Fasten your Seatbelts: The Fed and the Art of Economic Cycle Maintenance
A critical shift in global market risk…
In our May 11, 2022 newsletter, we shared data-driven market analysis to help long-term companies more accurately track the capital markets. We pointed you toward a single metric to help you track the long-term health of the capital markets — Ameribor. Market behavior has accurately tracked the analysis we shared in early May. Our insights aim to support your long-term planning with a sense of urgency — by providing a level of bespoke transparency normally reserved for only a select group of market insiders.
We are now 35 trading days into this broad market dislocation phase as the Fed actively combats inflation by raising interest rates. On June 16, 2022, the market signaled a steep increase in stress to our financial system. Below is a graph that brings the relationship between systemic credit risk (Ameribor) and systemic equity risk (VIX) up to date. In the Appendix below, you can review the dislocation thresholds shared in our May 11, 2022 newsletter.
On June 16, 2022, Ameribor made another sharp jump from the 91 to 94bps range to 170bps. This now exceeds pandemic credit dislocation levels (high of 146.23bps) but is still well below Great Recession levels (high of 463.11bps). So what now? This change raises the issue: What makes this market environment so different from others?
Global Entry…
This piece is intended to be an update to the May Newsletter. The key takeaways are set forth below. For those of you who want a more fulsome travel experience, feel free to read on. The summary below speaks to the following critical insight: Long-term U.S. companies are confronted with a strengthening U.S. dollar which will adversely impact short-term revenues and profitability.
- Market dislocation began in March of 2020. Aggressive Fed action coupled with record setting Congressional stimulus paused this dislocation until May 5, 2022. On June 16, 2022, the market signaled a deepening of our current market dislocation.
- Companies should expect the markets to provide brief capital raising and/or refinancing windows of opportunity over the next 12 to 18 months; consider stock buybacks with healthy skepticism.
- The factors below will take time to resolve themselves, however, with the U.S. positioned at the center of global monetary policy, the value of the U.S. Dollar will likely increase but the overall impact may be less severe than some are predicting. Remember, tracking Ameribor will give you the early preview on the evidence of recovery, well before it becomes “news.”
- Inflation is soaring but it is a very unique form of inflation — characterized by a combination of rising oil-prices driven by the Russian war in Ukraine, global supply-chain issues stemming from the Pandemic, and China experiencing their own version of the 2008/09 Great Recession.
- The Fed is raising interest rates to tame inflation driven by supply-chain constraints described above, but this tool is actually best suited to tame demand driven inflation.
- In essence, the Fed is now raising rates in an attempt to cool the demand it fueled through aggressive asset purchases. The Fed is cooling demand that the global supply-chain is not equipped to satisfy. This is not the best tool to combat supply driven inflation, but it is the only tool the Fed has available to deploy.
- A cease-fire in Ukraine coupled with the reopening of the Chinese supply-chain could have a significantly positive impact on taming inflation and allow for an accelerated recovery.
Runway lights & instrumentation…
The best way to contextualize our current market environment is by shining a bright light on the capital markets stakeholder with the deepest and most influential pockets — the Fed.
- It is important to understand the mandate these deep pockets are meant to serve — maximum employment and stable inflation.
- It is even more important to understand the key mechanisms the Fed can use to funnel its deep pockets toward the fulfillment of its mandate — interest rate policy and asset purchases.
Currently, the Fed is using an inefficient, blunt force instrument to manage inflation — raising interest rates. Not all types of inflation are created equal. Raising rates is typically most effective to combat traditional demand driven inflation — overheated demand that is chasing normalized supply. We are not experiencing traditional demand driven inflation. We are experiencing an acute global supply-chain driven inflationary environment — normalized demand chasing weak supply. An understanding of the Fed’s aggressive asset purchase strategy beginning in March 2020 sheds light on where we are, today.
Asset purchases represent the Fed’s most sophisticated and surgical tool to manage supply and demand equilibrium. It was the tool that helped the U.S. emerge from the 2008/09 Great Recession. The economic crisis in 2008/09 did not carry inflation risks, nor did it carry supply-chain risks. The Fed’s job was to stimulate demand in order to create equilibrium against a healthy supply-chain.
Typically, the Fed lowers interest rates in order to reduce the cost of money. This helps stimulate the economy by improving demand. Prior to the Great Recession, the Fed was raising interest rates in order to quell overheated demand, however, rates were already fairly low by historical standards. When the mortgage crisis hit, the Fed cut rates to zero but it needed more firepower to reinvigorate demand.
On September 1, 2008, approximately two weeks before Lehman Bros. declared bankruptcy, the Federal Reserve balance sheet stood at $905.3B. On September 22, 2008 the Fed’s balance sheet increased to $1.2T and ballooned to ~$2.2T by May 2009. The Fed purchased over $1T of assets (most of which were considered troubled assets) and by May 18, 2009, market gridlock was dislodged and broad-based liquidity was restored. In addition to cutting rates, the Fed boosted demand through asset purchases in order to help demand meet normalized supply — allowing for a return to economic growth.
