My friend Chris Whalen was kind enough to use an interview he did with me in his weekly publication on financial and banking issues, The Institutional Risk Analyst. Chris has had a distinguished career, and it was a pleasure to interact with him again.
This summer Chris and I are cohosting the June gathering at Leen’s Lodge in Maine. We’ve decided to invite some new participants and, for my part, to include readers who follow these conversations. If you are interested in joining us for the weekend after Father’s Day, email me your full contact information and we can see if a space is open. Spaces and guides are limited, so there are no guarantees.
I will insert the interview text below but want add a detail first. As I mention in the interview, we used SOFR to estimate a financial distortion that, we believe, exacerbated the December market selloff. We cited a 60-basis-point anomaly in pricing and a spike in certain interest rates that coincided with the stock market selloff and the widening of bond market spreads.
The direction of causality is never perfect. Coincidence isn’t proof of causation. But last December there were no other new elements that coincided. Also note how certain riskless rates were stable while others spiked. That oddity gives us high conviction in the view we articulated in our writings and in our interview with Chris.
We’re happy to discuss more in Maine and elsewhere. Here’s the full interview text with some minor edits for compliance purposes.
-David R. KotokSan Francisco | In this issue of The Institutional Risk Analyst, we feature a conversation with David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors in Sarasota, Fl. David is an investment advisor, an observer of the evolving American political economy and an experienced fly fisherman. He and his colleagues at Cumberland publish commentaries on the markets and the world which may be found at www.cumber.com.
The IRA: David in your commentary last week (“Jay Powell, GSIBs, Christmas Eve Massacre”) you refer to December as a “massacre.” We concur. In fact, we are gathering more and more data that suggests our friends on the Federal Open Market Committee almost ran the proverbial ship aground in December. New issuance in the bond market went close to zero for several weeks and the flow of new home mortgages also cratered and has not yet recovered. There seems to be a lot of collateral damage here. Tell us what you see.
Kotok: I am in agreement. What I did in the commentary last week was to go through the estimates of the “global systemically important banks” or “GSIBs,” some 29 banks, and looked at the capital cost of a rule which came together in a perfect storm in December. Under the radar, except for those who looked for it, was a multi-hundreds of billions or even trillions of dollars in liquidity contraction. Why? Because the big banks pulled back from the markets at year end in compliance with the GSIB rule. A mispricing of whole segments of the so-called riskless market was triggered and resulted in a massive cost to the markets that we can estimate. Trillions of dollars in meltdown of market value were triggered because of billions in reallocations. This occurred because of the cost of a rule regarding the 29 designated large banks or GSIBs. Note that this is a rule which is totally unnecessary. Fed Chairman Jay Powell has said that he is satisfied with the capital structure of the big banks. I agree with him.
The IRA: The tightening of the REPO markets was very visible in December, long before the end of the month. Customers with collateral were shunned by the big banks, benefiting the smaller desks.
Kotok: The GSIB rule caused the big banks to step back from the market. On December 31st, the SOFR rate which is supposed to reflect a risk free overnight rate for funds was 60bp over referenced Treasury yields. The cost came because the big banks were incented to shrink, to convert assets into cash and other risk-free exposures. You can see the spike in REPO rates and the change in holdings. Any Bloomberg terminal demonstrates the visual spike. People who have expertise in the money markets saw it. You saw it. We saw it. But 99% of investors had no idea why the money markets were seizing up. They didn’t see that this is a temporary liquidity crunch that has nothing to do with default risk or credit risk. The risk is derived from the imposition of a rule, a regulatory provision called GSIB. But investors did not see that. They saw markets shifting violently and volatility spiking. They saw the spread on the credit default swaps of the United States rise by 50%. They didn’t understand that the Credit Default Swap is a hedging device used when such spikes happen.
The IRA: To add another datapoint to your analysis, in Q4 2018 the securities holdings of all US banks fell modestly, but there was a huge surge in Treasury holdings roughly equal to the runoff of the Fed’s portfolio. And there was continued erosion in certain types of deposits. This may be why Chairman Powell had to back off on further shrinkage of the Fed’s balance sheet.
