The Market Is Poised For Catastrophic Losses
July 31, 2018
Our financial system has reached a point of extreme instability as a result of combination of factors including high valuations, historically low interest rates, massive on and off-balance sheet debt at all levels (government, corporate, and individual), significant complexity in an under-regulated (and largely uncoordinated) global financial system, and a central bank that has lost the ability to control its desired outcome.
My thesis is based on three key points:
1) Our financial system has reached a point of significant instability
2) Market stresses across asset classes are signaling that the unwind has started
3) Reflexivity in the system will result in cascading losses
I believe the financial markets face the potential for very significant losses in the near to medium term. I encourage all readers to reduce your exposure to risky assets (those with high leverage, unjustifiably high valuations, and inappropriately low yields) and seek out safe havens to protect your wealth and maximize the ability to capitalize on the opportunities that will later arise should the market downturn materialize.
In this essay, I will focus on how the Federal Reserve has created a system of significant fragility.
The Federal Reserve Has Lost Control
The “Fed Put”
To understand our current fragility, we first need to understand the Federal Reserve’s role in our economy.
The Federal Reserve has three objectives: 1) maximize employment, 2) stabilize prices, and 3) moderate long-term interest rates. The first two get most of the press and are often referred to as the Fed’s “dual mandate”. Historically, they implemented their mandate primarily by using open market operations (the buying and selling of US government securities) to increase or decrease the money supply to impact the cost of money. The idea is that the Fed could stimulate a soft economy by increasing the availability of money in the economy, giving borrowers access to cheaper capital, and encourage investment which would lead to an eventual rebound. Likewise, the Fed acted for the opposite effect when the economy overheated.
Initially, the goal of monetary policy was to directly impact lending conditions when the economic environment warranted. The Fed was not directly targeting asset prices. Naturally though, if financial conditions worsened, one would expect asset prices to fall. Therefore, when the Fed eased, the economy improved and asset prices improved as well. This correlation eventually morphed into the market’s perception of causation. In other words, the Fed’s actions became inextricably linked with a perceived desire by the Fed to prevent pain to financial market participants.
This linkage eventually led to a system-wide complacency in risk-taking. How did that happen?
The Federal Reserve’s actions served to dampen or “sell” volatility. Every time our financial markets hit a snag, and market participants felt that pain in the form of lower asset prices, it was the same pattern. The Federal Reserve (and the Federal Government, more broadly) caught the pop as it was happening, reflated it as quickly as possible, had some hearings on what went wrong, made a few regulatory changes, paid lip service to the long-term risks of our actions, and moved on.
By rescuing the financial system (and correspondingly, the participants in the financial system) time and again, they created what the market coined the “Fed Put”. The Fed Put meant that when the system faced stress (often in the form of falling asset prices), the Federal Reserve would lower interest rates and inject liquidity (monetary liquidity, not trading liquidity) into the system to stabilize and reflate asset prices to encourage risk taking and investment. The net effect of this strategy was that when you purchased any security, you also effectively purchased protection against price declines, or a put option on the market, sold to you by the Federal Reserve.
Think of it this way. When you buy a security, the price today takes into account the market’s view of all of the potential future outcomes, weighted by its view of the probability of each outcome occurring. When the market knows that the Fed will step in when prices fall, that knowledge lowers the probability and severity of downside outcomes occurring. That then served to raise the expected return for these securities that exceeded the return one would have achieved had the Federal Reserve not been suppressing volatility. This ultimately led to higher asset prices. Later, in the wake of the 2008 financial crisis, they went further when they explicitly and aggressively sold volatility using their QE program by bidding in the market for treasuries and mortgage backed securities.
Why would they do this? They did this for the reasons stated earlier. They wanted to soften the effects of an economic downturn. When asset prices fall, equity value in the system falls more quickly, and leverage in the system correspondingly rises (similar to when the price of your home falls, your equity falls at a faster rate because of the debt). That results in economic losses in the banking system, which then further halts the flow of money through the economy. By injecting liquidity into the system, the Fed facilitates the raising of all asset prices (loans, stocks, homes, commodities, etc). As a result of rising asset values, the leverage in the system declines and money can flow more freely again. Banks start to lend again. Companies are able to invest. The economy grows. It is a way to restart the economic engine, so to speak. As a result, the Fed, over time, moved to an explicit, if largely unstated, policy of supporting asset prices.
