The Boom Died Months Ago, and Had Nothing To Do With Rate Hikes

The Boom Died Months Ago, and Had Nothing To Do With Rate Hikes
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There was excitement all over that particular Thursday. Stocks were up, the S&P 500 rising by more than 2%. It was the continuation of relief that began a few days before. The big one, though, was oil. WTI rocketed by 10%, one of the largest daily gains in the modern history of the energy market.

For the next few days, the rally in crude would keep on going. By the end of trading the following Monday, oil had surged a cumulative 27%. It wouldn’t matter. This was the last days of August 2015.

It had happened before, too. During some of the worst market conditions in generations, the middle of September 2008, there were speculators all over the oil market. We only hear about them when they sell, nobody complaining in the days immediately following Lehman about the rampant, unhinged bidding for the WTI benchmark.

On Monday, September 22, after a full week of digesting the most serious financial consequences since the Great Depression, there was oil up a massive 16% in a single day. It was the tail end of a powerful ricochet that had resulted in an impressive if ultimately meaningless 33% rebound.

Over the next two and a half weeks, the world went to hell. WTI itself would give back another 35%, and then an additional 56% by the time the FOMC would meet in mid-December to surrender on panic and depression. And then more beyond that.

We don’t remember these rallies because they were superseded and overwhelmed by the domination of the opposite direction. In August 2015, the crude market was gripped by turmoil, the trading of its last week or so the eye of the hurricane. The sole reason there was such a big upward move on that particular Thursday was because the unfolding crash had suddenly amplified the Monday before.

The old adage is still applied: buy when there is blood in the streets. Sometimes, you end up buying at the first sight of it before all or even much of it has been bled.  

Oil rallies of this size are unusual simply because an oil crash doesn’t happen very often. When WTI collapses, pay attention not because of the opportunity to cash in immediately rather because it announces that serious problems already visible have achieved a critical point.

This past Wednesday was a good day in the electronic CME pits. The US benchmark crude price surged by just about 10%. Before then, WTI had collapsed by more than 40% since October 3. Forty percent is something of a threshold, consistent only with a forward economic downturn. Stretched out over a couple years, a decline of that magnitude would be good for consumers; condensed into just a few months, it’s panicky liquidation.

What’s most remarkable is the excuses prevailing even long into an oil crash. The media over the last several years has become fixated on the unemployment rate to the exclusion of every other indication. It was this way in 2015, too, where the “strong” labor market was supposed to be insurance against “overseas turmoil.”

The oil smash unmistakably announced, and announces again in 2018, the two mistakes simultaneously: turmoil wasn’t limited to foreign economies and the domestic labor market meaning US economy couldn’t have been that strong to begin with. We find ourselves in that familiar territory for a fourth time. But why?

That’s what I don’t get about these “fire the Fed” folks; they’re way too late to that conclusion having arrived at it for all the wrong reasons. Their message is therefore unhelpful to the point of harm.

It begins with the realization that there are Democrat Economists and Republican Economists. Each group really believes that the key to recovery and economic success is to do the opposite of the other one (and therefore all criticism is based in this relationship). In 2017, the latter saw the opportunity to recreate the “Reagan economy” by nullifying and reversing what the former had done.

At the top of that list was Obamacare, taxes, and regulations (Dodd-Frank). Many had blamed the health insurance mandate for suppressing the labor market particularly medium-sized businesses by strangling them with what amounted to a tax on hiring and maintaining full-time labor.  This was on top of the actual tax (Supreme Court ruling) of the individual mandate which surely constrained consumer spending for millions.

Trumponomics was above all undoing what Republican Economists saw as the mistakes of the previous administration (who was doing the same thing as they saw of the Bush administration). Tax cuts and deregulation. Tax cuts and deregulation. Tax cuts and deregulation.

I make no argument against these on their own individual merits. Tax cuts are a good thing as is often deregulation. But that’s not the debate for 2019, nor was it the problem anyone was attempting to solve. People should be able to keep more of their own money; letting them do that wasn’t ever going to be the catalyst for an actual economic boom, however.

