What's Next Isn't a Flood. It's Downright Historical.
Companies in the US as well as around the world have participated in an all-out debt binge. This hasn’t been because of the Federal Reserve’s actions; on the contrary, the huge surge in borrowing has been in spite of Jay Powell’s “heroic” efforts. As nearly forty-one million American workers have filed initial claims for unemployment compensation over the last ten weeks, an unfathomable one-quarter of the entire workforce, it’s more than worth the exercise of trying to figure out why.
COVID-19, sure, but is that all that there is lurking underneath?
According to former Fed Chairman Ben Bernanke, the US central bank (acting in concert with others around the world) ended what it claimed was a subprime mortgage fiasco by undertaking “courageous” emergency actions. Things today that are commonplace like QE and ZIRP back then were new and mysterious; just the way monetary policymakers like it.
The media did most of the work from there, writing up the systemic “rescue” as if the Fed had flooded the world with dollars. Money printing, in other words.
This led to an initial backlash often sharp and brutal. Leading the charge were leading monetarists, including Anna Schwartz, who claimed Bernanke’s was overdoing it. His reckless flooding wouldn’t just overcome the deflationary forces then stacking up against the global economy, it would unleash a tidal wave of uncontrolled inflation which would destroy the dollar and the bond market altogether.
Because the inflation never happened, the most vocal early critics easily silenced, process of elimination, the Fed must’ve been right with its response. This is a false dichotomy since these two possibilities were never mutually exclusive. There was, as it turned out, another more sinister option.
Anna Schwartz like Martin Feldstein and the others didn’t understand the monetary nature of the assignment, and so they were proved wrong without even the slightest hint of runaway inflation anywhere outside of a temporary return in crude oil. But it was also untrue that Ben Bernanke had succeeded in the way he led everyone to imagine. No flood; no money; no recovery.
Ironically, it was Anna Schwartz’s partner Milton Friedman who taught the world how to properly vet the situation. He called it the interest rate fallacy simply because the discipline of Economics lacks so much discipline it hasn’t trained Economists let alone the public about how interest rates really work.
We’ve all been taught that low rates equal stimulus, and high rates are constrictive akin to monetary tightening. This conflates several key concepts, beginning with the lack of definition about which rates are doing what. It was further compounding by the clown Greenspan who despite his reputation for saying nothing with a tremendous amount of words, so-called fedspeak, he had for once dared to be unusually straight about a subject he’d have been better served had he kept it unclear like his usual practice.
Greenspan’s “conundrum” wasn’t a mystery but a confession. Here was the Fed Chairman telling Congress, quite openly, he had no idea how the bond market worked; a rather important deficiency given what we are all led to believe happens in the great global economy.
The Fed, as Greenspan told it, commands in the manner in which we are all familiar; lowering the federal funds rate as stimulus, or raising the policy target intending to choke off a little credit leading to tightening in credit therefore cooling a perhaps overheating economy.
The bond market’s role was believed to be merely ceremonial. As the “maestro” testified in front of legislators, the risk-free spline of US Treasury yields should be thought of as a matter of objective math.
“The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more-distant forward rates remain unchanged.”
And this is how econometricians treat the yield curve: as a result of past policy choices handed down from on high rather than a signal about future conditions independent of the central bank.
Greenspan the clown, therefore, displayed for posterity his plain ignorance on a central topic of monetary importance.
But that was Milton Friedman’s view, too. Though much of what Greenspan ever did during his long tenure was done in Friedman’s name, not so much when it came to interpreting bond yields. The father of monetarism had pointed out all the way back in 1967 how Economists had it all wrong.
“As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”
This put Alan Greenspan’s series of one-year forwards at odds with all economic history – including 1967 when the track of interest rates overall was once again about to prove Friedman exactly right. The Fed throughout the seventies, the Great Inflation, had kept trying to tighten monetary control to no avail – the inflation, like bond yields, kept moving ever-upward always out of reach of Arthur Burns.
So, the inflationists of 2009 and 2010 were wrong about what Bernanke was doing, but so, too, was the mainstream characterization which had employed an inappropriate dichotomy: if no inflation, then Bernanke wins. Every time bond yields fell, the media attributed lower rates to Bernanke’s success because of the lack of inflation, even though it was perfectly clear at the time this was untrue.