While this is a noble endeavor in theory, it is problematic in practice. The problem is that market participants need to feel pain when they make mistakes. If they are not doing sensible things with money, a properly functioning market system should punish them for their lack of prudence. Otherwise, they are incentivized to take risk that they shouldn’t be taking because prices are rising.
For example, under normal circumstances, if a loan has a high probability of loss, I should demand a higher yield to account for that risk than one with a low probability of loss. However, if Federal Reserve is there to save me against downside outcomes, both the probability and severity of losses are lower than it otherwise would be. Because that probability is lower, I am therefore willing to accept a lower yield to make that investment and the price is bid higher. This type of activity is happening across the market in all asset classes.
When the Fed is suppressing downside outcomes, riskier assets get a disproportionate price benefit because the probability and severity of downside outcomes are normally greater for riskier assets, all else being equal. When those factors (the probability and severity of downside) are being suppressed, the corresponding price reaction is better. Thus, anyone who doesn’t take more risk underperforms those that do. Riskier loans that yield 10% can perform as if they’re loans that should yield 6%. On the other hand, a less risky loan yielding 5% may perform like a loan that should yield 4%. While all loans end up yielding less than they would otherwise yield, the riskier investment gets a disproportionate price benefit from the liquidity injections of the Fed. Yields across the market come down as a result of this dynamic.
This support by the Fed creates a vicious cycle (or a feedback loop) where: (1) the amount of capital dedicated to doing risky things increases in the system as a whole; (2) the downside of the Fed not bailing out the system the next time increases because an increasing amount of capital is now dedicated to risky behavior; (3) market participants know this and, thus, they realize the Fed has no alternative but to save the system when it fails; and (4) market participants, knowing the Fed must bail out the system, increase the magnitude and degree to which they engage in risky behavior. The loop continues and risk in the system grows.
This also has a tendency to lead to a positive feedback loop of permanently rising asset prices. As the volatility of the market is suppressed, the expected value of the market rises, as noted earlier. However, once that new price level is achieved, the logic continues to apply and the loop restarts. When buyers buy the asset at the higher price, they too must be supported by the Fed and protected against downside outcomes. This continual Fed support to each subsequent buyer of an asset causes a continual re-rating of assets higher. This is how asset bubbles form.
The long-term issue with this strategy is that with each subsequent bail out, the market, and correspondingly, the balance of the economy, is dedicating more and more capital to increasingly risky investment behavior which have a shallower tolerance for economic downturns (otherwise, they wouldn’t be risky investments). Thus, the longer that this loop goes on, the Fed is forced to save the system at earlier and earlier points of stress on the system. These days, when the market drops even 5% to 10% very quickly, market participants already begin to opine on how soon the Fed will “change course”, become “more accommodative” or “bail us out”. A system that is increasingly intolerant of stress is one that is, by definition, more fragile.
Think of our economy as a long-distance runner. Every time our runner slowed down a bit, we fed him some stimulants and sent him on his way. He continued to win races, but each time, his win was a little less sturdy. He started to wobble on the track. He collapsed after races with increasing frequency and severity, even on races that weren’t that long. Every time he did, we just handed him more drugs. At some point, our runner can’t go on. He’s got an arrythmia, and he’s about to go into cardiac arrest. That’s where we find ourselves today.
During the financial crisis, the Federal Reserve began to dramatically expand their balance sheet through a quantitative easing program (QE). In that process, they created money that was then used to buy securities in the form of treasuries and mortgage backed securities, as noted earlier. That money then circulated into the economy, although with somewhat disappointing results relative to expectations. They found themselves forced to buy securities to the tune of approximately $4.5 trillion, far larger than they had originally envisioned, as they went from QE 1 to QE 2, to QE 3, to Operation Twist, and most recently to QE 4. As that money cycled through the economy, it increased income for businesses and individuals, eventually making it in the hands of investors that used that cash to purchase assets. The sheer volume of capital, an increase of $12 trillion including the European Central Bank (ECB) and Bank of Japan (BOJ), created a global asset shortage and bid the prices of all asset classes higher.
