A 'Second-Half Rebound' Is a Mythical, Unicorn-Like Concept

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The ubiquitous second half rebound. Like a unicorn, it is a mythical creature for times like these. In July 2015, for instance, Federal Reserve Chairman Janet Yellen testified to Congress that unforeseen “headwinds” had materialized. The oil price crash rather than hasten consumer spending (like a tax cut, they all said) had heralded all sorts of negative financial consequences. The dollar most of all.

But Yellen dismissed these, saying, “this sluggishness seems to be the result of transitory factors.” Many Economists had become amateur meteorologists, the Fed’s top boss being one herself. In addition to the cold of winter, Ms. Yellen mentioned how there had been a port strike on the West Coast and the always-present “statistical noise.”

Because of what she said were the strong economic fundamentals of the economy, as well as expert monetary policies here and abroad, there was no danger beyond the little bump in the road which started out 2015 on the wrong foot. The second half would bring with it the rebound.

“As a result, the FOMC expects U.S. GDP growth to strengthen over the remainder of this year and the unemployment rate to decline gradually.”

The unemployment rate did continue to decline; in fact, nearly four years later it still hasn’t stopped. But in 2015, the economy grew worse anyway. It nearly hit a recession in Q4, with revised estimates putting the start date in the very same quarter in which Yellen was then testifying.

The word “transitory” is, comparatively speaking, a new entry into the lexicon. The concept behind it is not. For every setback and false dawn over the last twelve years, each began with what were supposed to have been temporary factors easily overcome by powerful stimulus of all varieties.

On April 2, 2008, then-Chairman Ben Bernanke went before Congress, too. This wasn’t the regular, semi-annual Humphrey-Hawkins theater. Instead, the Joint Economic Committee was demanding answers. Just two weeks before, Bear Stearns had been shockingly bailed out, shepherded with great assistance from the central bank into the reluctant arms of JP Morgan.

Don’t worry, testified Bernanke. Just passing headwinds.

“We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies; and growth is expected to proceed at or a little above its sustainable pace in 2009, bolstered by a stabilization of housing activity, albeit at low levels, and gradually improving financial conditions.”

It was an interesting take, though maybe not for the most obvious reasons. This passage and the sentiment it was built up from illustrates a lot of what continues to plague the global economy.

Monetary policy in particular had come to focus on the aspects of the burgeoning crisis policymakers thought the real trouble underlying everything. As Bernanke said shortly after Bear, they wanted the “stabilization of housing activity.” From that, it was merely expected how everything else including the second half rebound would fall into place.

Central bankers were not alone in this belief. It was as common and widespread as anything. Earlier in 2008, in February during Bernanke’s usual Humphrey-Hawkins appearance much of the focus was on home owners. Only weeks before Bear, Congressmen were chastising the Chairman for not doing more about mortgage rates.

Mortgage rates.

Republican Gary Miller of California complained:

“It [the Fed] has done a good job of lowering the cost of funds to lenders, but from mid-January we're looking at the opposite when it comes of mortgage rates to people who want to buy a house. They tend to be going up.”

The Chairman countered by pointing out when given enough time (say, into the second half of the year) those short-term rate cuts would follow through into the housing market and therefore calm the situation. “I think we do still have power to influence the housing market and the broader economy, but your points are well taken.”

Obviously, that wasn’t true. The Fed was still cutting rates and instituting all sorts of “unconventional” new policies well into and after what had become a second half nightmare.

When policymakers had gathered the prior September, in 2007, they had begun the cycle without any fear of recession at all. It wasn’t a sharp economic contraction which had preoccupied their time and efforts. Rather, they had come to believe that by expending so much time and effort on the problem (as they understood it) there would never be a contraction.

The 2007 rate cuts began with the premise that they would amount to insurance against any looming downside no matter how big and entrenched.

Speaking about Bear Stearns in July 2008, also in front of Congress, Chairman Bernanke noted:

“In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets.  The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy.”

As it turned out, an orderly failure led to the same horrible results anyway. By focusing on housing and the perceived credit risks associated with subprime mortgages in particular, there was never enough consideration about “suddenly losing access to short-term financing markets.”

To policymakers, the problem was Bear Stearns; too much perceived credit risk by institution. It never really dawned how it might be the other way around.

It may seem like the same thing just perceived from alternate angles, but these are two very, very different problems. Why was Bear denied this funding? The official answer was given by then-Fed Vice Chairman Donald Kohn in yet more testimony to Congress, this time in June 2008.

“Loan loss provisions rose sharply during the first quarter to $32 billion, exceeding net charge-offs by more than $14 billion, as the institutions were building their loan loss reserves in advance of expected further deterioration in loan quality. Increased concern over the potential for more losses from traditional lending activities has also been evident in the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices, which in recent quarters has shown banks tightening their lending standards and terms.”

The central bank’s crisis strategy was clear: bolster financing markets by reducing the costs overall (rate cuts) and targeting liquidity programs as needed, thereby assuring participants that the subprime mortgage credit problem wouldn’t be spread. By thus steadying the financial system, the housing market would bottom and economic growth would transit through a dicey but transitory soft patch.

Second half rebound and then better days in early 2009.

No wonder it didn’t work out so well. The premise was entirely backward. By analyzing everything through the prism of credit risk, housing, and subprime mortgages, authorities presumed an otherwise healthy monetary system in need of only some official reassuring. Once received, the system would go back to doing its healthy business-as-usual; preserving from spoil all the good apples in the bunch.

