Weekly Commentary: Pondering The New Treasury Secretary

The U.S. Goods Trade Deficit jumped to a then record $76 billion back in July 2008. A few short months later, financial chaos unleashed the “great recession” economic crisis. Traditionally, large trade deficits are evidence of loose monetary conditions and resulting unsustainable spending patterns. By May 2009 – only 10 months from the all-time record – the Goods Trade Deficit had shrunk to a seven-year low $35 billion. It’s worth noting, as well, that M2 money supply expanded $253 billion, or 3.1%, during 2009.

Fast forward to the current crisis period. M2 has surged $419 billion in only six weeks. Over the past 38 weeks, M2 has expanded an unprecedented $3.60 TN, with year-over-year growth of $3.785 TN, or 24.7%. October’s Goods Trade Deficit was reported Wednesday at $80.3 billion, lagging only August’s record $83.1 billion. Last month’s Trade Deficit was actually 21% ahead of pre-crisis October 2019.

No doubt about it, this crisis period is unique. More than three Trillion worth of Fed liquidity injections coupled with a more than Three Trillion fiscal deficit has thrown traditional crisis dynamics on its head. In this New Age Crisis backdrop, financial conditions have actually dramatically loosened. Money supply has skyrocketed, and stocks have gone on a wild speculative moonshot. Corporate bond issuance surged to new records. And, as noted above, booming imports pushed the Goods Trade Deficit to an all-time high. At $170 billion, the second quarter Current Account Deficit was the largest since 2008.

The bloated services sector has accounted for a majority of historic job losses. Massive stimulus has bolstered spending on goods – which has fueled the rapid recovery of imports. Home sales have boomed, with the strongest house price inflation in years. It’s only fitting that stimulus-induced “Terminal Phase” Bubble excess now engulfs the housing sector as well. That asset inflation and Bubble excess run rampant in the throes of crisis should have us all worried.

Bear markets, recessions and even crises are fundamental to capitalistic systems. While painful, wringing excess out of both Financial and Economic Spheres is essential to long-term soundness and vitality. And the sooner the better. Wait too long and policymakers won’t risk reining in Bubble excess. Yet such analysis sounds hopelessly archaic these days, as excess, distortion and structural impairment compound in perpetuity.

Central banks have made the conscious – and fateful - decision to abrogate Capitalism’s adjustment and cleansing processes. A solid case can be made we’re at the most dangerous phase of the Bubble period: financial and economic fragilities (associated with decades worth of excess) ensure central bankers push extreme stimulus measures while turning a blind eye to outrageous excess.

Various thoughts come to mind when I ponder Janet Yellen. I recall one of her early press conferences. It was Jon Hilsenrath’s (of the Wall Street Journal) turn to pose a question to the new Fed chair. A beaming smile came across Yellen’s face, which struck me as unusual in that circumstance. But, mainly, it conveyed an endearing warmth and sincerity. She’s not the typical Washington operator. A career academic, she can at times appear naive. Yellen is certainly not a financial markets person. I don’t distrust her (which distinguishes her from her two most recent predecessors).

Janet Yellen as the new Secretary of the Treasury is being universally well-received by the markets. She is proven – a consummate dove. And it’s difficult not to admire her – such a long and distinguished career along with a notably humble, amiable and compassionate demeanor. But in my commitment to accurately chronicle history – determined to counter historical revisionism – there’s a salient aspect of Yellen’s career that should not be overlooked: Her failure as Fed chair.

Chair Yellen assumed the reins from Ben Bernanke in January 2014. Recall that the Fed took extraordinary measures – including expanding its balance sheet by $1 TN - in response to 2008 Crisis Dynamics. Yellen was Fed vice-chair when the Fed in 2011 publicly formalized it’s “exit strategy” from extreme monetary stimulus. Rather than normalize, the Fed fatefully again doubled the size of its holdings to $4.5 TN by October 2014. Fed assets expanded $500 billion during Yellen’s first year at the helm of the Federal Reserve – when there was a strong case for the Fed shrinking its balance sheet

The S&P 500 (SPX) returned 32.4% in 2013 and another 13.7% in 2014. The small cap Russell 2000 (IWM) returned 38.8% in 2013 and added 4.9% the following year. The Nasdaq 100 (NDX) returned 36.9% and 19.4%. M2 expanded about 6% in 2014. At 7.15%, growth in Consumer Credit rose at the strongest rate since year 2000. Business debt expanded 6.7% in 2014, the briskest pace since booming 2007. After peaking at 10% in late-2009, the Unemployment Rate ended 2014 at 5.6%.

