The Powell Party Is Just Getting Started, and It's the Opposite of Festive
Why wasn’t it Christmas? Everything we had ever been taught pointed to the celebration. One prominent stock market analyst said, “we’re having champagne and cookies.” That was the way share prices reacted globally. The Dow jumped 330 points, while the NASDAQ and S&P 500 were both up near 3% on the day.
The date was September 18, 2007. The Federal Reserve had just announced that it was cutting the federal funds rate for the first time in years. Subprime mortgage problems had been contained, Bernanke assured everyone about six months prior, but in case they weren’t going to be the Chairman wanted everyone to rest easy regardless.
Not only did FOMC members vote for unleashing “stimulus”, they doubled its typical size. Alan Greenspan’s Fed had habituated markets to 25 bps increments. Bernanke in September 2007 delivered a fifty.
And on top of that, US monetary officials purposefully made a bigger deal of it by altering what today is called forward guidance. The central bank wasn’t going to be idle any longer. They wanted the whole world to know there would be more cuts to the federal funds target if that’s what the economy needed. Policymakers who before were unmovably stubborn had suddenly become uberdovish.
Another investment advisor quoted by CNN was positively giddy in response, “It's like the Christmas present you really wanted but weren't really expecting.”
Of course, that’s not really how it turned out. Even by Christmas 2007, let alone Christmas 2008, it was clear this was beyond normal. Stocks would eventually peak in October and then over the next few months things would spiral. “Bond” markets, where everything that mattered coalesced, grew even more chaotic and distorted.
That first rate cut wasn’t something to celebrate, it was instead a warning that conditions had already gotten out of hand. We’ve been taught from Econ 101 that Economists working at the top of every central bank dictate. Late summer 2007 showed it was the other way around, monetary policy was instead reactive and not all that effective in reaction.
Not long into 2007’s holiday season Bernanke’s Fed was talking about, and implementing, strange new pieces to the monetary toolkit; things like TAF auctions and dollar swaps with other central banks. Why did other central banks need dollars? Conventional wisdom says straight rate cuts are unholy power in the hands of the enlightened few. But now the whole world needed weird new supplements?
This, by the way, was what certain markets like eurodollar futures had been anticipating for a year beforehand. According to the curves, the Fed may have believed in its optimistic view but participants in this deep money regime knew better about who was hedging what and why. Rate cuts were coming, this market screamed, and then they did.
Then they didn’t stop. Just before Christmas 2008, ZIRP. Global ZIRP. The reception for those was more funeral-like.
It was a worldwide economic wipeout that seemed, for those celebrating rate cuts like children, to come out of nowhere. Even during those tumultuous months at the end of 2007, many places seemed fine if not downright booming. In Germany, for example, that country’s factory sector was humming along. New orders for manufactured goods leaped 15% year-over-year in October 2007, and then grew by 13.6% that November.
The German economy is uniquely positioned as a global bellwether. You hear it often enough how there are really two zones in Europe, the north versus the south, where in the former more productive factors combine such that those countries contained in it produce far and away more than they need. Germany in particular, the European export powerhouse shipping its bountiful produce beyond just the other parts of Europe.
As Germany’s export sector goes, so it must be out there in the rest of the world. Thus, when the minus signs eventually started to show up here, the child-like enthusiasm for rate cuts and the expanded toolkit was more and more washed away by a much harsher, frightening reality.
But what reality? Subprime mortgages weren’t nearly enough to halt and then wreck the global economy.
A double-digit decline in German factory orders finally hit in October 2008. By then, there was no doubt about anything; central bank “stimulus” wasn’t something to cheer, it was everything to fear; central bank forecasts were wildly and painfully optimistic, even when they were downgraded; there was no decoupling, as many had claimed when it was just the US apparently struggling with a subprime mortgage problem, somehow it had all been transformed into a worldwide meltdown of unthinkable proportions.
