Dear Valued Clients and Friends,
I closed out our annual “money manager due diligence week” last week with a luncheon put on by the Economic Club of New York with Federal Reserve chair Jerome Powell. He surprised me by saying some things that I was not expecting, and he also said a lot that I could have predicted verbatim (okay, I did predict verbatim) before the speech.
But despite all my earnest desire that the main action in markets let alone the economy not be at the whim of a few unelected academics, the Fed is the major story of markets right now. Their propensity to stay way too loose for way too long, followed by a period of being way too tight for way too long, is the cyclical and rotational story of our economic and market-oriented experience for 25 years.
We met with nearly twenty money managers last week (across a wide variety of asset classes in both private and public markets). We did not meet with a single one who did not bring up the Fed, the state of monetary policy, the potential direction of monetary policy, and its impact on how they think (and, in some cases, act).
So let’s jump into the Dividend Cafe where today is all about the Fed, the rubber chicken, and the radicals who stormed the stage before the speech began. Well, actually, we spend very little time talking about the rubber chicken or the people who stormed the stage and delayed the event for fifteen minutes while security and law enforcement did their thing. Those things really happened and were quite upsetting (especially the chicken). But the Dividend Cafe today is all about the actual words of Jerome Powell and what it all means. Off we go …
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Some basic takeaways of what he said
Jerome Powell is one of the rare Fed chairs who has capital markets experience. He spent many years at private equity firm, Carlyle, and was a Fed governor in 2012 when then-Fed chair embarked upon QE3 (the massive addition of over $2 trillion on the Fed balance sheet over three years after the financial crisis had ended). Powell’s response at the time to QE3? Real skepticism, especially as to how they would ever undo it.
2012 Powell was ahead of his time and would have proved prescient had he not flipped years later. But like my decision to draft Drake London in fantasy football but then choose not to start him in week two, it is not good enough to be “sort of right.” You have to see it through.
Powell was the Fed chair who was appointed by President Trump at the recommendation of Secretary Mnuchin in 2017, and who in 2018 began lifting the Fed funds rate while at the same time reducing the balance sheet via quantitative tightening. It worked until it didn’t work, and it also was challenged by the co-existence of President Trump’s trade war with China. But by late 2018, Powell had pushed it too far; credit markets seized up, risk assets rebelled, and he famously capitulated in January 2019, reversing course on all fronts.
My own take then (and now) is that his mistake was likely trying to do the fed funds rate reversal and the quantitative tightening at the same time. His predecessor (Chairwoman Janet Yellen, who is now the Secretary of the Treasury) had left him a brutally unfair situation by leaving rates too low too long and a balance sheet that had grown too big for too long. The “normalization” process needed to go one track at a time, in my opinion. I am not sure much has changed.
Some basic takeaways of what he said
He predicted that future real; GDP growth would trend to a 2% annual level, a very interesting projection on two levels. First, he is admitting we are not getting back to our +3.1% trendline level for real GDP. Taking for granted that we will get to 2% is an admission that we will function with 33% less growth than we have for generations. But, it is also noteworthy because the post-GFC real GDP growth was NOT 2%. The chairman may be more optimistic than he ought to be (I mean, we only had $10 trillion of debt back then; now we will soon have $30 trillion – one would think the overhang on growth is getting worse, not better).
He is clearly pleased that the economy has not suffered immensely as they have substantially tightened monetary policy. Real GDP growth has outperformed all expectations, and labor markets have as well. The problem, of course, is Milton Friedman’s famous “lag effects,” whereby the impact of monetary tightening may always be felt later. “Not yet” is a tough way to do policy.
Mea culpa, not really
He did say that what the Fed did at the time of COVID was necessary then, or at least seemed necessary based on what they knew and feared then, though with hindsight, they can see that a little less monetary policy would have been okay. I was not so much focused on the woulda coulda shoulda of 2020 but rather how loose they stayed for how long over the next 24 months. But that wasn’t really addressed, and after those crazies stormed the stage, I didn’t feel like standing up and yelling a question uninvited.
Long end of the curve
Why is the long end of the curve getting crushed? I have posited that it is yield-sensitive buyers taking over yield-insensitive buyers. But perhaps there are forced sellers out there driving things more than a certain composition of buyers. QT is the sort of “forced seller” in this case. The Fed having to roll off $80 billion per month of bonds (a trillion dollars per year) is signaled and known in the market, and it distorts price (in this case, to the downside, meaning yields go higher).