The end result of so much incremental liquidity in the system is that you have a market with much higher earnings, tighter credit spreads, and trading at higher multiples (i.e. lower yields) than they would have otherwise been if the liquidity had not been injected into the system.
A Powerful Magnet
Having so much liquidity in the system can be incredibly dangerous. There is a global mispricing of risk as investors bid up all asset classes. With so much money chasing so few assets, global market volatility comes down significantly.
Think of the fed’s liquidity injections as a magnet between capital providers and the capital markets or between investors and investments. While the liquidity is there, the magnet is strong. As bumps, real or imagined, try and pull the magnets apart, these effects are quickly shrugged off as the magnets snap back together. As soon as an asset class hits a snag and trades down, it has a tendency to get bid right back up. Each time these selloffs happen while the Fed is being accommodative, the sell-offs get shorter in duration and magnitude relative to what they should be because market participants realize it doesn’t pay to sell.
Just look at the statements made by David Tepper of Appaloosa Management on CNBC on September 24, 2010. At the time, he explained why he was long the market, saying the following:
“Either the economy is going to get better by itself in the next three months…What assets are going to do well? Stocks are going to do well, bonds won’t do so well, gold won’t do as well. Or the economy is not going to pick up in the next three months and the Fed is going to come in with QE. Then what’s going to do well? Everything… in the near term though not bonds…So let’s see what I got — I got two different situations: One, the economy gets better by itself, stocks are better, bonds are worse, gold is probably worse. The other situation is the fed comes in with money. Up to the point that the Fed comes in with money, the stock market can go down a little bit but not that much because I have a put. You gotta love a put, especially when the government is issuing it. So I can’t go down that much. It doesn’t mean I’m going up to that point but after that I’m going up. OK? So what do I do? I gotta buy. I can’t take the chance of not being a little bit longer now… that’s how easy it is right now.”
Here, Tepper he is acknowledging the simple fact that the Fed has given him a put on the market and therefore must buy stocks because the Fed has limited the prospects for significant downside in the near term from the equation. The Federal Open Market Committee (the committee of the Federal Reserve Board that sets policy) had just released its statement and they indicated that the Fed was ready to embark on another round of liquidity injections into the market if necessary (this ended up being QE2). And he was right. The following rally that ensued in the market was dubbed the “Tepper Rally” because of his comments that day on CNBC.
Think of the snags we’ve hit since the global financial crisis in 2008. You’ve had multiple budget showdowns between Republicans and Democrats, a downgrade of US debt, Greece issues specifically and ECB issues broadly, mounting US federal debt ($21 trillion today) that will explode higher in the coming years from obligations already made (entitlements to the tune of another $60–70 trillion), massive and uncontrolled Chinese leverage issues, etc. The list is huge. These are all still real issues but they seem like distant memories for a market with excess liquidity. Economic rationality goes out the window in times of market exuberance. No matter what may come, the Fed will be there to save us.
To Tighten or Not to Tighten? The Federal Reserve’s Big Problem
The question is, why now? Why is now the time when this dynamic all breaks down? Haven’t we been here before? Yes, we have, but we have now reached a point of spiraling systemic instability.
As noted earlier, monetary policy in this country has largely been balanced between softening the effects of economic downturns and curtailing excessive growth. The Fed tightens when they see risks of inflation. The Fed eases when they see risks of a weakening economy. (This is the blue loop in the image below). However, this loop, what I call the “Normal Monetary Policy Loop” becomes more unstable over time because, as noted earlier, an implicit “Fed Put” pushes people out on the risk curve and the economy becomes increasingly weighted to risky investments that would not have been undertaken had the Fed Put not been in place. As we go around and around on the blue loop, we create an economic structure of massive instability, like a game of Jenga where any wrong move can result in a collapse of the structure. Such structures do not bend. They break.