At best, bond yields behaved in no discernable way while these early QE’s were ongoing. When the Fed was actually buying the securities, their prices tended to be all over the place. In more than one case, yields actually rose rather than fell. And overall, Treasury yields dropped considerably more without QE than with it.
Having been taught only the Greenspan approach, it might have seemed like bonds were still obeying central bank commands with perhaps the timing a little off. The matter was then given another dollop of the absurd with the introduction and hype of “forward guidance” without much thought as to its “what” and “why now.”
You see, even central bankers like Bernanke know the difference when it comes to timing. Low rates as “stimulus” as he sees them, including QE which is merely low rate policy extended at the zero lower bound, are a temporary matter. Once that stimulus is successful, what happens next?
When money is plentiful and economic opportunity abounds (at low-enough perceived risks) the demand for the safest and most liquid instruments drops, leading to a drop in prices and therefore higher yields on the whole of this class of securities.
Therefore, the issue of the 2010’s wasn’t yields, necessarily, it was success. What I mean is simply this: despite all the public celebration about economic growth achieving what looked kind of like it could have been something nearer to recovery, the Fed’s central bankers knew from the very beginning it wasn’t really happening (I mean, one, two then three and four QE’s spaced out over a six-year period isn’t solid evidence of anything but lack of success).
Rather than assume QE hadn’t been effective, that there had been no flood of money or dollars at all, Bernanke’s policymakers instead left Friedman and fingered bond yields. The explanation they settled upon was low rates (and QE at the ZLB) had been successful because they all believed it couldn’t possibly fail, therefore what caused the lack of recovery was rates rising prematurely.
Or, more specifically, the possibility that rates might rise prematurely. Fears of a BOND ROUT!!! that never leaves the future tense, this is what has kept the economy under wraps for a decade?
If you hadn’t noticed already, this is more than bordering upon the realm of the absurd. According to this theory, QE/low rates are effective stimulus which first lowers rates across-the-board, but because it is effective stimulus the potential for rates to rise then cuts off that stimulus. So, QE works very well - except in that it seems easily thwarted by a potential result that never actually happens.
The solution in the fevered minds of central bankers is therefore something called “forward guidance.” Seeking to avoid what they’re forced to see as a harmful rise in rates choking off what they’ve calculated low rates had just accomplished, authorities speak directly to the bond market telling investors there that the central bank will just keep on keeping on; that bond purchases will continue even after perfectly clear signs of recovery and growth have been established.
The idea, deployed most comically in 2013, was that bond market participants would be so enthused with such central bank promises of a backstop they’d forgo selling US Treasuries and other safety instruments even as monetary opportunities in the roaring real economy presented themselves all around. Bond investors aren’t just Greenspan’s simpletons any longer, they’re trained seals who factor that theoretical first one-year forward above everything else.
The reason authorities are “forced to see” rising rates as harmful even though they’re historically associated with exactly what these same policymakers are aiming to achieve is, again, lack of success. Something must be wrong. It can’t be central bankers, can it?
And the answers are laid bare in these very interest rates. Tight money. No flood; no money; no recovery. Greenspan the clown had shown the way, ironically, once you realized what he was really saying – the bond market disagreed with the “maestro” about especially monetary and economic risks.
One, several, or maybe all of the links in his theoretical chain of one-year forwards severed by nontrivial dispute.
He thought there weren’t many risks in the middle 2000’s worth holding to safety instruments, Bernanke famously agreeing with him. The bond market instead blasting its warning far and wide: do you not see this freakin’ housing bubble? That was the conundrum.
Still lower yields in the 2010’s was merely its continuation – Bernanke’s Fed had responded poorly to what was really a global dollar shortage (the global dollar surge pre-2007 had been the reason for the US housing bubble as well as so many other bubbly, non-moderate conditions globally) and then kept up with its poor response year after year, QE after QE.
Unable to fathom how monetary policy could’ve utterly failed, forward guidance has been set aside in favor of other, even more implausible explanations. There’s R* which assigns blame to you and me: Americans are lazy and drug addicted (they used to cite Baby Boomers until the data proved unequivocally that folks who should be retiring are actually being forced to work more and longer) and therefore QE didn’t let us down, we must have let down QE (I’ll assume your apology to Dr. Bernanke is in the mail).