But where Powell was outstanding was his clarity that the long end of the bond curve reflects real yields going higher – term premium – and not higher inflation expectations. That TIP spreads are up a whopping 17 basis points on the year while the 10-year yield is up over 100 basis points tells us all we need to know. Powell tackled this head-on and it indicates to me that (by default) they know the long-end is misbehaving because of QT and not a structural markets fear.
What makes the term premium go up? Bonds and stocks being correlated! Bonds cannot hedge stocks when they are positively correlated to this degree, so they lose that hedge utility, and term premiums expand (out of fear of or actual supply shocks). A world in which stocks and bonds are non-correlated produces natural buyers of bonds more interested in their hedge characteristics, and it puts downward pressure on yields. It is a fascinating but undisputable reality of markets. And the Fed chair expressed the humility that they don’t really know what is going on with long bond yields, all the while expressing plausible explanations that need to be understood by investment managers.
What he didn’t talk about
First of all, the loudest silence of the day was the lack of talk about China’s weakening economy. I do not believe he mentioned China’s economy at all, and the idea that China’s economy might dis-inflate the way it is, suffer this shock to growth, and impact global growth accordingly, with no impact to U.S. growth or to domestic bond yields strikes me as fanciful. Some notion of global conditions may seem outside the Fed’s mandate, but the inter-connectedness in real life makes it the Fed’s business. No perspective was forthcoming. My view? If China’s flu gets bad enough, we catch a cold, and Powell knows it. Even if he can’t say it, he knows it.
Mr. Phillips on Aisle Stop It!
His comments on the Phillips Curve were most fascinating to me. He expressed his view that the Phillips Curve model showed a high correlation between inflation and low unemployment in the 1970s (he is wrong) but then said it was true that for the next three or four decades, the correlation sort of went away (yes, as we had extended disinflation and low unemployment). But then he said the model seemed to have resurfaced lately with low unemployment and high inflation quite correlated (presumably the rationale for staying tight – to destroy jobs before you feel like the inflation risk has subsided).
First of all, I just want to ask what kind of model is it that works in one decade and then not for three of the next four decades and then starts to work again? That is not called a model but rather “arbitrariness in a bottle.”
His acknowledgment that the model works when it works and doesn’t when it doesn’t seemed to me like a tacit admission that trying to destroy jobs to judge the efficacy of monetary tightening may not be the best practice in the months and years ahead.
Their practical considerations
He acknowledged they are killing homebuilders but didn’t really know what to do about it.
He disputed that regional banks were facing an apocalypse around commercial real estate, first stating the risks there were not “broad” (I noticed he did not use Bernanke’s famous 2007 word about “systemic”) – but also reassuring the audience that regulators are working directly with those regionals where they fear a concentration.
He stated that the cost of capital was a bigger deal to small companies than big ones, and I am not totally sure if what he meant was, “So it’s not as big of a deal if the cost of capital impairs some small companies.” My own view is that the cost of capital impacts multi-faceted elements of the economy, and a high cost of capital is not a problem if there are productive uses of capital and it reflects a natural rate of borrowing costs. But excessively tight conditions do a lot more collateral damage than just to “small companies.”
He seemed to me, and again, I am reading between the lines here, to not agree with his own vice chair of supervision who is attempting to tighten capital standards for big banks. He reiterated clearly (and accurately) that he thought our big banks were very well capitalized and dodged the question about why they would want more capital cushion for them by saying that the issue was “out for comment.”
Conclusion
The Fed has all but told you they are not going to raise rates again, but they have also postured themselves as being prepared to “stay high (tight)” for a long time. It has not blown out bond spreads (yet), it has not impaired jobs (yet), and it has not impaired real GDP growth (yet). The Fed is right about all of that.
The question is really simple. Will they be content to take the victories, or will they hold on to the point of destroying them? Powell didn’t give us the answer to that question last week.
Quote of the Week
“Where shareholders are not first, they will eventually be last.”
~ Paul Singer
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My team spent the last two days in our annual retreat, all sixty of us in Newport Beach from our seven offices around the country (Newport, New York City, Nashville, Minnesota, Austin, Oregon, and Phoenix) … It was a simply delightful time, and there are few things I love more than seeing all of our like-minded people together, fighting the good fight. We have no semblance of contentment when it comes to delivering a client experience, and our goals for 2024 are entirely centered again around enhancing that value we create.
To that end, we work.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
