With 40 years in the investment business encompassing both institutional and private clients, we have been a student of the markets for decades. One thing that always stands out is that when the US Federal Reserve (FED) starts raising interest rates, we start to see the structural weaknesses in the economy. Warren Buffet has a famous quote: "A rising tide floats all boats….. only when the tide goes out do you discover who's been swimming naked." Quite simply, we and others have been waiting to find out where the problems lie, and so far, we haven’t seen any. Baffling.
In the 2008 – 2009 time period, called the Great Financial Crisis, commercial mortgage bonds of all types, liar loans for personal real estate, all were shown to cause financial stress almost bringing the financial system down. Currently, No STRESS within the banking system, or in the corporate world as the companies are generally in good financial shape, having refinanced as many loans as they could at much lower interest rates. Individuals who were thoughtful, also refinanced their mortgages at the artificially low rates caused by the pandemic.
Please keep in mind there are no geopolitical considerations in this article. It is hard enough trying to figure out what we are doing at home (U.S.), to try and figure out what the rest of the world is doing.
I have never liked the saying, “this time is different”, however it bears consideration as to the main thrust of this article which starts in the next paragraph. The FED quite simply during the onslaught of the pandemic (February 2020) took all sorts of loans onto its balance sheet enabling the economy to keep operating. This leads to the article I am referring to below.
One of my good friends and colleagues, Andy Loechl, CFA from Seattle, sent me an article from David Zervos of Jeffries musing as to why things (the economy) were not a lot worse as the US Federal Reserve raised interest rates. It is a little long, however, I think it is very important. The following is his analysis, and it struck a chord with me (the bolding/underlining in the art is RMH):
“The revelation began as I was wondering why things were not a lot worse. Or more specifically, why there have not been more serious global economic and financial stresses. After all, over the last 11 months the Fed Funds rate has risen 450 bps and the Fed balance sheet has contracted by over $500b from its peaks. At the same time, monetary policy has tightened markedly across the entire G20. And while there have been extremely large total return losses throughout the fixed income markets, and plenty of ugliness in the growthy equity space, overall market functioning has generally been orderly. Further, the economic fallout, particularly when looking at labor markets and corporate earnings, has been largely nonexistent.
I guess I just thought there would have been some more spectacular blowups. I found myself harking back to the tightening cycle of 1994…, That particular tightening cycle had just 300bps of Fed rate rises, with no change in the balance sheet, over about the same amount of time as our recent tightening cycle – 11 months. Other major central banks were also tightening at that time, albeit by smaller amounts. But back then, fixed-income markets largely stopped functioning. Orange County went bankrupt by choking on MBS derivatives. A guy by the name of David Askin almost singlehandedly destroyed the entire agency MBS market. Mexico broke its peg and plunged into the Tequila Crisis. Prop desks inside of both the commercial and investment banking worlds lost records sums of money. And it was nearly impossible to trade in parts of the Japanese or European sovereign debt markets. A lot of stuff broke, and a lot of folks, particularly in the interest-rate-focused portions of the financial markets, lost a lot of money.
So why are there not more David Askins blowing up the MBS market? Why are there not more Jon Corzines blowing up bank prop desks? Why are there no Orange Counties or Mexicos? Where are all the massive losses after 450 bps of rate hikes and over $500b of QT?? Then it hit me – it was so obvious I couldn’t believe I’d missed it: A massive chunk of the losses that would usually occur during a rate- hiking cycle were being socialized on the balance sheets of global central banks.
Back in 1994 the Fed balance sheet was tiny – just a few percentage points of GDP, and it only held T- bills. Today it’s ~40% of GDP and it holds a ton of those same interest-rate exposures that blew up so many folks in 1994. And in Europe and Japan, the central bank balance sheets are much larger as a percentage of GDP than in the US, with even larger holdings of spicy rate-sensitive risk assets.
Just for some perspective on size here, the Fed + ECB + BoJ balance sheets total around $22 trillion. For argument’s sake, let’s say they are all down by about 10% on a mark-to-market basis. (I would say that’s conservative since there are many MBS bonds that the Fed holds with high 70s to low 80s dollar prices). So we are talking about $2.2 trillion of losses that have been WITHHELD from the private sector during this tightening. In the old world, aka pre-unconventional monetary policy, those losses would have been distributed to the market – often in concentrated/leveraged hands. Today, though, those losses are socialized… Had this $2.2 trillion been set loose into the global financial markets over the last 11 months, my guess is there would have been some epic blowups and a much more serious drag on economic activity. That’s the big revelation!!!