In our last newsletter, we shared how the Fed and globally systemic banks mutually share levels of transparency and information that far exceed the legal limits of the equity markets. Keep in mind, these are globally systemic banks across the United States, Canada, Europe, and Asia. Moreover, there are many other financial institutions, beyond the 30 globally systemic banks, that also have access to the U.S. Federal Reserve Window. The Fed carries the enormous responsibility of being the primary stakeholder responsible for global credit and money supply.
In March of 2020, many were anticipating a long and protracted global economic recession, if not a global economic depression. After all, the world never before witnessed a simultaneous shut-down of global economies of a scale, magnitude, and breadth like we experienced in 2020. We endured a lot of pain on an individual, family, and community level. In addition, there were industries like travel and leisure that suffered greatly. However, why did the economic and capital markets impact, on a macro level, seem so brief and fleeting? The answer lies in the lessons learned by the Fed’s asset purchases in 2008/09 and the aggressive application of those lessons toward its asset purchase strategy beginning in March 2020.
Prior to March of 2020, the Fed was slowly raising interest rates after years of sitting close to zero percent. Facing an imminent global economic shut-down the Fed cut rates to zero, again. In its estimation, this was not nearly enough firepower to offset a potential economic collapse.
In 2020, the Fed applied its learnings from the Great Recession and engaged in an aggressive asset purchase strategy to mitigate the impact of a global economic shutdown. The Fed’s balance sheet increased from $4.1T in March 2020 to $7.7T in March of 2021. The Fed removed the riskiest assets from banks to ensure they had ample lending reserves and to incentivize them to continue lending. This tactic creates an “easy money” environment that spurs consumer and business spending. The focus was on supporting demand to blunt the effects of a global economic shutdown.
Make sure your seatbelts are securely fastened…
In addition to the more than $3T of asset purchases by the Fed, congressional stimulus programs during 2020 and 2021 amounted to over $5T. It’s no surprise that we are wrestling with inflation when over $8T of asset purchases and stimulus has been pumped into the economy and capital markets in just over two years, against the backdrop of a weakened supply-chain.
The Fed used the tools within its authorized mandate to support demand by creating massive global liquidity. While the Fed has the tools to support demand, it has no ability to fix a global supply-chain crisis. So, we now have improved demand chasing abnormally weak supply.
On June 22, 2022, Fed Chairman Powell’s testimony reiterated a well understood constraint on federal reserve powers — that interest rate policy is an imprecise and blunt instrument to limit inflation and address rising unemployment. Since it’s imprecise and blunt, the market will continue to be volatile despite these interventions.
The Fed is now attempting to cool down normalized demand (not overheated demand) in order to bring it into equilibrium with abnormally weakened supply. This is a very short-term fix and it is not a recipe for a healthy economy.
Today, the Fed’s balance sheet sits at nearly $9T. A significant amount of these assets represent troubled and toxic assets offloaded by global banks and purchased by the Fed. The impact of these purchases may be the only safeguard protecting the economy and capital markets from collapsing. It is no surprise to us that the results of the global banking stress test on June 23, 2022, were strong.
We may experience turbulence…
The current state of the capital markets cannot be separated from the March 2020 market dislocation. We are experiencing an extension, or another chapter, stemming from a global economic shutdown driven by a tragic ongoing pandemic.
We are actually about two years into an unprecedented global market crisis. We just didn’t notice the trillions of troubled assets strapped into the jump-seat of a jumbo jet the Fed is flying while trying to minimize turbulence and orchestrate a soft landing.
The impact of the Fed’s asset purchases, which began in March 2020, is still being felt today. While there are many other variables influencing the current state of the capital markets, they all seem to stand on the foundation of the Fed’s balance sheet.
The Fed is landing a very different plane…
It appears the combination of a Fed strategy to insulate the market from a substantial amount of troubled and toxic assets could potentially hold the market together, just long enough, for interest rate policy and an improved supply-chain to tame inflation to the sub-4% or sub-5% levels. The greatest impact on inflation would be a return to a more normalized supply chain. This cannot happen soon enough since the Fed wants to limit damage it is doing to healthy demand so it can drive growth as our global supply-chain comes back online.
Recovery could potentially take another 12 to 18 months, barring any unforeseen events. If we assume we are 27 months in (March 2020 starting point), this would bring the recovery time of this crisis to about 39–45 months. Some of you may recall our email update a few weeks ago where we compared the likely recovery period of this market dislocation as being similar to the one related to Black Monday — which took ~36 months.
Implications for Long-Term Companies…
We are not going to debate the Fed’s mandate, the demands it places on the Fed, or the merits of their response to these demands. The fact is, we are in historically unprecedented territory. What we learned from actual historic precedent is that our current level of financial stress is far less acute given the Fed’s willingness to shield the global market from trillions of troubled assets.
The capital markets would benefit from reform that minimizes short-term and misaligned incentives that manifest into trillions of troubled and toxic assets that now reside, quarantined, on the Fed’s balance sheet. However, the purpose of this particular newsletter is not meant to promote an agenda for financial system reform. It is meant to support your long-term planning with a sense of urgency — by providing a level of bespoke transparency normally reserved for only a select group of market insiders.
