Today the bond market resumed its violent move with higher yields which shocked the world after President Donald Trump’s resounding victory.
So why is this happening?
There are two prevailing trains of thought and both are worthy of consideration in this author’s opinion.
First option is that the markets recognize that the GOP and Trump lack the necessary discipline to reign in government spending to levels which are indicative of a contraction in the annualized increased rate of change. The new administration wants to both “fix” the US military and seal the border while engaging with a trade war with China. None of those options are cheap and in fact all of those policies are highly inflationary.
The second option is that the investors, both domestic and foreign, recognize that the Federal Reserve had blundered again and in fact started an inflationary cycle several months ago by stopping rate increases, ceasing to accelerate quantitative tightening, and endorsing the idea that the lower inflation rates published by both the Fed and US government were indicative of transitory disinflation. The problem with that theory is that if it is a “false positive” then inflation could bounce back with consequences for the Fed’s policy of cutting rates which will appear in early 2025.
These mistakes have happened before in history and to think this is just an isolated incident of central bank malpractice would be incorrect.
I. 1927 Chicago Federal Reserve 0.50% Rediscount Rate Cut
Many people forget that market intervention by the Federal Reserve Board and the New York Fed is nothing new. If one looks at what happened after the Fed did on September 6, 1927, it becomes abundantly clear that this song may not be on vinyl, but does sound familiar.
The 1927 cut resulted in the greatest land and stock market boom until the next one some 80 years later. The excerpt below is from The Chicago Fed History: 1915-1939 tells the tale of how the Fed evolved and mistakes are walked into despite the best intentions:
An early controversy involving the Chicago Reserve Bank highlighted the issue of the discount rate. The incident initially involved Chicago Reserve Bank Governor McDougal and Benjamin Strong, the head of the New York Reserve Bank. In 1927, Strong was leading an effort to reduce the discount rate. Strong’s outlook was a global one — he favored an easy money policy to aid the European financial position. McDougal, traditionally a conservative in credit policies, opposed the move as did several other Reserve Banks. Strong wrote to McDougal in August 1927 exhorting the Chicago Bank to join a System-wide effort to ease credit. McDougal was not persuaded. In a letter to Strong, he wrote, “It is understood that the governing factor…is the international situation, and it seems to me that the desired result has already been attained through the reduction in your rate.” As far as uniformity among the Reserve Banks was concerned, McDougal wrote, “up to the present time we are not convinced as to the necessity of having a uniform rate in all districts.”
Strong replied, “My dear Mac: I have read that austere letter of yours…and after finishing it felt as though I were sitting in an unheated church in midwinter, somewhere in Alaska.” According to Strong, lowering the discount rate “is neither a New York question nor a Chicago question nor a district question but a national question bearing upon our markets in Europe, consequently an international question.”
Still, McDougal and the Bank’s board held firm. The discussion erupted into a controversy when the Federal Reserve Board ordered the Bank to reduce its rate on September 6. The Board’s action aroused bitter controversy within the System and a fair amount of publicity outside the System. Two of the strongest dissenters against the Board’s action were Carter Glass and H. Parker Willis. Strong himself opposed the move and tried to prevent it.12 According to the New York Herald Tribune, the controversy centered on “the long smouldering question of whether in matters of fundamental policy the several regional reserve banks of the system are to be granted self determination. …”
The Chicago Bank complied with the rate reduction, but also announced that it would seek an opinion from the U.S. Attorney General as to the legality of the Board’s action. Later, however, the Bank had second thoughts, and the convenient resignation of one of the Board members supporting the forced discount rate reduction helped to ease the controversy. The issue was not resolved, but the trend toward centralization had received additional impetus.
In the end, the Discount Rate was cut from 4% to 3.5% and the blow off top rally in the economy would rage on until the autumn of 1929. The rest is history, as historians are prone to say.
II. Inflation and Volcker’s Folly
There are many central bank historians and celebrity economists who view Fed Chair Paul Volcker as some sort of hero for his stringent actions against inflation in 1981. What most historians and market economists fail to do is remind people of his folly to allegedly help President Jimmy Carter’s administration win re-election in 1980.
The 10 year US Treasury tried to warn the Fed in the summer of 1980:
The cuts initiated in May and June of 1980 were as I described from this article, as Volcker’s Folly:
The theory that the Fed does not cut rates excessively moving into the final months of a Presidential election cycle first became an obvious misnomer when Federal Reserve President Paul Volcker cut rates prematurely in May and June of 1980 by over 10% as his Fed speculated the stagflationary recession was ending and inflation contained.
Volcker’s Folly, as some economists called it, was to prematurely believe that despite persistent background inflation, the spikes or raging inflation of the past six years was over. As history and the chart indicates, he was incorrect and despite a relatively easy money policy compared to 1979, the incumbent lost the 1980 election.
In the end, the cuts only resulted in an immediate and violent short term bounce in the inflationary pressures which were complicated by the failure of the Carter administration to develop a viable domestic energy policy while engaging in numerous overseas blunders with regards to foreign policy.
III. The GFC and Bernanke
Sometimes the Fed thinks that a tight policy is better and in the case of the Great Financial Crisis, Chair Bernanke held the reigns too tight, failing to recognize the growing credit crisis that many of us recognized from Main Street to Wall Street.
It was not until the summer of 2007 when the Fed recognized the problems as the bond market began lowering rates and the Fed followed suit. In fact,the August emergency 0.50% discount window cut on August 17, 2007 was believed to be part of a coordinated behind the scenes effort to save Goldman Sachs which was apparently grossly on the wrong side of some credit derivatives trades.
The problem the Fed did not recognize is that the resetting mortgage rates were entirely too high for the “new” home buyers in the 2004 through 2007 vintages and was already presenting default issues as the economy began to slow down. While Bernanke was concerned about the stability his worries about inflation kept his Fed too high for too long.
IV. Powell’s Play for History
This past week, Chairman Powell led the way promoting and obtaining another rate cut in the Fed Funds Rate bringing it down some 75 basis points in less than 90 days. By doing so, this Fed has declared a de facto victory over inflation although the PCE indicators used by the bank might be defective in measuring actual consumer pain from persistent embedded inflation.
Thus when the CPI morning is issued tomorrow morning, it might be reflective of similar numbers Paul Volcker’s Fed saw in July of 1980. However this false confidence that the current Fed is more modern, knows better, has better models, etc. might be the very bravado which induces an Arthur Burns style result.
If Powell and his team are wrong, which I believe they are, a stagflationary outcome with limited consumer credit growth in tandem with financial stress will result in cyclical inflationary surges which my last three to nine months in concert with flat to slightly negative economic growth of similar duration. Those periodic cycles may not overlap, which greatly complicates further Fed action and signaling to the markets, especially withe a perceived adversarial Executive Branch taking office in January of next year.
Buckle up, as this ride could get bumpy and quite loud.
Got Gold?
Views: 122
