Here we go again, again.
The unemployment rate is at a historic low. GDP is above 3% and with the recently enacted historic tax cuts, poised to go much higher. Inflation is at the Federal Reserve’s target. Housing starts and sales are booming and housing supply is at an all-time low. Equities are hitting new highs. Oil is hitting new highs as well and inflation is starting to percolate. Global economies and markets are performing well. Credit spreads are at historically tight levels. Spare levels of capacity are running tight and there are no indications of a downturn on the horizon. No I’m not talking about 2007. I’m talking about the here and now.
There were similar conditions in 2007 that led to the financial crisis of 2008. The main catalyst to the 2008 financial crisis was easy monetary policy allowing risks to build while letting the economy run too hot for too long. Yes, easy money policy and the Fed reducing accommodation too slowly led to the 2008 crisis. This resulted in the current and most accommodative monetary policy in history over the past decade.
Historically, current economic conditions would result in monetary policy and Treasury bond rates at least 3% to 5% higher. This disconnect of the current Federal Reserve Federal Funds Rate, the size of their balance sheet and historic low yields in the bond market verses the state of the US and global economy is the biggest and only tangible risk to the short and mid-term outlook to the economy. Yes, the biggest risk of a recession is Federal Reserve policy itself.
After years of accumulating trillions of bonds and pegging rates at 0%, the Fed understands they have created systemic risks to the US and global economy. They have encouraged the most risk taking the bond market has ever seen. Bond yields are lower, spreads tighter and supply almost double than that of the conditions leading to the 2008 crisis. In fact, bond yields are so low they are either predicting the deepest depression the world has ever seen (contrary to every economic and market indicators), or reflect a bubble blown by the last decade of unprecedented monetary accommodation.
The Fed recognizes they need to reverse policy and are behind the curve. If the Fed unwinds rates and their balance sheet too quickly, they will be held responsible for the market normalizing. The problem with the bond market normalizing is bond yields could shoot up 3% or more leading to long duration bond losses of 50% or more.
However, the slower the Fed takes to remove accommodation, the less likely accommodation will be removed at all. Take for example the last time Fed Chairman Greenspan removed accommodation at a 25 bp rate per meeting. The Fed telegraphed this move to minimize volatility. But according to past Fed studies, when everyone knows what the Fed is going to do, they already prepared for it rendering monetary tightening impotent. Monetary tightening has no impact slowing down growth, reducing risk and therefore reducing the risk of increasing inflation. In fact, when everyone knows what the Fed will do, the end result is increased risk taking trying to compete with the competition that will also be taking on more risk.
Yes, the Fed is damned if they do and damned if they don’t. Due to the unprecedented overpriced conditions in the bond market, a calamity is assured. It’s just a question of when and how bad it will be. In 2008, it was easy to justify your losses by blaming current conditions on the bad banks. However, this time around, the blame will be squarely on individual risk takers who continued to hold onto a decade long trade well after they should have set up for the next chapter. So in order to prepare those traders and portfolio managers that have ignored the fundamentals and continue to support the market with poker like doubling down and all in bets, here are some excuse to have at the ready when the bond market catches up to the rest of the economy and markets and normalizes.
I was in college when the last crisis hit – I misunderstood the Fed and the market risk.
I was in high school when the last crisis hit – I misunderstood the Fed and the market risk.
I was in middle school when the last crisis hit – I misunderstood the Fed and the market risk.
I was in elementary school when the last crisis hit – I misunderstood the Fed and the market risk.
Where else are you going to invest!
I was forced into it.
The music was playing I had to dance.
I thought these conditions would last forever.
It’s Trump’s fault.
It’s Obama’s fault.
It’s Yellen’s fault.
It’s Bernanke’s fault.
It’s Greenspan’s fault.
It’s Powell’s fault.
It’s the banks fault… again.
I didn’t know cash was an asset!
No hablo Ingles.
Sorry to say that when there is such a historic disconnect between the bond market and the fundamentals, it doesn’t end well for the bond market. The crisis of 2008 came after 7 years of over accommodative Fed policy and a disconnected bond market. Now after 10 years of accommodative policy that made the previous cycle look tame, the unforeseen risks in the system are multiples larger. But surely the bond market investors of today are more sophisticated and savvy than those of 2008. And given that, after 10 years of closing their eyes and crossing their fingers, I’m sure they already have a plethora of well strategized excuses ready to roll.
by Michael Carino, Greenwich Endeavors, 12/20/17
Michael Carino is the CEO of Greenwich Endeavors and has been a fund manager and owner for more than 20 years. He has positions that benefit from a normalized bond market and higher yields.