Happy Black Friday
Amsterdam | As the financial world happily fixates on who will be the next Fed Chairman, I am in Europe celebrating the 30th anniversary of Black Friday, October 19, 1987. Three decades ago, I was on a trading desk at Bear, Stearns & Co in London along with David, Joey, Gregory, Peter and Paul, among others. We had just finished a remarkable four year run, but the party was over.
That fateful day, our Treasury/MBS trader Matt got his eyes ripped out early in the day. His big mistake was answering the phone. Investors lifted every offer for US Treasury paper to be found. We were short a couple of bucks before 10 AM with no offers to be found. We stopped answering the phone way before lunch. Fortunately, we had large sell orders from several Japanese insurance companies so by the close Matt was flat and went home to have a couple of well-deserved pints.
This story is relevant today because the markets seem to have forgotten how it feels to be physically molested without the protection of Mother Fed. As I told Frank W. from Handelsblatt earlier today, the crash in 1987 was the last financial crisis where the private markets were allowed to function without government support. We had manipulated markets when I worked at the Fed of New York, but only on the margins.
Since 1987, however, the US government (i.e. the Federal Reserve) has turned market stability into an entitlement. The degree of government intervention in the markets has grown enormously since Black Friday 1987, with no authority or even acknowledgement from Congress, begging the question as to whether the United States can any longer be described as a free-market democracy.
Whether we admit it or not, the global markets are in the hands of a cadre of “experts” at the various central banks, who make decisions based upon private deliberations and questionable reasoning. The markets depend upon these experts to provide the expected stability, making the entire financial system more fragile today than ever before. Neither capital nor even market intervention by central banks is the issue here. The currency of financial stability is, more than ever before, confidence. And the people who are piloting the starship have not a clue what they are doing.
Case in point, the FRBNY is conducting “stress tests” on how the sale of mortgage backed securities will impact the markets. The tests are tiny, double digits millions of dollars. The fact that the Fed is even doing this illustrates not only the fragility of the financial markets, but the lack of understanding and familiarity that the FRBNY has with the markets it is supposed to surveil. With Treasury 2s to 10s at the narrowest spread ever, one has to wonder just what the Fed is waiting for in terms of portfolio sales. See chart below c/o Ed Harrison. Fact is, the Fed is in a special trap of its own design. By continuing the process of QE (that’s “quantitative easing” in FedSpeak) beyond the first round in 2010, the central bank skewed the credit markets to an enormous degree and, in the process, boosted asset prices for everything from stocks to bonds to commercial real estate. The rally in stocks is all about cheap credit.
Naturally, the Fed cannot “normalize” interest rates (and credit spreads) unless it first sells a large chuck of the $3.8 trillion in securities on its book. But Janet Yellen & Co on the FOMC, know now that they have screwed up large by continuing with QE after 2010. Naturally they are reluctant to admit this error. Like the Church of Rome, the Fed is never wrong. And Yellen is afraid to put the proverbial magic bus into reverse for fear that both stock and bonds, which are now 100% correlated, will tank simultaneously. And they are right to be concerned.
Chair Yellen is wedded to a neo-Keynesian/socialist world view. Thus the FOMC has moved benchmark rates before selling any of the mortgage paper or Treasury bonds in the System Open Market portfolio. Anybody who understands the bond markets and duration will tell you that there is more that sufficient demand to soak up $50 to $100 billion in MBS per month in current market conditions, especially when you consider that agency MBS issuance will probably be down $400-500 billion in 2017 at $1.6 trillion vs $2 trillion in issuance last year.
Yet somehow our friends at the Fed can look at narrowing bond spreads and a completely manic stock market, and do nothing. Raising benchmark rates is pretty much an exercise in futility because there is no “cascade” from Fed Funds to longer maturities. Indeed, absent some pesky externalities, bond prices are likely to rise and yields will fall because of the intense demand for duration from end investors and other central banks, who continue to buy public and private debt.
Remember that with short-term “risk free” Treasury rates at current levels, the net-present value of equities is far higher than current market valuations. Yet by the time that President Donald Trump gets around to picking the next Fed Chair, the markets will be ready for a truly cathartic collapse, a “reset” if you will. The only thing that will delay the great repricing will be, naturally, a tax cut from Washington. Once that final act of idiocy has been achieved, however, there will be no more shiny objects to fascinate Wall Street.
Banks and interest rate investors will be starring at a flat yield curve – the traditional signal for an approaching recession – and there will be no real reason to keep playing at the big table. Indeed, the smarter players will be taking the money off the table before Congress actually votes on a tax cut. Fact is, most large cap stocks that are bobbing around at multi-year highs will tumble once the proverbial deed is done in Washington. Tesla anyone?
Once the stock market begins to crack, Yellen & Co will not only need to delay asset sales, but they will probably be bullied into mimicking the European Central Bank and the Bank of Japan, and start buying both bonds and stocks in the name of financial stability. For as we mentioned earlier, financial stability is now an entitlement, like defaulting on your home mortgage. So start practicing your Italian, make sure that you have plenty of ammo and food at home, and sit back to watch the spectacle unfold.
Happy Black Friday