The thesis is one of secular change – an extraordinary multi-decade Bubble period transitioning (in a highly destabilizing manner) to a most uncertain New Cycle. Historical perspective is crucial.
May 19 – Bloomberg (Steve Matthews): “Federal Reserve Bank of Kansas City President Esther George said the ‘rough week in the equity markets’ was not surprising, partially reflecting the central bank’s policy tightening, and doesn’t alter her support for half-point interest-rate hikes to cool inflation. ‘I think what we are looking for is the transmission of our policy through markets’ understanding that tightening should be expected,’ George said… ‘It is one of the avenues through which tighter financial conditions will emerge… Right now, inflation is too high and we will need to make a series of rate adjustments to bring that down… We do see financial conditions beginning to tighten so I think that’s something we’ll have to watch carefully. It’s hard to know how much will be needed.’”
Esther George could not have been much clearer. Inflation is too high and must come down. Financial conditions must tighten, and securities markets are a key monetary policy transmission mechanism. And the Fed today has little clarity on how far this tightening process will need to go.
The “world” – certainly including Market Structure – has gone through monumental change since the last real tightening cycle back in 1994. The Fed has lost control.
It was only during the early-nineties Greenspan era that financial conditions came to play such a prominent role in policymaking. He aggressively manipulated the yield curve (slashed short rates 5 percentage points in less than two years to a three-decade low 3% as of Sept. 1992), creating an extraordinarily profitable (borrow short/lend long) “carry trade” for the severely impaired U.S. banking system. Financial history was fundamentally altered, as Fed policy created enormous easy profits for the fledgling leveraged speculating community. The 1994 bond bust would have posed an existential threat to the hedge fund industry, if not for the powerful GSE liquidity backstop.
Greenspan came to relish the incredible power he could wield over system Credit, market liquidity, financial conditions and economic development. Moreover, the Federal Reserve system emerged from 1994’s acute speculative deleveraging and market instability with a new doctrine of avoiding policy measures that could unleash a “risk off” tightening of financial conditions.
Since 1994, so-called “tightening” cycles have been gradual and timid affairs, with the clear intention of avoiding bouts of de-risking/deleveraging. Indeed, Washington would move aggressively to thwart stress building on the leveraged speculating community. Bouts of late-nineties instability were met by rate cuts, massive GSE liquidity injections, and Fed-orchestrated bailouts. Between 1994 and 2003, GSE assets inflated $2.254 TN or 360%. With accounting fraud curbing the GSE’s capacity for market liquidity backstops, it was then left to the Fed and QE to deal with 2008’s de-risking/deleveraging mayhem. (more…)