“It was the best of times, it was the worst of times, it was the age of wisdom,
it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity,…”
A Tale of Two Cities
I'm back -- Chris
This week’s meeting of the Federal Open Market Committee is being set up in the financial media as a contest between the anti-inflation tendency led by Fed Chair Janet Yellen and the pro-growth forces led by President Donald Trump. Would that it were so.
Chair Yellen, lest we forget, is perhaps the most left-wing Fed chief to ever hold the position. She has overseen eight years of radical monetary policy that has done little to encourage job creation or growth, but has created asset bubbles in sectors ranging from commodities to real estate to common stocks. Soaring prices for US equities and high yield debt are the big achievements of the Yellen FOMC.
This unprecedented experiment in social engineering by the FOMC has been conducted in the name of achieving the Fed’s primary mandate, namely full employment, but has failed in achieving this end. There is no demand-pull response from the economy even after eight years of quantitative easing totaling trillions of dollars and near-zero interest rates. Instead we see price inflation in various asset classes that is an order of magnitude higher than the statistical indications of inflation that so vex Chair Yellen.
Meanwhile the Trump Administration has spent the past six months posturing about how it wants to create jobs by lowering taxes and increasing spending in areas such as defense. In order to pay for this expansion of defense spending, doubtless to support the perpetual State of War, President Trump proposes to cut health care entitlements to millions of elderly Americans and slash discretionary spending on other government services.
Of course, the fiscal implication of Trump’s schizophrenic program of Keynesian spending and supply side tax cuts has caused yields on government bonds to rise rather precipitously. This phenomenon, in turn, has put the kibosh on the US housing sector, where lenders are literally drowning in loan applications but have few homes to sell. Layoffs are mounting in the housing finance sector as lenders prepare for a 1/3 decline in lending in 2017 vs last year, mostly due to lower refinancing volumes.
The Dodd-Frank regulations, which Mr. Trump also promises to fix, have caused a dearth of new lending for construction and development of single family homes. The Basel III bank regulations championed by the Fed are another negative factor in the lending equation, although construction lending has finally started to rise. But the low interest rate environment implemented by Chair Yellen has caused a boom in lending in other sectors, particularly autos, commercial real estate and multifamily.
While the performance of prime and below prime auto ABS securities remains excellent, the “Big Three” US auto makers are looking to get shellacked over the next few years as loan defaults rise and residual values for autos fall. The curse of sales incentives, as I discuss in my new book “Ford Men: From Inspiration to Enterprise,” is killing industry bottom feeders like GM and Chrysler. And all of the impending carnage in the auto sector is attributable to the bold action by the FOMC, who incredibly pretend that a “wealth effect” via inflated asset prices and credit volumes can somehow make up for flat income and productivity levels. The sad fact is that, unlike the 1970s and 1980s, today dropping interest rates does nothing to boost income levels or consumption. See my review of Dave Smick’s new book, “The Great Equalizer,” in American Conservative.
Meanwhile in Washington, the seeds of the next crisis in single family homes are being planted as a confederation of realtors and affordable housing advocates push for the adoption of “enhanced” FICO scores as the basis for extending mortgage loans to low-income borrowers. The logic goes that if Betty or Billy can manage to make their utility or car loan payments every month, why not give them a 30-year FHA mortgage?
Of course, the data suggests that the car loan and utilities rank senior in the credit waterfall of most consumers, but no matter. A full court press is underway to get the GSEs and FHA to accept loans underwritten with enhanced FICO scores in MBS deals. One intriguing possibility is that banks will be given “qualified mortgage” status for mortgages held in portfolio or sold into MBS in return for accepting enhanced FICO scores as part of the underwriting process.
So while on the one hand the Fed frets about inflation, on the other hand its radical cocktail of monetary policy experiments has distorted asset prices and lending patterns. Remembering the golden rule of “yield to commission,” the Street will always sell credit to somebody in some form. When Dodd-Frank and Basel III demonized single family mortgages, the Street swung towards commercial real estate and auto ABS.
The final piece in the policy kaleidoscope are the US markets, with stocks and high yield debt soaring but Treasury prices falling due to market fears regarding the impact of the Trump policy agenda. The Street remains chronically short duration, partly due to the fact that the FOMC has accumulated $4.2 trillion in Treasury debt and MBS.
The goal of the FOMC should not be to increase short-term interest rates per se, but to decrease the duration of its investment portfolio and, most importantly, get the private markets to support that duration without assistance from the central bank. Otherwise, as the Fed pushes up short-term rates, the yield curve will flatten, and banks and other leveraged investors of all descriptions will suffer even further.
As I noted in a note for Kroll Bond Ratings last month:
“At present, the $4.2 trillion in securities on the Fed’s balance sheet is muting the markets response to Fed policy moves as well as delightful externalities emanating from Washington. When the duration of the Fed’s portfolio is back down near two years on average, regardless of the nominal size, then the FOMC can declare victory in terms of ending the extraordinary support following the 2008 crisis. Again, the challenge for the FOMC is to think less as economists and more as bond investors since, after all, the Fed is now among the biggest bond investors in the world.”