2017/07/27 Commentary: Balance Sheet Chicanery
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Commentary: Thursday, July 27, 2017
Balance Sheet Chicanery
It’s tea leaf time again… as in reading the ones the FOMC left at the bottom of the cup with the minimal changes to the statement released yesterday in a no projections revisions or press conference meeting. While those changes are easy enough to interpret, the bigger challenge for the Fed and market participants attempting to understand its impact is whatever it is up to now on the highly anticipated adjustment of its Brobdingnagian balance sheet. And we say highly anticipated after it failed to be more explicit in Wednesday’s statement, as some had suggested it would be wise for it to do. [For more on that see Wednesday morning’s Commentary: Balance Sheet Backlash? post.] We’ll return to that balance sheet reduction assessment shortly as yet another sign the Fed is engaging in its same old ‘normalization bias’.
Except now it is with ostensibly tough talk on the balance sheet reduction rather than serial future interest rate hikes, and for good reason. Yet the same reasons Janet Yellen had to reverse rate hike expectations in her recent Congressional testimony applies to the balance sheet reduction plans as well. More below.
A review of the FOMC statement (our mildly marked up version) illustrates how the Fed has become not just ‘data dependent’… it is overtly data sensitive in a way that is almost unseemly. Yellen’s reversal of hawkish sentiment was reversed once again in the statement’s more upbeat minor change. As noted in our annotation, the first is the shift to “have been solid” from “moderated” in the June statement. One good US Employment report and the Fed is back to stronger language on the strength there.
The second was the removal of the term “somewhat” from the phrase “running below 2 percent”, which reinforces the degree to which the weaker inflation tendencies seem a bit more ingrained than the Fed was willing to admit previous; and once again that is in spite of the still confident US employment view. And the last was the indication near the end that the further balance sheet reduction details will be forthcoming “relatively soon’, implying the September meeting. And with that we return to the chicanery…
Authorized Subscribers click ‘Read more…’ (below) to access balance of the discussion. Non-subscribers click the top menu Subscription Echelons & Fees tab to review options. As this is a ‘macro’ assessment, Market Observations remain the same as last weekend’s update (lower section) of last Thursday’s Commentary: ‘Normalization Bias’ NOT Back Redux post, and there is no Extended Trend Assessment in this post.
NOTE: Given the likelihood the US economy will now get the structural reform that we (along with Mario Draghi and others) have been loudly complaining was not forthcoming since our dual It’s Lack of Reform, Stupid posts in January 2015, we need to adjust our view that a potential economic and equity market failure is coming. We previously referred you back to our December 8, 2015 post for our major Extended Perspective Commentary. That reviewed a broad array of factors to consider Will 2016 be 2007 Redux? While a continued regime of higher taxes and more regulation (i.e. under Clinton) might have fomented a continued weak or even weaker US economy, the tax and regulation changes proposed by the Trump administration will hopefully still be approved by the Republican Congress and diminish the similar fears we had to what transpired in 2007-2008.
▪ … as the balance sheet reduction will be marginal enough to be more so symbolic than real in terms of its effect on bond market yields. That is especially so if indeed as we and others expect, the inflation pressures will not be very strong in spite of US and global employment gains. For much more on all of that please see last Thursday’s Commentary: ‘Normalization Bias’ NOT Back Redux post and the previous (post-Yellen testimony) Commentary: ‘Normalization Bias’ NOT Back!! post.
We encourage anyone who has not reviewed those posts and especially the very informative access to estimable outside sources to still do so. It’s very good insight on ECB psychology as well as the Fed. The final opening section comments and link out to the assessment from Fulcrum Asset Management’s estimable Chairman Gavyn Davies in last Thursday’s ‘Normalization Bias’ NOT Back Redux post is especially telling.
Along with other analysts’ critiques in the previous posts of why central banks reliance on seemingly defunct ‘Phillips curve’ relationships between employment and inflation is a real failure, he also offers a more recently developed alternative. It is compelling on why some other central banks have had to remain very dovish, and even the Fed has had to so quickly truncate its plans for the significant further rate increases signaled as recently as its June 13-14 statement, projections and press conference.