In summary, given historical trends in past financial crises, coupled with the unique events we are experiencing around the world, companies should expect an equity market that will only provide brief capital raising and/or refinancing windows of opportunity over the next 12 to 18 months.
- Be prepared to take advantage of these open windows.
- Be mindful of a strengthening U.S. dollar which will adversely impact revenues and profitability.
- Be strategic and thoughtful as you experience pressure from investors to buy back stock as the value of your cash will only increase during this period of time as your weighted average cost-of-capital rises.
LTSE’s Capital Markets Advisory Group stands ready to support you.
Sneak Preview for Our Next 2022 Newsletter…
In the midst of inflationary concerns and a slowdown in global economic growth, a war on ESG has been brewing. In recent weeks, there has been a flurry of news stories addressing ESG factors. These stories range from the German authorities raiding DWS and its majority owner, Deutsche Bank, over allegations of ‘greenwashing.’ The Securities and Exchange Commission (SEC) is investigating Goldman Sachs over similar concerns. Elon Musk is taking to twitter to voice his frustration over Tesla being omitted from the S&P ESG Index while Exxon maintained its position in the index.
Simultaneously, Gary Gensler’s SEC is pressuring issuers to provide more transparency with respect to their ESG credentials. This initiative recently manifested itself in the SEC’s proposed rules on climate change and cyber-security disclosures. Leveraging our credentials as an SRO, LTSE provided comments to the SEC on its proposals that took into account the viewpoint of many of the companies we work with.
Fundamentally, climate risk is an investment risk and one that needs to be addressed . However, to think there is a ‘one-size-fits-all’ solution to solving sustainability-related issues can be considered naive. It was also apparent that the SEC’s proposed rule related to climate change was developed to aid investors, rather than issuers. We contested this stance given the constraints that could be placed on issuers.
Later this week, we will review our position on the SEC’s proposed climate change disclosures and provide you with a unique perspective on the challenges associated with measuring ESG. Perhaps there is a better way, one that takes into account the viewpoints of all stakeholders…watch this space.
Appendix
Dislocation occurs when many investors engage in “flight to quality” trading. They flock to large cap, profitable companies and sell, often with little price sensitivity, growth stocks. You may also witness large blocks of forced selling in the equity markets purely to create liquidity to protect fixed-income portfolios that, as you will see later, have become illiquid.
Some describe the VIX as a measure of fear in the equity markets. Below is a table that simplifies how to read the VIX and defines equity market dislocation, in the traditional sense:
As of May 9, 2022, the VIX reads at 34.75. While this indicates an equity market dislocation, the equity markets are largely short-term and fickle. Since the beginning of 2022, the VIX has closed in dislocation territory 23 times and not for more than 11 consecutive trading days.
By contrast, at the beginning of the pandemic, the VIX closed in equity dislocation territory for 50 consecutive trading days (February 27, 2020 — May 7, 2020). During the 2008/2009 Great Recession, the VIX closed in dislocation territory for 170 consecutive trading days (September 15, 2008 — May 18, 2009).
Why are some periods of equity market dislocation fleeting, while others are sustained? The duration of equity dislocation matters much more than its episodic occurrence. We actually have data explaining this dynamic — and it does not originate in the equity markets.
The size of the credit market is multiple times larger than the equity market. Global credit is the dog and the equity market is the tail. Watch the dog.
It’s the dog that wags the tail…
The global credit markets are vast and complex. We could share a laundry list of credit statistics related to federal reserve policy, auto-loans, mortgages, fixed-income derivatives, bond defaults and the yield-curve, etc. — but we’re not going to do that.
Similar to the VIX, there is a leading indicator in the credit markets that distills credit sentiment into one metric. It is the rate that measures the solvency and perceived risk of global systemically important banks.
There are only 30 globally systemic banks and they effectively control global credit and money supply. Today, this leading indicator is called Ameribor (Ameribor’s predecessor was called the TED Spread).
Ameribor is expressed in basis points. One basis point is one hundredth of one percent and 100 basis points (100 bps) is equal to one percent (1.00%). Credit dislocation occurs when Ameribor trades above 60bps for more than 10 to 15 trading days.
Dislocation means that these globally systemic banks cannot fully assess one another’s balance sheet risk. As a result, liquidity (money supply) may freeze up. The table below simplifies how to read Ameribor and its concordant market conditions.
Simply put, the data show that when Ameribor signals credit dislocation for more than 10–15 trading days, that equity market dislocation will be sustained. The length of this dislocation is largely dependent on both economic conditions (economic growth, unemployment, inflation, etc.) and artificial economic stimulus (interest rate policy, quantitative easing, etc.).
Ameribor is a unique metric. It is driven by the activity of globally systemic banks. These banks share significant balance sheet risk (syndicated loans, etc.) and carry massive counterparty risks (interest rate hedges, derivative contracts, etc.).
These banks are in regular dialogue with one another, the federal reserve bank (the “Fed”) and other banking regulators. It is a metric that is able to behave more rationally than the VIX.