Kotok: Individual banks around the world were acting rationally to protect their institutions. Can’t blame them for that. Collectively the 29 GSIBs imposed a temporary liquidity crunch on the entire system. And the result was that at one point the Treasury REPO rate shifted to a five hundred basis point spike. If riskless paper spikes in one day by hundreds of basis points, what is the cost? I computed what one basis point costs per trillion of market move in SOFR. The 29 GSIB banks represent hundreds of trillions of dollars in balance sheet and derivatives. And they wonder why the equity markets almost melted down? By the way, that may explain the bizarre December phone call that Treasury Secretary Mnuchin made to the biggest US banks. He was just "checking in to see if they were okay" According to press reports. Since the reason for his call was never fully explained, the reports of the call only worsened the market sentiment which was already based on faulty understandings.
The IRA: Agreed David. We think that the accumulation of evidence suggests that the Fed and other prudential regulators came dangerously close to running the global economy aground. This is a terrible refutation of the whole idea of “macro-prudential regulation.” Monetary policy goes one way, prudential rules go another and none of the agencies involved have any idea as to the net effect on the markets.
Kotok: Well, they sure were focused on a lighthouse or what they thought was a lighthouse but it turned out to be a pile of rocks.
The IRA: We have this strange confluence of monetary policy, where the FOMC is reversing past policy, and prudential rules. The Treasury is issuing and the Fed is now buying short-term paper again, essentially unwinding “Operation Twist.” And then, on the other hand, we see prudential policies that restrict liquidity. And nobody seems to understand what it all means for the markets or the economy. When they close the door of the Fed’s boardroom, are they focused on the markets or on the DSGE models? If we cannot rely on the numbers we see on the screens every morning to govern market risk allocations, isn’t the FOMC doing more harm than good?
Kotok: Yes. Those who are looking at DSGE models and those who are in the throes of the debate over whether the Philips curve is reliable need to answer a question. If we know that these tools are unreliable, then why are the dot plots used by the FOMC still measuring two of the main Philips Curve components? This reminds me of the General Eisenhower story about D-Day. In January 1944, Eisenhower was planning the invasion of Europe. And he asked his staff advisors for the long range weather forecast of weather for June, 1944. The experts replied that long range weather forecasts were notoriously inaccurate. But General Eisenhower's staff insisted on a forecast because they needed it for planning purposes. We can put the Fed's "dot plots" and long range Fed forecast models in the same category. The only thing we know about them is that they are wrong at the time they are created.
The IRA: Since we are talking about WWII history and General Eisenhower, our next book is tentatively titled “False Mandate” and goes back to the origins of the Humphrey-Hawkins law. Do you remember Rep Augustus Hawkins? He was the first African American from California in the United States Congress and co-authored the 1978 Humphrey-Hawkins Full Employment Act. Hawkins never lost an election in 58 years of public service. Rep. Maxine Waters (D-CA) inherited his seat in Congress. Speaking of long-term economic forecasts, can you tell us when the FOMC decided that zero and two are the same number when it comes to inflation? The Humphrey-Hawkins statute of 40 years ago says zero is the definition of price stability.
Kotok: Ha! May I invite a corollary? Two percent inflation means that the real value of your wealth will be cut in half in forty years. A person born today under the current Fed 2% policy who inherits $1 million at birth will have a quarter million worth of buying power remaining when they die, if they fulfill their current life expectancy. If the Fed is successful with their current policy objective, they will destroy three quarters of the real wealth of the average young person living today. Sounds rather harsh doesn’t it?
The IRA: No, you are quite right. The Humphrey-Hawkins statute says pursue full employment, then seek price stability which is defined as zero. Because of what has changed over the past forty years, the Fed staff in Washington has come up with this convoluted construction whereby zero = two. Two is really “price stability” because the system cannot tolerate deflation, which means that savers will never get a chance to buy a stock or distressed property and create future wealth. All of the bias of US monetary policy is on the side of the debtor (by using inflation as a hidden tax) and on transferring wealth from savers to debtors. Don’t we make a mockery of Thomas Piketty’s assertion that the return on wealth is greater than nominal growth?