Others, like those at the BIS, for example, have simply tied themselves in knots trying to extract monetary policy success from the mountain of evidence all pointing directly to its complete failure. Acknowledging the correct interpretation of persistently low rates and yields, Hyun Song Shin, the Head of Research at the BIS, wrote in 2017:
“Very low yields on long-term government bonds may not necessarily signal prolonged future economic stagnation and deflation but instead reflect efforts by institutional investors to limit risk.”
I remember when I first read this; I had to read it again three and four times. Dr. Shin, I thought, had a lot to offer and was one of the few who was willing to be honest (at times) about the global situation. Not an official to just cavalierly dismiss the long list of inconvenient results.
What he was saying in 2017, though, amounted to a meaningless tautology designed poorly to muddy the picture. Why else would institutional investors be overwhelming, at times, in their pursuit of limiting risk? The answer can only be prolonged future economic stagnation and monetary deflation caused by liquidity and money problems. Both sides of the same coin, in other words.
No flood; no money; no recovery.
And that brings us to 2020. Though the spark, the big shock, was non-economic in nature the end result was the same nonetheless. Global dollar shortage, and by all accounts an historic one.
Commercial and industrial loans are an important direct link between the real economy on its supply side, meaning potential, and the financial system. Normally, you want to see C&I lending on the rise because it means companies are likely investing productively, hopeful about future opportunity. Perceptions become reality.
Despite low rates, commercial lending never regained its former glory; rising after 2008 at a much-reduced pace no matter how low yields or the Fed would go. Score another one for Friedman.
Furthermore, commercial credit of this type stopped growing entirely right around January 2019 – right when bond yields were, once more, falling precipitously. The beginning August 2019 – when bond yields were signaling recession – to February 2020, C&I loan balances actually declined modestly in absolute terms.
Beginning March 2020, however, and continuing into May, it’s been an epic surge. Absolutely through the roof. The Federal Reserve reports lending here has exploded by 25%! There’s never been anything like this before in any single year, let alone a period less than three months.
Did the Fed gain control of the bond market finally, figuring out Greenspan’s magic in that first one-year forward? After all, March, April, and May have seen Jay Powell’s Fed put Bernanke’s 2008-09 labors to shame. Big. Bigger. Biggest. Flood!
Alas, no. And the reason is confirmed to us, among other places, by JP Morgan chief Jamie Dimon. In his annual letter to shareholders written in April 2020, Dimon admitted:
“Companies have already drawn down more than $50 billion of their revolvers to prepare themselves for the crisis (this already dramatically exceeds what happened in the global financial crisis). Many others have requested additional credit, which we have been offering judiciously – more than $25 billion of new credit extensions were approved in the month of March alone.”
In fact, according to the Fed’s numbers, almost all that huge rush into C&I was attributable to lending by the 25 largest domestic banks who were doing as JP Morgan has been.
Companies all over the real economy, it seems, aren’t thrilled with the prospects of the Fed’s “flood” of “liquidity”, instead more determined than at any time in history to underwrite their own liquidity.
In short, Ben Bernanke’s carefully crafted story about the last twelve years has all been a huge lie. Companies like McDonalds and Caterpillar remember only-too-well having been forced to beg at FRBNY’s door for that Fed branch to buy commercial paper each couldn’t sell. Survival had been at stake, money tight for even the best names, and after having survived GFC1 and its official clown-show they all remember it very differently than his “flood.”
With an even bigger “flood” this time around, it’s perfectly clear the biggest corporate names aren’t waiting around to see if Jay Powell pulls it off. They already know how this ends.
And since they do, prudence dictates corporate liquidity measures extend far beyond drawing down every possible bank revolver – it also means hyper-control of costs, by far the biggest one for any business being labor.
Low bond yields are a clear indication that Economists and central bankers have no idea what they are doing. That being so, what must record low yields indicate? If you’re a clown, you try to say you’ve got forwards on your side, the world, and bond market, right where you want it.
While the media continues forever onward with its flood stories and inflationary proclamations, too ignorant and unaware of recent history along these very same lines, America’s corporate managers like the world’s bond investors (the banks themselves) know what’s next isn’t a flood at all. It’s downright historical.