August 26. We’ll fix it when it breaks

Powell’s Jackson Hole speech was interesting, if only in terms of its omissions.  Perhaps in response to recent criticism of the Fed, it was pretty much boilerplate, “Stay in our lane” type stuff.  Stick to our mandates and manage expectations amid myriad uncertainties.

What was the most glaring omission?  Reference to financial stability, which some had thought was going to be a stealth third mandate for Powell’s Fed.  There was but one off-handed comment regarding the topic:  “Whatever the cause, in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.”

Most of the speech dealt with navigating monetary policy by the stars of the neutral interest rate, the natural rate of unemployment and the inflation objective. It’s an obtuse defense of the Fed’s independence and qualitative decision-making. Thus, Powell lauded the Greenspan Fed for holding rates steady as inflation failed to materialize in 1996 through 1998.  Here’s the quote from Powell’s speech:

Over the next two years, thanks to his considerable fortitude, Greenspan prevailed, and the FOMC raised the federal funds rate only once from mid-1996 through late 1998.  Starting in 1996, the economy boomed and the unemployment rate fell, but, contrary to conventional wisdom at the time, inflation fell.

I found a rather interesting WSJ article from May 8, 2000, ‘How Alan Greenspan Finally Came to Terms with the Market’.  Far from exhibiting teflon fortitude, Greenspan was constantly wrestling with asset valuations and the appropriate Fed response.  It was in December 1996 that he gave the famous “Irrational Exuberance” speech.  Stocks fell in the immediate aftermath, but then quickly resumed their upward march (see chart below).  As the article details, over time Greenspan accepted the surge in stocks as being “…driven largely by ‘very intelligent investors.’ He added, ‘That’s not the same as saying that they’re going to be right. But they are rational, informed judgments.’

The article explores how Greenspan’s thinking evolved: After 2 1/2 futile years, Mr. Greenspan dropped the project. To his 1996 question, “how do we know when irrational exuberance has unduly escalated asset values?” he finally gave this answer in 1999: It’s impossible to know, except in hindsight.

And so, in May of 2000 we’re back in present tense:  Mr. Greenspan’s conclusions are evident in his recent words and actions. He has backed away from suggesting the market is overvalued, yet feels that monetary policy should reflect the market’s impact on the economy. The bull market’s surprising endurance has driven the Fed into its first sustained drive to raise interest rates in six years. Friday’s report that unemployment fell to a 30-year low of 3.9% means that campaign will continue, as the Fed is expected to raise rates again — possibly by half a point – at its May 16 meeting.

This was the time of ‘wealth effect’ discussions.

As can be observed in the second chart below, the correctly predicted 50 bp hike to 6.5% in May 2000 was the last of the cycle. The vertical line on the stock chart is the date of the WSJ article.  Stocks had actually topped earlier in the year, and it was later in 2000 when Nasdaq imploded (amber line).  The Fed’s response was to slash rates in 2001 from 6.5% to 1.75%.  Is it worth noting that 2/10 treasury spread was -45 bps in April 2000 and -40 in May?  And that the peak 10 year yield of 6.68% was set in January 2000?  (which incidentally is the highest of this century).


















The point of this trip down memory lane is to highlight what appears to be an inconsistency in Powell’s speech.  He knows that dislocations in financial markets are the largest risk the Fed faces, but has chosen to focus – at least in this speech – on basic economic parameters in terms of policy.  It’s also worth a mention that both Friday’s speech and the Fed minutes released on Wednesday noted constraints on fiscal policy with respect to a response in the event of a possible downturn, due to large (unsustainable) deficits.  In 1998-2000 the Federal Gov’t ran budget surpluses!

Where are we now?  Longest bull market ever.  SPX made a new all-time high.  VIX sub-12.  Market cap to GDP nearing the high set in 2000. The unemployment rate is right where it was at its lows in 2000, 3.9%.  The curve is making new lows.  The 2/10 treasury spread closed the week just under 20 bps.  The red to gold euro$ pack spread is on its low at MINUS 1.  The most inverted part of the curve is reds to greens (2nd to 3rd year out) which settled -2.0.   Many analysts think that effects from the tax program will be waning by mid to late 2019.  The Eurodollar curve appears to be sending the same message.  As for stocks, it’s TINA. There Is No Alternative, especially if yields are steady to lower.  Rational and informed.

Steady as she goes, keep hiking until something breaks.  Which might explain why the Fed’s staff is fretting about how to handle the ELB (or effective lower bound) when we next experience it, which was the opening topic in the Fed minutes released Wednesday.

In terms of the Fed’s fine-tuning of communication skills, I’ll just end with another timeless quote from the WSJ article, perhaps equally appropriate for the Fed and for other branches of government.

Many of those who make their living in the stock market felt much the same way. “Why don’t you guys shut the f— up?” one investor told an official of the Federal Reserve Bank of New York at a recent social event.

Just a couple of other notes.  The earthquake map remains highly active.  The Japanese tsunami was in 2011, on March 11.  At the start of 2011 the US ten year yield was as high as 3.65%.  By late September it was 1.73%.  How much was Japan and how much was related to other factors? As Fred Sanford would say, “This is the big one! I’m comin’ to join you Elizabeth!”

Auctions of 2s, 5s and 7s should keep pressure on the curve early in the week.



8/17/2019 8/24/2018 chg
UST 2Y 261.6 262.4 0.8
UST 5Y 275.0 272.2 -2.8
UST 10Y 287.1 282.2 -4.9
UST 30Y 302.9 297.1 -5.8
GERM 2Y -65.0 -59.5 5.5
GERM 10Y 30.5 34.5 4.0
JPN 30Y 84.7 83.3 -1.4
EURO$ Z8/Z9 36.5 34.5 -2.0
EURO$ Z9/Z0 -1.0 -2.0 -1.0
EUR 114.38 116.22 1.84
CRUDE (1st cont) 65.21 68.72 3.51
SPX 2850.13 2874.69 24.56
VIX 12.64 11.99 -0.65
Posted on August 26, 2018 at 10:59 am by alexmanzara · Permalink
In: Eurodollar Options

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