Kotok: Precisely. Now if the Fed were to say listen, we are incapable of handling monetary policy affairs at zero. Let’s admit our frailty. And, by the way, I think this would be a fair statement. One needs only to look at the Bank of Japan and ECB to see the mess that can be created if you stay at zero long enough. And we are witnessing both the BOJ and the ECB at the point where there is zero probability of a policy change that leads to extraction. The BOJ balance sheet size is about equal to that nation's GDP. And the assets are yielding near zero percent. Imagine a Fed balance sheet of $20 trillion size. That would be a similar metaphor. The ECB will soon roll €700 billion in TLTRO. What they must wrestle with is that if, they do not increase the amount to €900 billion or €1 trillion, then they will have done zero stimulus.
The IRA: Well, that is because they call QE stimulus. There are many people who see QE as an engine of market distortion and eventually deflation – unless it is made permanent and indefinite.
Kotok: Of course, but whatever the impact, it will be nothing if the amount is not increased. We will have neutralized an already neutered neutrality.
The IRA: Agreed. But what the FOMC has learned over the past few months is that you cannot withdraw the liquidity provided by QE without destroying the system. You can maintain neutral and have economic stagnation. But you cannot withdraw the liquidity once it is put into the system. In Europe, even the cessation of new asset purchases has put the EU economy into a tailspin. Without the constant heroin drip of QE, the enfeebled European economy has started to contract. And the US is not much better.
Kotok: Yes. But we are not as bad off as the ECB or BOJ. There is still a chance in the US to get this right. The current FOMC, in my view, has ignored Chairman Ben Bernanke’s warning, which he repeated several times, that if we shrink the balance sheet we will only be taking it back up in due time. He very politely said “why shrink it?” And no one can answer that question. There is at least discussion now of a $3.5 trillion baseline for the Fed balance sheet as a target. We both have friends in the Fed System who believe that the balance sheet should be reduced back to the pre-crisis level, but that it not going to happen. In my view that would be a horrible mistake. I would size the balance sheet at close to $4trillion target to meet all upper thresholds for required reserves, survey-based (ask the banks what they want and need) desired excess reserves , Treasury operating balances, special items and currency. That mix today requires a balance sheet size of about $3.5 to $4 trillion and will require balance sheet growth of between $100 and $200 billion a year.
The IRA: Our friends represent a more tradition view of the world, a more prudent view. But when the Treasury, which is the dog in this story, is borrowing $100 billion per month, traditional views about taking the balance sheet down to required reserves and whatever is required to accommodate Treasury issuance misses the point. Once the FOMC under Bernanke made the decision to pursue QE, there was no way to take it back. The Fed cannot ignore the reaction of the markets that we saw in December. The markets have subsumed everything. So the FOMC must obviously allow the balance sheet to grow to keep pace with Treasury debt issuance. The alternative is political suicide. The Fed’s first priority is whether the Treasury issues debt tomorrow, correct?
Kotok: Yes. We cannot afford anything that introduces a risk perception about the US Treasury's ability to finance itself. May I add a second priority? Can the Fed grow its balance sheet so that the Treasury may enjoy $100 billion addition each and every year in seigniorage? This keeps the US banking system stable and the lender of last resort status of the Fed intact. Can we maintain the status as the least worst major reserve currency in the world and thereby finance $1 trillion in deficits every year? That is the unspoken truth. My stump speech now has four charts that focus on what a $1 trillion deficit and a four percent unemployment rate means year after year. We are less than a decade away from a $1 trillion interest bill for the United States.
The IRA: Thank you David.
The original commentary that launched this conversation can be seen here: https://www.cumber.com/cumberland-advisors-market-commentary-jay-powell-gsibs-christmas-eve-massacre/
Cumberland Advisors, USF Sarasota-Manatee and the Global Interdependence Center are pleased to invite you to our third annual Financial Literacy Day, Financial Markets and the Economy event. The date this year is Thursday, April 11, 2019 and it runs from 8:00 A.M. – 5:00 P.M. It's only 50 bucks and includes a full interactive day of talks, panels and Q&A, plus a catered lunch.
Panel discussions will include:
* Outlook for the US Stock Market & Global Economic Outlook
* Special Session: Health, Hunger and Philanthropy
* How the World Looks in Economics and Geopolitics
* Keynote Speaker: Gretchen Morgenson, The Wall Street Journal: Senior Special Writer, Investigations Unit
* A Conversation with Susan Harper, Canada’s Consul General in Miami
Full information and cost available at: http://USFSM.edu/FinancialLiteracy
Please join us.
-David
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