The Fed slashed rates to zero (zero to 0.25%) on December 16, 2008. Janet Yellen was in charge for a full two years before the Fed finally made a baby-step 25 bps adjustment off the “zero bound” in December 2015. The Yellen Fed then procrastinated a full year before taking its next little step. Rates were only at 1.25% when Yellen departed the Federal Reserve in February 2018. The S&P 500 returned 67.3% during Yellen’s term as Fed chair, with the Nasdaq100 doubling in four years of exceptionally loose financial conditions.

The Bernanke Fed (with Yellen as vice chair) should have moved to commence the monetary policy normalization process. I always assumed Bernanke was hesitant to risk reversing his ultra-loose monetary course for fear of imperiling the “Bernanke doctrine” and its centerpiece of exploiting the securities markets as the primary mechanism for system reflation. It is not easy to explain why Yellen remained so timid in starting “normalization”.

It’s not hyperbole to call the Yellen Fed’s delay in pulling back extraordinary stimulus as an epic policy failure. Jerome Powell assumed control of the Fed with the intention of finally moving forward with rate normalization. But it was too late. The Fed had badly missed its timing. The Powell Fed ratcheted rates up to a still low 2.25% by December 2018 – and the wheels were coming off.

A highly speculative and levered securities marketplace can function only so long as financial conditions remain ultra-loose. Predictably, market structure evolved profoundly during a decade of unprecedented monetary stimulus and Fed backstopping. Trillions flowed into the perceived safe and liquid (“money-like”) ETF complex. Trillions of levered speculative holdings accumulated at home and abroad. Moreover, loose finance coupled with faith in the Fed’s liquidity backstop ensured mounting excess throughout the derivatives complex.

The S&P 500 suffered a 15% swoon in December 2018, with somewhat larger losses for the Nasdaq 100 and the small cap Russell 2000. Perhaps more importantly, instability erupted in corporate Credit. Powell was widely criticized for raising rates that December in the face of market instability. I commended him at the time for his effort to weaken the markets’ reliance on the “Fed put.” Markets, however, would have no part of it. A decade of excesses and latent fragilities has done their damage. Markets castigated Powell into immediately reversing course – into announcing his “pivot.”

And rather than slacken, the Fed “put” emerged more powerful than ever. The episode confirmed what the markets had already assumed: Bubble excess and associated fragility had reached the point of no return. The Fed was hamstrung by an epic Bubble and associated systemic fragility. Power had shifted decisively to the financial markets, with the Federal Reserve’s subservient role relegated to shielding and pacifying an increasingly unstable system.

The Fed was cutting rates again by July (2019), and the Fed’s balance sheet was again inflating in September. Despite stock prices at record highs and unemployment at multi-decade lows, the Fed was compelled to adopt “insurance” monetary stimulus to counteract late-cycle vulnerability in “repo” and other short-term funding markets (used for leveraged speculation). The Fed’s 2019 stimulus exacerbated speculative excess, forging a marketplace keen to disregard myriad risks including an advancing pandemic. Market excess, distortions and the incapacity for self-adjustment contributed to March’s near market meltdown.

From a July 2017 Reuters report: “U.S. Federal Reserve Chair Janet Yellen said... she does not believe that there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash.” The Yellen Fed disregarded the massive accumulation of speculative leverage outside of the banking system, along with fragilities that would force the Fed and global central bankers to resort to grotesque pandemic response monetary inflation.

November 24 – Financial Times (James Politi and Colby Smith): “Shortly after Joe Biden picked Kamala Harris to be vice-president in August, Janet Yellen, the former US Federal Reserve chair, briefed the pair on the slump triggered by the coronavirus pandemic and what they could do about it. According to one person…, Ms Yellen told the Democratic ticket that interest rates were low and likely to stay there for a long time, creating considerable fiscal space for new stimulus and investment. The intervention was well-received by Mr Biden and Ms Harris, whose economic plan calls for billions of dollars of government spending. Now Ms Yellen, 74, is set to be nominated by Mr Biden to be the next US Treasury secretary, handing her a second act at the pinnacle of American economic policymaking.”

Do low rates essentially create unlimited capacity for deficit spending? Or is this a crazy late-cycle dynamic whereby Fed largess is distributing ropes for our federal government, the leveraged speculators, corporations and the U.S. household sector to hang themselves?

It’s difficult for me to believe that Secretary Yellen will avoid having to contend with a historic financial and economic crisis. And Wall Street is quite comfortable that Yellen is precisely the right individual to work intimately with the Powell Fed to orchestrate whatever crisis response necessary to sustain the greatest Bubble in human history. The scenario of the Federal Reserve knee-deep in partisan political muck – with its credibility and reputation soiled in the eyes of at least half of a deeply divided nation – seems more likely by the week.

Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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