Onto Balance Sheet ‘Chicanery’
Accusing the Fed of ‘chicanery’ regarding its looming balance sheet reduction program might seem a bit strong. Yet consider that it means (according to the Oxford English Dictionary), “The use of deception or subterfuge to achieve one's purpose.” And in this case it is as we noted at the outset of this post that the Fed is still trying to make the case that US employment is so strong that it needs to tighten.
Even as more and more observers allow that the old ‘Phillips curve’ employment-inflation relationships are so obviously breaking down, the Fed seems to be engaging in another form of its same old ‘normalization bias’ from back in 2015 and early 2016. Except now it is with ostensibly tough talk on the balance sheet reduction as a form of tightening rather than serial future interest rate hikes, and for good reason…
…which is the problems further short-term rate increases represent for a yield curve that already remains too flat for many folks. And that means especially the major banks. However, there is a real question on just how much balance sheet reduction will help.
Bond Market Pricing
We know that most of our readers absolutely do not need schooling in bond market pricing and yields… so treat this as a brief reminder. The degree to which bonds (especially govvies that have virtually zero default risk) price at a premium to inflation in most cases provides the ‘real yield’ (i.e. after any erosion of the bond earnings from inflation are factored into the real return.)
And to revisit one of the most extreme historic cases, this was most prominent into the early 1980’s when inflation fears were still very high and so were government (and all other) bond yields in deference to that. Adding to the pressure on prices (and upward pressure on yields) were the huge US government deficit financing needs that led to record government bond auction volumes.
Yet from approximately 1984 onward especially into 1986 those massive US T-bond and T-note auctions were very well received. While the anticipation and event of the auctions might have caused some downward pressure on the bond prices, they seemed to almost miraculously recover after each auction was complete. And in spite of the continued sizable auctions, from May 1985 into April 1986 the 30-year US Treasury Bond yield imploded from around 10.5% to 7.5%!!
What in the world had transpired to create such confidence in lower inflation that implied a still acceptable ‘real yield’ at such significantly lower nominal bond yields (and massively higher prices)? It was that phase’s implosion of sustained high Crude Oil prices. As the previous high oil prices had fostered major over-production, prices dropped sharply.
After the first OPEC oil embargo in 1973 West Texas Intermediate Crude Oil went from $20.00 per barrel to $117.00 in July 1980. After holding up at no worse than $60.00 per barrel into November 1985, by February 1986 it had dropped to roughly $30.00 per barrel. And the sustained lower inflation assumptions from an area that had massively contributed to the 1970’s ‘stagflation’ in the developed economies was enough to drop bond yields in the manner noted above.
‘Normalization Bias’ Still Here
This gets us back to our assumptions on the Fed’s balance sheet reduction being more chicanery than real tightening. It allows it to take a misguided nominal stance against the inflation pressures that leave it wanting to tighten without upsetting some positive aspects of the strengthening US economy; which would be the case if it were to continue raising short term interest rates.
And the nature of the problem is just what the Fed had seen in 2015 and early 2016 on any threat to raise or actual hiking of short-term rates. Those had the potential slow a US economy which it must have sensed was growing slower than it would like to have imagined in its ‘normalization bias’ tainted view. Otherwise why would it have signaled the potential for rate hikes so many times only to demure at the actual FOMC meetings? This lack of stronger US growth also allowed the longer term bonds to rally (i.e. long-term yields weaken) right into the Fed’s threats to hike during that period. Also note that longer-term yields remaining low at present is still part of the Fed’s problem on…
It’s the Yield Curve, Stupid!
…the still rather flat ‘yield curve’. That is a real problem for the Fed, which extends to being a problem for banks that are pressuring it to allow the yield curve to widen. As such, it is as much the Fed’s respect for that as the sense that too many further short-term rate increases (i.e. the ‘federal funds’ rate that it directly controls) may weaken the economy. Of course, any weakening of the US economy will also exacerbate the situation by further weakening the inflation that is remaining more subdued than the Fed would like; and well below its 2.00% Personal Consumption Expenditure target. (As is the case for other central banks, as extensively reviewed in the previous posts noted above.)
So as much as the Fed is respectful of the degree to which the US economy and inflation are not strong enough to absorb the sort of rate increases suggested at June’s FOMC meeting, it also cannot afford to flatten the yield curve with more short term rate hikes. Especially if there were any concerns about US growth that rallied the govvies (i.e. lower long term yields) into higher short term yields, that would be a problem.
