The Financial Crisis: 'What Has This Got to Do With Monetary Policy?'
A spike in inflation was the catalyst for the 2008 financial crisis, not real estate imploding or mortgage delinquencies. And now the Fed is about to make another policy error.
In April the Fed took the Fed funds rate to 2.0%, over 300bps lower than it was in August. By July 2008, the dollar remained under pressure and oil was going vertical to $140/bbl. This was having a profound impact on rates of inflation. The June report of PPI and CPI saw the year-over-year growth rate spike to 9.0% and 5.0% respectively. This was a huge burden on a deteriorating economy, and in fact relative to the economic growth rate, these spikes in inflation were higher than the inflation spikes in the 1970s.
CPI Vs. NGDP
It is my belief that this spike in inflation was the catalyst for the financial crisis, not real estate imploding or mortgage delinquencies. The Fed was behind the curve, and they panicked. The market was not going to wait around to see what Helicopter Ben was going to do. Collateral and credit deflation was Bernanke’s worst nightmare and he had already defined what he would do to combat it. The market knew this and did what would be expected by immediately pricing in the most inflationary monetary policy.
This inflation spike was the proverbial straw that broke the camel’s back. It's not oil that caused the crash, it was a shock to a weak system. Inflation risk premiums became interest rate risk premiums, which became credit risk premiums and eventually equity risk premiums. These exploding risk premiums meant collapsing dollar prices of highly leveraged securities on highly leveraged balance sheets, which meant collapsing book value of equity. These exploding risk premiums triggered a financial crisis.
It can be said that the financial crisis was the product of monetary policy error. The policy error in overly tightening with inflation risk falling and a yield curve inverting in 2006 and a policy error in overly easing with inflation risk rising and yield curve steepening in 2008.
This past week, Bloomberg’s Stephanie Ruhle and Eric Shatzker interviewed macro hedge fund titan Stanley Druckenmiller who, under George Soros, broke the Bank of England. The man knows a thing or two about interest rates and monetary policy. While various Fed members, economists, and Wall Street strategists focus ad nauseum on the impact of tapering and forward guidance, Druckenmiller gave you all you need to know about interest rates in one sentence:
RUHLE: Well I want to go back to QE. If you think about QE and what asset class has been manipulated most because of it, would you say stocks or bonds?
DRUCKENMILLER: I would say stocks. I have been really wrong on the bond market in the last three or four months.
DRUCKENMILLER: I -- I have been waiting for this decline for two years and I completely missed it because, first of all, the stuff we were talking about earlier in the show, that's -- that's too far down the road in my opinion for the bond market to pay attention to. But I have always found in bonds if you can predict a relative change in the economy relative to consensus, you'll make money in bonds if you get that equation right. And --
SCHATZKER: Even in a world of QE?
DRUCKENMILLER: Yes. And two or three months ago, I thought people were overly optimistic on the US economy. It's my judgment that that assessment turned out to be correct, but bonds went down anyway for non-economic reasons because we have the unwind going on. And for whatever reason, while I anticipated it down the road, I did not think it would happen while the economy was softening.
Druckenmiller is not some pundit sounding off on his opinion, nor is he a bond mutual fund manager talking his book. Druckenmiller knows the market as well as any participant and also has access to the best market intelligence. He knows when interest rates are reacting to shifts in economic expectations or to forced shifts in positioning. As I emphatically stated in Bond Market’s Memo to the Fed: This Is Not a Misunderstanding, This Is a Blow-Up, the reaction to tapering was not a misunderstanding of monetary policy, it was a leveraged carry trade blow-up:
By focusing on the price movement as a misinterpretation, Fed officials are making it clear they don’t understand there is a liquidation going on and this is a growing risk factor. They don’t get that it's not the size the market reaction that’s relevant; it's the size of the trade. Ironically, just as they confused QE flow for an easing discount when yields fell, they are now confusing a tightening discount for QE carry trade unwind flow.
Druckenmiller knew there was a pervasive carry trade that was going to unwind, and he wanted to front run the carnage but didn’t think it would happen as growth was slowing. Interest rates are rising for uneconomic reasons, not because they are discounting Fed rate hikes, but because of a QE carry trade blow-up -- and its happening as growth decelerates. This is unprecedented in modern market history and sets the stage for a financial accident. The question is where the breaking point is. Is it a 3% 10-year? Four percent? Or has it already been triggered?
The Fed committed a policy error when they introduced forward guidance of an inflation target de facto nominal GDP target in the context of a new round of QE and then immediately reneged despite a decelerating nominal growth rate. The market was long this inflation target via various carry trades and the Fed blew them up.
The Fed is about to make another policy error by removing accommodation of asset purchases in lieu of solely relying on forward guidance for rate hikes in order to stimulate inflation expectations. The Fed will tell you that tapering isn’t tightening, but the evidence suggests otherwise. Loan growth has all but ceased since rates started rising in May, and the term structure of the front of the eurodollar curve for three-month LIBOR futures is near record steepness, richening forward rates for term borrowing. This tightness is undeniable and is happening as growth decelerates to the slowest growth rates of the recovery.
No one thinks we are on the precipice of another financial crisis, and positioning for statistical fat tails can be hazardous to your portfolio. But policy errors tend to preclude such events, and I think we are seeing the Fed commit multiple policy errors as they pull accommodation into decelerating growth and low inflation. I don’t think it will be a catastrophe, but markets have become accustomed to a world of excess liquidity for a long time, and if the move in the bond market is any indication, this excess liquidity can evaporate rapidly. It’s impossible to know the catalyst ex ante, but odds are it will be bond market related to a monetary policy error.