Perversely, stock markets in September and October 2007 were cheering their own destruction. The panic had already begun weeks before, in early August, a fact that first 50 bps cut acknowledged. Investors there didn’t know it because they had allowed themselves to be mesmerized by Economists’ magic tricks. No one ever thought to question whether Alan Greenspan claiming to control all money, credit, and economy by moving the federal funds target a quarter point here or there was blatantly ridiculous.
This is the behavior of brainwashed cultists.
Ten years later, few have taken the opportunity to contemplate. Central bankers continue to enjoy prestige and their words come off like economic gospel. In Europe, Mario Draghi says his economy is booming still, but a little less now. It remains hot enough for his central bank, the ECB, to wind down QE and even think about raising rates.
Only, significant economic questions have arisen as well as the “strong worldwide demand for safe assets.” Even though Germany’s 2-year schaetzes “yield” around minus 60 bps, about 20 bps below the ECB’s money market “floor” set by its deposit rate, there is no end in sight to the market bid for them. The 10-year bund is as low as 11 bps in yield as of this writing.
In terms of Germany’s place in the world economy, that’s an even bigger question if only because the vast majority of people continue to believe in Santa Claus. The German factory sector has broken down during the very period Mario Draghi said it was the perfect time to withdraw. His economic boom.
New orders for German goods first contracted last March, about 3%. Though they would rebound in April, jumping 7%, orders posted another small minus for May. The global economy’s first hiccup.
At the same time, the world’s markets were trying to shake off the dust of uncertainty after having been buzzed by liquidations and further by distortions in money and bond curves.
On May 29, 2018, the whole system was hit with a massive collateral burden in global repo and almost certainly FX derivatives (the dollar wasn’t supposed to rise). Curves went inverted, particularly eurodollar futures. The implication, in plain terms, was a nontrivial chance Jay Powell being forced to give up whatever rate hikes he had planned and then, contrary to everything he had said in his short tenure as Federal Reserve Chairman, turn around and cut them.
Why would he ever do the same thing as Bernanke?
Last August, German factory orders declined almost 2%. In September, by more than 5%. A small rebound in October, +2.2%, then the plunge: -3.4% in November and finally, according to data released this week, -10.8% during that chaotic month of December.
Minus eleven for German manufacturers is equivalent to their worstmonth in 2012 – when all of Europe was last undergoing a nasty and acknowledged recession. It is equivalent to October 2008.
It’s not just eurodollar futures that seem to have it right. The oil market, for example, has previewed Powell’s total, 180-degree turnaround. Before October, global oil prices were rising and futures curves were in what’s called backwardation. This is the shape of a market in physical balance between supply and demand (where the commodity being traded for now and in the future is perishable or regularly used up).
Since mid-October, the futures curve has been pushed back into contango; an arbitrage opportunity where investors who have the financing capability can buy current crude available for sale and store it somewhere for many months or several years into the future. The steepness of the contango dictates both the level of potential profit for doing that as well as the lack of market participants thinking this is a foolish thing to do.
I wrote about it several months back:
“What does it say about the world economy if commodity investors are, for example, steadfastly discounting current product so as to entice contango? This financial encouragement toward future rather than current delivery and use can be as foreboding as it sounds, but only in certain cases…
“Contango can show up, obviously, if demand subtracts. Should the local or global economy weaken, the same situation in the futures market would arise. Producers would have to discount the short-term futures contracts relative to longer ones so as to begin the incentivization toward more storage. If you aren’t going to be able to use what’s available today, it has to go into a tank or pipeline somewhere until demand returns.”
Crude production is quite predictable, even over the long run. It takes a lot of time for new wells and ventures to come online, and everyone has a good idea when existing wells should run out. So, the supply trajectory is relatively more easy to estimate. What always changes is demand.
Demand is much harder to predict because, well, in the mainstream central bankers are Santa Claus. How does anyone in the mainstream go about establishing their perceptions about future demand? They start with the economy Jay Powell and Mario Draghi describe and forecast. Booming economies and increasing use for crude.