These orthodox Economist tools can be useful even powerful incertain economic cases, though not in all economic cases. It appeared (to certain especially Republican Economists) that’s what happened in the early eighties, tax cuts and deregulation, which sparked the best economy since our pre-industrial days. If it worked thirty-seven years ago, why wouldn’t it perform the same magic today?

Such simple logic just isn’t logic. What was wrong with the global economy in 1979 or 1982 wasn’t at all the same thing as what has plagued the global economy in 2008, 2014 or 2018. You make the argument for tax cuts on the basis of tax cuts; if you try to make it about recovery you aren’t even speaking the right economic language.

As this year ends, this has become more and more apparent (though it was pretty evident all along, at least to those without these preconceived political biases). Not so says this group; it is all the Fed’s fault for spoiling the economic boom they created. Fire the Fed.

In the calendar year of 2017, the FOMC, the US central bank’s policymaking body, voted to raise the federal funds range three times, 25 bps each time.

Toward the end of last year, the excitement over the presumed boom was, according to these people, going to become so good that the bond market was about to be utterly devastated. In late October 2017, one Bloomberg story announced, “bond bears may finally be having their moment.” In it, one of the latest so-called bond kings, Jeffrey Gundlach, was quoted as saying, “The moment of truth has arrived for secular bond bull market!”

If the economy had moved out of a decade of malaise and into sustained growth, the rout in the bond market especially for safe assets like US Treasuries really was going to be epic. The transition from low rates consistent with a paradigm of no growth (and tight money) to more normal rates consistent with actual growth would be momentously painful.

Ironically, it would also have meant a more aggressive Federal Reserve.  A booming economy can spark consumer price inflation and with the unemployment rate plumbing new multi-decade lows the probability seemed substantial enough. Competition for scarce workers, as implied by a 4% and less rate of unemployed, would mean businesses passing on higher costs to consumers who could afford to absorb them given the worker benefits (wages) derived from a scorching labor market.

And if any of that had actually been happening, no one outside UST’s would’ve cared one bit about the short-term interest rate. When things are really cooking, four, five, maybe even six rate hikes in a given year are visibly inconsequential. During 2005, for example, Greenspan’s FOMC raised the federal funds target eight times and economic growth wasn’t anything to get excited about. Nor was it derailed by them.

So, if things are going wrong at the end of 2018 it isn’t because of the four that were done this year. If the Fed’s hiking is to blame, then this boom is the most fragile boom ever seen in history. Or, it was.

The Bank for International Settlements (BIS) wrote twelve days ago in its quarterly review of the global situation:

“Financial markets swung widely, eventually netting a sharp correction, during the period under review, which started in mid-September. Asset prices fell across the board and US government yields widened in October before retracing that increase and dropping further as the selloff of risk assets spread. Volatility and term premia jumped. A further round of turbulence, this time accompanied by lower yields, hit markets in December. The repricing took place amid mixed signals from global economic activity and the gradual, yet persistent, tightening of financial conditions.”

And that was all before this past week. An economic boom doesn’t produce “mixed signals from global economic activity”, and it certainly was not the way 2018 was supposed to have unfolded. When Economists are forced into positive spin about obviously negative developments you know things are already way, way off track.

We are supposed to believe a federal funds target range of 2.25% to 2.50% is the reason? The boom was so huge it was going to be biblical, and yet it can’t take just 2.50% at the top? Nope. This is pure nonsense, politics at its worst.

We are left with only the one inescapable conclusion: there was no boom. Nothing had changed when the Republican Economists took over from their Democrat counterparts; just as nothing had changed when those Democrat Economists had replaced their Bush contemporaries. The economy is unchanged heading toward a twelfth year regardless of political affiliation.

I’ve written all along that this is the worst case - by far. The malaise is persistent an entire lost decade plus, and yet nobody can really see it. It hasn’t been a straight line. The economy swings up and down, lurching toward what looks like recovery and a boom only to be derailed as if keeping to a regular, sadistic schedule.

When it’s on the downward side everyone is confused and defensive, honest inquiry thrown out the window in the ages-old practice of CYA. And when it’s on the upswing, as it was in 2017 as 2014 or 2010, it’s the greatest thing ever.