Under this scenario, Bear Stearns was rejected because it was the one bad apple.

As I said, that’s very, very different from what really happened – and why 2008 was the result. It hadn’t been an otherwise healthy monetary system weeding out some bad actors, those pegged as egregiously wicked evil housing speculators. Rather, it was a broken system trying to make some sense of the consequences of the system everyone all at once realized was breaking.

The fact that it was Bear which went first was a big clue along these lines. Bear Stearns wasn’t some subprime peddler – it was everyone.

Under that condition, “losing access to short-term financing markets” takes on a whole different set of implications. None of them very good, beginning with flailing, failing, and ultimately impotent monetary policies. What good are rate cuts for something like this?

What I mean is this: the funding market saying, “we’ve got money for everyone, we just don’t know who is good and who is bad” is a whole different ballgame than, “we don’t even know how much money is available for anyone.” In this context, anyone who can or does secure that cheaper funding is going to hoard it. Things only get worse from there.

Where were the credit losses in 2015? There were almost none, and what little was booked was nothing out of the ordinary for business-as-usual. But globally, it was very different from business-as-usual.

It’s easy to think that credit risk was the difference in 2015 being nothing more than a near recession in the US and 2008 becoming the Great “Recession.” That doesn’t take account of the entire system, however. For many places, particularly in emerging markets, 2015 was their 2008. It was that bad.

In December 2014, the BIS had warned about what it said was increasing fragility particularly related to overseas markets. In its Quarterly Report, the institution reviewed what had just happened in the few months before publication. Notably, October 2014.

“This sharp retreat in risk appetite reflected growing uncertainty about the

global economic outlook and monetary policy stance, as well as increased

geopolitical tensions. As selling pressure increased, market liquidity temporarily

dried up, amplifying market movements.”

Though they had rebounded after the eye-opening trading session on October 15, markets were exhibiting growing cause for concern. “But recent developments suggest that markets are becoming increasingly fragile.” Still no credit losses.

Among the BIS’s chief worries related to this “fragility” was the potential for dollar problems. Where US mortgage-related finance had once dominated the offshore financial world, in dollars, after 2008 much of what was left turned to foreign largely EM corporate issuers. The BIS didn’t make mention of the implications as far as collateral chains (transformation) might have been concerned, but they were all over October 2014 whether officially recognized or not.

In light of the turn, “suddenly losing access to short-term financing markets” became paramount once more. Against the backdrop of the rising dollar exchange value, what happened starting in 2014 like what happened starting in 2007 was in many ways as old as banking and fractional lending itself. All we have been talking about here is currency elasticity.

A highly elastic currency increases or decreases in volume together with the level of business, including financial business. An inelastic currency is typically one like that of the gold standard – a fixed or nearly fixed amount which relies on prices to redistribute and work through imbalances.

The world is supposed to be running an elastic system; that’s what central bankers have been claiming for decades. And it was this which monetary officials in 2008 believed they had achieved, rescuing the housing market therefore securing the rebound. In 2013, Ben Bernanke described the Federal Reserve in this role, its first.

“The new institution was intended to relieve such strains by providing an ‘elastic’ currency-that is, by providing liquidity as needed to individual member banks through the discount window; commercial banks, in turn, would then be able to accommodate their customers.”

The nature and tempo of the central bank windows have changed over the years, but the basic proposition has not; at least insofar as the theory is concerned. What would happen, though, if there were no working windows?

More than the potential for scarcity.

Writing about the December 2014 BIS report, Ambrose Evans-Pritchard in Britain’s The Telegraph newspaper realized, “The implication is that there is no lender-of-last resort standing behind trillions of off-shore dollar bank transactions.”  No kidding.

As 2008 showed, there was no real lender-of-last-resort anywhere. Not really, certainly not one that functioned with effectively elastic currency. Rather than figure out the proper monetary specs for something like that, officials were busy with their alternate plans to save the housing market from a few rotten apples.

In the technical sense, what Evans-Pritchard wrote was true. In effective terms, however, there has always been a different sort of lender-of-last-resort. As noted last week, the repo market has played that role in the absence of central banks still pining away over spoiling fruit. That’s ultimately what happened in October 2014 – the fragility related to the repo function (globally in dollars) being interrupted by a (renewed) shortage of collateral.

On October 15, everyone piled into UST’s worried about collateral chains and bottlenecks. Over the course of the next year and a half, for many EM’s it was a second half nightmare. The US economy was in many ways lucky to have emerged with only a sharp slowdown (the very fate of those same EM’s in 2008).

What ended Bear’s long and storied run was a lack of acceptable collateral. What if the elastic currency of the modern repo-based system isn’t something like bank reserves, it is instead collateral itself? Collateral elasticity. It’s not a product of any central bank but of the system itself, which is what makes it so enigmatically fickle.

Which brings us up to the second half of 2019. Officials aren’t worried about a recession, nor are they much concerned about housing or credit losses. The rate cuts which are coming are just insurance for that anticipated rebound passing by non-specific financial “cross-currents”, as current Chairman Powell called them this week. Like Yellen four years ago, the new Chairman doesn’t really know why there’s weakness nor where it is coming from.

Cross-currents, headwinds, transitory factors. What if those all relate to inelasticity in collateral? Well, it wouldn’t be the first time it had thwarted a second half rebound. Credit losses still aren’t required.


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

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