Many folks have felt for some time that the lack of any real ‘risk free’ yield classically associated with government bond investment is a problem. That is true for both the average investor and major entities like insurance companies, which have longer term obligations which increase at a pace faster than the recent and current paltry bond yields.
Key Constituents
Yet focusing on one of the key central bank constituents (true globally and not just in the US), the banks benefit from a positive yield curve. Historically one of the ways that the Fed and other central banks assisted the return to economic growth out of recessions was to allow the banks (especially the major banks) to ‘regrow’ their balance sheets. That was accomplished by the banks holding reserves garnered at low short term yields, and investing them at the higher long-term ‘risk free’ government bond interest rates.
And that has become even more important after the 2008-2009 Crisis, due to especially the major banks being required to hold much larger percentage reserves against the loan books and other businesses. Especially due to all of the other pressures from post-Crisis prosecution of major banks for misdeeds during the 2005-2008 Credit and Housing Boom, the banks were holding additional reserves as a buffer against any regulatory fines.
This created some of the relatively largest major bank balance sheets in the history of finance. The individual who articulated the best path for the banks due to higher statutory reserve requirements that had to be augmented with additional protection against any regulatory fines for previous (perceived or real) misdeeds was JPMorgan-Chase Chairman and CEO Jamie Dimon. In the company’s 2015 annual report he described the policy his team had instituted as a “fortress balance sheet.” He went on to describe that as…
“…enhanced capital and liquidity, our ability to survive extreme stress of multiple types, our extensive de-risking and simplification of the business, and the building of fortress controls in meeting far more stringent regulatory standards.” Rightful and well said.
What is the importance of that for the current ‘yield curve’ discussion? Simply that the recently higher short term rates are running up against limits at which they are potentially a drag on the banks that the Fed would like to see lend more. The Fed needs to allow banks to earn a better return on their balance sheets to help them prosper… and lend.
“More Symbolic Than Real”
This is why the Fed shifting over to balance sheet reduction from short-term interest rate hikes is less of an elective move than a requirement of the situation. The Fed’s short-term rate hike program has simply ‘run out of road’ in the context of yield curve implications.
For a very well-informed view on that we turn to Mr. Bill Gross originally of PIMCO fame and now with Janus Henderson. In a very pointed CNBC interview after Wednesday’s FOMC statement Gross notes that the pace of the Fed’s balance sheet reduction “…is akin to something like watching paint dry.” That is the observation at the beginning of the video clip, and he even notes that this is the same sentiment he has heard directly from some Fed officials.
He goes on to note some of the same things we have been signaling regarding the Fed’s shift, especially that it wants to appear to be tightening, yet cannot afford any further short-term rate hikes at this time. We also encourage you to watch the relatively concise interview for the specifics of the potential actions under the balance sheet reduction program as signaled so far. Gross notes that this will only amount to approximately 1.0% to 2.0% annually of the Fed’s balance sheet.
That fits right into the degree to which it is (as he notes) “…more symbolic than real.” And the same is true for its likely lack of impact on longer term bond yields. As noted above, those will substantially be set at a differential to underlying inflation (that ‘real yield’ again) more so than the sheer amounts of debt securities on offer at any given point; except as a very short term influence.
As a final point on that, it was very interesting that during the Fed’s massive Quantitative Easing purchases of US treasuries and other securities the bonds tended to rally on the announcement of the next round of Fed purchases. And the rallies mostly continued right into the actual purchase program commencement, only to sell off after that. The strength of the equities on the continued Fed liquidity infusions was enough to ‘spook’ the bond markets once the purchases actually began.
In those cases the additional massive Fed buying did not have much impact on a bond market beginning to worry about inflation. So why should the bond market be concerned about the nominal Fed fixed income supply provision to the markets, except as a short term psychological drag that will be better assessed in the context of what transpires with inflation across time.
▪ There is no Extended Trend Assessment in this post. This is a ‘macro’ assessment. In spite of the short-term impact of various matters reviewed previous, Market Observations remain the same as last weekend’s update (lower section) of last Thursday’s Commentary: ‘Normalization Bias’ NOT Back Redux post.
Thanks for your interest.
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