When the boom doesn’t really boom, however, oil may move back into backwardation, as it did in later 2017, but it won’t be at $100 or more. And if that non-booming boom suddenly disappears, the result is the disaster contango and crash (which is actually worse than what a hypothetical movie it sounds like would be, one starring Sylvester Stallone’s brother Frank and Kurt Russell’s ex-wife Season Hubley).
German factories more than a month ago were indicative of at the very least a high probability of global recession, if not one already, confirming the oil market’s fears over global demand and therefore its contango shape and plunge in price.
What would make Jay Powell cut rates and do it maybe even at some meeting in 2019? German factories at minus eleven and oil markets in contango, both of which agreeing with the eurodollar futures curve that has been warning about this very scenario for almost eight months already.
The more time passes, the more Economists say this is nothing. And yet, as each month rolls by, the more that scenario plays out.
Neither Jay Powell nor Mario Draghi want you to know, but they both see it, too. That’s ultimately what this new uberdovish stance is all about. How can the Fed be reassuring at the same time it begrudgingly, abruptly changes course? Give the NYSE an unexpected Christmas present.
Since Christmas Eve 2018, global share prices have been lifted by one monetary policy pause after another (it only takes a pause nowadays, that’s how degraded). They are, echoes of 2007, cheering the increasingly likely demise of what was always way short of an economic boom.
Borrowing a phrase from a friend (offshore, no less) who apparently borrowed it from George Soros, we are not predicting Euro$ #4 we are witnessing it.
Strong worldwide demand for safe assets.
You know what it is that central bankers are missing. The same thing they were missing in 2007, the same thing that’s been missing since the missing money seventies. I wrote here in these same pages in March 2013, nearly six years and two “booms” ago, how it was enough of a beginning to contemplate the story behind M3:
“The Fed, however, was actually honest here, and that should have been, and should be still, meaningful in the context of monetary engineering and the economy’s paradigm shift in 2008/09. Those two elements of M3, repos and eurodollars, were the epicenter of crisis. The fact that it would have cost the Fed too much to attempt to measure these ‘money’ aggregates shows just how far the banking system strayed from the light of the regulated regime. Yet, as the Fed demonstrated in the first sentence of its official rationale, our central bank had little interest in that monetary/banking arena.”
They substituted interest rate targeting for the purposes of managing expectations in place of actual monetary competence. Alan Greenspan’s 25 bps mockery as the replacement for defining, measuring, and understanding the radical changes to money and banking. The stock market was central bankers’ true medium for the experiment; Pavlov’s salivating dog conditioned upon the mere mention of a dovish morsel.
Unfortunately for them, eurodollar trumps the Dow. Expectations even in record high stock prices are no match for the effective money condition of the real and global economy.
If the central bank doesn’t do money, then who does? Global banks. But there are fewer and fewer of them willing to put up even minimal resources after each time we go through these things. This is the reason why demand falls and the economy never really gets back up again afterward; leaving it so fragile and exposed, perfectly set up for the next one.
Goldman Sachs is just the latest to announce, after getting somewhat back in following Euro$ #3, it has had enough (again). From Bloomberg this week:
“Goldman Sachs Group Inc. is considering plans to reduce the capital dedicated to its core trading business within the fixed-income group, a nod from the bank’s new chief that the business may not be as lucrative as in its glory days, according to people briefed on the matter.”
Federal funds at 240 bps didn’t do this. The ECB ending QE didn’t do this. Strong worldwide demand for safe, meaning liquid, assets. As I finish up here, not only is the German 10s yielding 11 bps, Japan’s JGB 10’s are back to -2 bps, and the UST 5s yield 6 bps less than the 12-month bill. Massive global liquidity hedging. Something big is wrong with global money. Again.
Jay Powell sure isn’t Santa Claus but as a worst-case backup he may want to rent the red suit anyway and at least show up at his next press conference wearing it. Sure, he risks looking like a clown instead, though no more than he has already. At this point, why not go “all in” on expectations, turn the metaphor into visual reality. He may need to. The party is just getting started. It’s just the opposite of festive.