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Helicopter Ben Rides Again


As long as the Fed focuses on growth at the expense of inflation, the market will continue to price risk premiums accordingly.


A week later at the August 7 FOMC meeting -- despite the Fed's recognition of market volatility -- the assessment of the economy remained strong and the Fed maintained the same bias from January, keeping the FF rate at 5.25% (emphasis my own):

Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

The Fed was fully aware of the volatile market conditions and the housing "correction," but remained tight. The mortgage market was melting, but Bernanke would not waver, stubbornly fighting his inflationary reputation and seemingly oblivious to the contagion risk in the interconnected credit markets.

As later reported by Bloomberg, Bernanke received a phone call from former US Treasury Secretary Robert Rubin the following day. That set off a barrage of meetings with market experts including Bridgewater's Ray Dalio and former Salomon Brothers bond trader and mortgage market pioneer Lewis Ranieri. Was he getting a tutorial on how the structured mortgage market worked?

On August 17, only 10 days after the FOMC meeting in an unscheduled announcement, the Fed cut the discount rate by 50bps and changed its economic assessment to downside risks to growth due to market conditions (emphasis my own):

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

After two years of whistling past the housing market graveyard, the immediate policy 180 emitted a sense panic and capitulation. Bernanke would link heightened financial market risk with heightened economic growth risk to justify the abrupt change in policy. This is very important.

Once he moved on the theory that market "uncertainty" increased risk to economic growth, he set a precedent for preemptive intervention in financial markets whenever the Fed deemed it necessary to "mitigate" increase downside economic risks. This interpretation of the Fed's mandate is a defining moment in Bernanke's tenure.

The following six months of FOMC decisions would read like a horror story as it pulled its economic assessment and slashed interest rates 300bps, taking the FF rate to 2.25% by the March 2008 meeting. Bernanke's dovish reputation immediately began to manifest itself in the market. Despite the risk of slowing growth, discounts for inflation increased significantly. The dollar weakened, commodity prices soared, and the yield curve steepened. Helicopter Ben had demonstrated his inflationary bias. Once he gave the green light, it was clear the market wanted to be in front of the curve.

In August 2007, with the Fed worried about an uptick in inflation pressures, the YOY growth rates in the consumer price index (or CPI) and producer price index (or PPI) were a mere 2.0% and 2.3% respectively. With the dollar falling on the aggressive easing campaign, crude oil and other raw material prices were on the rise. By the spring of 2008, the market's inflationary discounts began showing up in actual inflation. The March PPI YOY growth rate virtually tripled to 6.7%, pulling the CPI to 4.0%, which was double the rate just six months prior.

Due to the ongoing housing "correction," this spike in inflation was occurring against the backdrop of sharply slowing growth. In Q3 2007, the YOY growth rate for nominal GDP was 5.2%, which was in line from the previous year -- but by Q2 2008, the rate had dropped to 3.1%. This was a double whammy. On the surface, a 4.0% inflation rate would not seem particularly onerous. But when you measure it against the weak nominal growth, you get a very oppressive rise in prices. The ratio of CPI to nominal GDP actually showed the 4.0% CPI to be higher relative to economic growth than the double-digit inflation spikes in the 1970s and 1980s. And it would only get worse.

The Fed finally ceased easing in June with the FF rate at 2.0%, giving an assessment of "diminished downside growth risk; upside risk to inflation" while inflation continued to rise. By July, nominal GDP had flatlined. But with the dollar continuing to deteriorate and oil prices up 100% from a year ago, inflation was delivering a crushing blow to an already teetering economy. The July reading for YOY CPI was 5.6%, but the PPI came in at a whopping 9.9%. Typically the PPI does not exceed the CPI as raw material costs get passed on to the consumer -- and aside from the 1970s, it rarely occurred. This unusual 400bps inversion driven by rocketing commodity prices produced a statistical fat tail.

The most inflation-sensitive market metric outside currency and commodities is the embedded inflation premium in the term structure of the yield curve. Between August 2007 and March 2008, as inflation spiked, so too did the 2YR/10YR spread, steepening dramatically from 50bps to 200bps. This inflation discount wasn't just occurring in the risk-free curve; it was also seen in the risk curve. Over the same period, the spread in the Moody's Baa corporate bond index widened from 200bps in August 2007 to 350bps in March 2008.

Most consensus valuation models measure credit and equity risk premiums over the risk-free rate, normally the 10YR Treasury. I have found that a far more consistent benchmark to measure the premium is the YOY growth rate in the CPI. In fact, while the earnings yield on the S&P 500 will routinely trade at a premium to the 10YR yield, it rarely trades through CPI. Going back 40 years, only during the inflation spikes in the mid-1970s and early 1980s did you see the S&P trade through the CPI; the two biggest market tops of the subsequent bull market in 1987 and 2000 actually occurred when the earnings yield equaled the YOY CPI.

In other words, market valuation is much more sensitive to inflation and the discount of inflation than to the actual level of interest rates. In July 2008, the 5.6% CPI spike hit the S&P 500 earnings yield, which I believe was the final straw that broke the market's back.
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