Nobody bothers to reason out why the greatest thing ever only seems to result in the same bout of muddle and disbelief each and every time regardless of D or R. The greatest economies in memory dissolve into nothing over the most nonthreatening of symptoms, things like “overseas turmoil” and now a 2.50% federal funds policy. Absolutely amazing, literally unbelievable.

As part of its plan to exit from its years of “extraordinary” and “emergency” monetary policies, the Federal Reserve in April 2014 created a call sheet it classifies as FR2420. The report is to be filled out and filed daily by eligible US commercial banks and thrifts, as well as both International Banking Facilities (IBF) and foreign banks operating subs in the United States.

The purpose of FR2420 is “the analysis of current money market conditions and [to] allow the Federal Reserve Bank of New York (FRBNY) to calculate and publish interest rate statistics for selected money market instruments.” Somewhere along the way, many years too late for 2008, it dawned upon US central bankers that their focus on the one money market rate, federal funds, and therefore only dollars traded domestically was perhaps too narrow for purposes of both policy as well as understanding the bigger picture.

Policymakers reluctantly noted the need for a more comprehensive perception of money market conditions, including supplementing the federal funds effective rate (EFF) with what’s now called the Overnight Bank Funding Rate (OBFR). The OBFR is derived from the transactions and balances banks report via their FR2420.

These include not just federal funds purchases but also “certain Eurodollar transactions.” About time, right? Recognizing that there is and has been some highly relevant business to US money market conditions taking place offshore, the OBFR is a very quiet transition to a more modern, almost 21st century framework.

But what gets reported on the FR2420 you ask? Part A is federal funds purchased. Part C relates to time deposits and domestically-issued CD’s. Part D includes other kinds of deposits.

Part B is the big one, or it should be. This is the segment dealing with eurodollars, but only those issued in amounts of $1 million or more (aligned with the standard eurodollar futures contract) negotiated at arm’s length including a stated interest rate (which can be zero or negative) for a specified period.

While that may sound like it covers a great deal of what might take place and what seems monetarily relevant, the instructions for FR2420 astonishingly exclude from its reporting duties all the offshore things we are more concerned about, even going so far as to specify these very things as what firms don’t need to report.

The shadow behaviors the Fed doesn’t want clogging up and complicating its FR2420 are: automatic eurodollar sweeps, security lending transactions, borrowed debt instruments, repos, and any eurodollars traded with “retail counterparties.” All the stuff at the very epicenter of what’s been wrong since August 9, 2007.

Therefore, something like May 29 doesn’t show up. It did happen, obviously, this massive, global collateral call roiling and upsetting global money, but for the OBFR therefore monetary officials it didn’t. This upgraded money rate, surprise, surprise, tracks almost exactly the federal funds effective rate (which, as I’ve noted in recent months, is itself a problem).

According to OBFR, May 29 was a day like any other - the very same message as provided by EFF. Some upgrade; they created an alternative to EFF so as to better comprehend global dollar markets only for it to almost exactly mimic the incomplete, misleading rate long (mis)used in practice. 

According to every other market, May 29 was the inflection point.

Whatever was left of 2017’s reflation and inflation hysteria, this so-called boom, it died just after Memorial Day. Everything changed and it had nothing to do with “rate hikes.” You can draw an almost straight line between then and the current liquidations, “selloff of risk assets”, and most of all the less mixed “mixed signals from global economic activity.”

Policymakers have finally started to deduce eurodollars in their work, but only the smallest tip of the offshore iceberg. They are about a quarter-century behind the times.

The tax cut and deregulations people are about forty years behind. On their say, we should fire the Fed?

Far be it for me to stick up for this central bank, if we are going there it should be for legitimate reasons. Jay Powell should be fired, along with the rest of them, for what’s being kept out of the OBFR rather than the current level of it. Sacking policymakers over 2.40% is the same lack of accounting as the last eleven almost twelve years; doing it because they omitted cross border repo and securities lending from FR2420 would be substantial progress.

Again, tax cuts and deregulation are potentially very good things; they just are not going to, cannot solve the current predicament. Listen to oil on this score, especially when crude posts unusually huge daily gains. The unusual has become almost regular because history rhymes. 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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