the same discredited assumptions a few years later. Some printing press.
They really have no idea what they are doing, and they never have. People have a very hard time internalizing this well-established fact. Since we are all taught that central banks are central, more than that that central bankers represent the highest ideals of scientific and technical excellence, DON’T FIGHT THE FED.
Except, the bond market has been doing just that for a very long time. It is doing it right now. As I write this, the 5-year UST yield is about equal to the yield on the 12-month bill, and 3 bps below the 2s. The eurodollar curve between June 2020 and June 2021 is inverted by almost 10 bps now, a significant escalation from just a week ago.
And by bond market, I mean the very global banks who in Economics theory take their cues from this federal funds kabuki but in truth actually dictate the global money direction and therefore the economic condition moving forward.
We’ve been hearing for more than a year about labor shortages, the unemployment rate, and consumer price inflation. And yet, these markets with the enviable track record are betting on the near opposite of all those things. Deflationary tendencies, overseas turmoil that is touching a little too close to home. Again.
The US and the rest of the world went through this just a few years ago. The myth and legend of Greenspan persists anyway because in its absence there would be only uncomfortable darkness, an enormous intellectual black hole no one in position of authority is prepared to deal with. Better to cling to the fairy tale than to admit chaotic reality. That is the true nature of Powell’s “rate hike.”
It’s not better, though. And we are being reminded for the fourth time in eleven years. By all means, fight the Fed. The bond market is and it has won every battle.