The bottom line here is that in the old pre-QE world, an individual, a company, or a municipality that locked in a loan with term funding would win, while the holder of that loan would lose. For example, every US household that gained from locking in a low mortgage rate for 30 years had those gains offset by losses at a bank portfolio, a pension fund, a hedge fund, or any other holder of the loan in the private sector. In the old days like 1994, the gains and losses in the fixed-rate term lending markets offset one another in the private sector – it was a zero-sum game for the economy as a whole.
But today, in the post-QE world, the loss side of this zero-sum game is not being realized in full. The central banks have become a socialized buffer for large portions of the losses, thereby creating a one- sided private sector stimulus effect from the rate hikes. That’s why both financial markets and the economy have held up so well after this tightening. Trillions in stimulus have gone to fixed-rate borrowers across the globe, while trillions in unrealized mark-to-market losses have hit the central banks, with no immediate negative economic or financial-market consequences. There are no shareholder revolts or forced sellers after central bank losses. No CEOs get fired; no valuations collapse.
This is a huge, and highly unpleasant, unintended consequence from QE. It implies that monetary policy tightenings are now much less potent than in the past. Before, a central bank could blow things up and slow down the economy with just the flick of a 300bps switch. But now, QE has become a monkey on the back of the inflation-fighting process, hampering the process of “getting the job done.” Of course, the obvious implications are that that policy will have to remain tighter for longer, and possibly go higher than previously thought. Or – another way to think about it – central banks just haven’t tightened as much as you think.
… longer-term disinflation, credit should be just fine while equities struggle to break out of their recent ranges. Also on the brighter side, one now needs to worry far less about the hard-landing effects on
riskier credit. And this whole storyline does create a nice dollar-bullish backdrop.
… I do think one could easily make the case that QE may have been even more powerful than we had initially surmised. There are all the positive effects that come from QE through raising inflation expectations and lowering real rates, as well as driving term premiums and risk premiums lower. Those are clear and well known. But when you look at the accrual gains in the Fed portfolio, which were cumulatively over a trillion dollars since the start of QE1, those created a continuous fiscal tailwind as the proceeds were remitted back to the Treasury. Looking at QT in the same way, there is a modest headwind as Fed remittances to Treasury cease; but now the Fed defers all accrual losses. This deferral during QT vs. the immediate recognition of the gains during QE creates a huge asymmetry. The fiscal tailwind from QE is much larger than the fiscal drag from QT. All that said, while some pundits and academics have highlighted the fiscal effects of QE/QT, I don’t think there has been anything written on the tailwinds that come from socializing mark-to-market losses on central bank balance sheets after rate rises. That is the most important point from all this analysis.
Summing it all up, the power of traditional rate-based tightening could have been returned to something more normal if central banks considered selling assets BEFORE raising rates. Sadly, though, the big bad bank holding companies of the world lobbied hard against it for their own self-interest. And they won. As a result, they got tons more NIM, and they got to avoid losses on fixed-rate assets (which they instead shoved onto central bank balance sheets). The central banks on the other hand have been left with mounting portfolio losses and a much less powerful inflation-fighting toolkit...
As I said at the beginning of this article, I was struck with thoughts that had not been answered through 40 years of witnessing market tightenings and the resulting corrections. Simply, where would the carnage be when the FED started to raise interest rates. The above argument suggests to me that the FED and other Central Bank Governments of the World will have trouble lowering the inflation rate in a timely manner.
We will be writing an RMH Market Watch on Artificial Intelligence (AI). The world has been awash with Microsoft, Google and others with their progress or lack of. I am not ruining the RMH Market Watch on AI by stating, AI will help with the drudgery of certain tasks, in the beginning.
For example, I was notified by Schwab that Amazon Brazil was trying to access my debit card with a trial withdrawal of $0.0. Card blocked. It then took me 20 minutes to get to someone to find out the details, some of the call was automated, an endless loop! Joy!
As always, we live in interesting times, and it is a joy for us to try and understand what is happening here in the US and around the world as it affects investments.
If there are ever any topics you wish for us to explore, please let us know. We are here to help and guide you through these times.
We thank you all for taking the time and reading “Market Watch.” It is meant as an educational piece on the always evolving markets. It is something we plan on providing every month, and your feedback is very important to us.
On a personal note, RMH is now in the position to bring on new clients so please be sure to share this informational letter with whomever you wish. RMH’s focus is on the customizable investment needs of individuals, families, and foundations. We enjoy working with our clients to better understand their goals, values, and passions for what is important in their lives. In expanding our client base, we look forward to working with people who share these same desires.
Richard Mundinger, CFA
Ashlyn Brooke Tucker
Jeffries: David Zervos, 02/13/2023
Fuller Treacy Money: email, February 24, 2023