With the significant amount of stimulus we contributed to the system since 2008, we have allowed risk to proliferate through the economy. Now, the problem is that the Federal Reserve has reached a point where no matter which way they turn, the likely result will be significant economic pain. There are limited stable solutions to our current situation that does not result in a reset of our economic expectations, significant re-negotiations of debt globally, and likely significant inflation (this is shown by the red arrows in the “Risk Unwind” section of the chart above).
Today, we have excess liquidity, risks of inflation, and high valuations. Given the fragility in the system, and the extraordinary amount of monetary (and fiscal) policy accommodation we’ve had to administer to achieve our current state, a tightening of monetary policy has significant risks. If we tighten monetary policy from here, we are very likely to have an economic crash (more on that below). That will then force us to immediately administer a rapid policy response to prevent a systemic failure. While we’ll be able to prevent a complete shutdown of the economy, we’ll also be on a much weaker footing. A very easy, emergency monetary policy response at this point, following an uncontrolled economic crash, will demonstrate to market participants that the Fed is unable to properly manage our financial system, leading to a loss of the Fed’s credibility, and likely, lower valuations.
On the other hand, if we don’t tighten today, we will likely spur significant inflation, leading to much higher yields. As interest rates increase, we will see a very significant pullback in valuations and, correspondingly, economic activity — in other words, stagflation.
The Fed’s Current Path
Faced with this dilemma, the Fed has decided to tighten monetary policy to avoid an inflationary spiral. They are now raising rates and letting their balance sheet runoff to the tune of $40 billion per month which will then rise to $50 billion later this year. In addition, the ECB and BOJ are tapering their purchases. In all, the global liquidity from these three Central Banks peaked in March 2018, at a height of $15 trillion. (See the below chart courtesy of Bloomberg).
The Fed is hoping this unwind of its balance sheet, and removal of their now explicit short volatility position and corresponding removal of liquidity will not cause a market crash. As outsiders to the Fed’s thinking, we have a tendency to believe that the Fed has knowledge we don’t have and policy tricks up its sleeves to facilitate whatever economic scenario they want. Unfortunately, the truth is a lot less exciting than that. The truth is they are making decisions based on the same information we have. The information is likely telling them that their present course is fraught with risk, but it’s the only option they’ve got. Ultimately, the Federal Reserve is embarking on an uncertain path with an uncertain outcome and the only thing they can do is hope that everything goes smoothly. The question we must ask is: what’s the likely outcome?
To answer that, one only needs to look at what the Chairman of the Federal Reserve Jerome Powell himself said, as excerpted below from the recently released transcript of the Federal Reserve’s November 23–24, 2012 Policy Meeting:
“….I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
My third concern — and others have touched on it as well — is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.
Take selling — we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position. When you turn and say to the market, “I’ve got $1.2 trillion of these things,” it’s not just $20 billion a month — it’s the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market.”
I think Evel Knievel said it best: “Anybody can jump a motorcycle. The trouble begins when you try to land it.”
Powell is saying that he is concerned that a balance sheet unwind cannot be done calmly. That makes perfect sense. If volatility has been suppressed downwards and asset prices have been bid up as a result of the expansion of the Fed’s balance sheet to $4.5 trillion, it’s only natural that market participants are going to want to get out before that unwind is finished.
What will be the result? Well, imagine you had a dance hall with 10,000 people in it. The dance hall is doused in kerosene and the Fire Marshall comes in and lights the building on fire. The building has only one exit. Let me ask you this. Do you want to be the first one to leave? Or do you want to leave when everyone else does?
Right now, market participants are dancing in a hall engulfed in flames because the market response has not yet been strongly negative. It’s only a matter of time until someone yells, “Fire!”
You may point to his commentary recently and say he’s changed his view of this risk. At the recent Semiannual Report to Congress testimony held on July 17, 2018, he statement contained the following:
“Looking ahead, my colleagues on the FOMC and I expect that, with appropriate monetary policy, the job market will remain strong and inflation will stay near 2 percent over the next several years. This judgment reflects several factors. First, interest rates, and financial conditions more broadly, remain favorable to growth. Second, our financial system is much stronger than before the crisis and is in a good position to meet the credit needs of households and businesses. Third, federal tax and spending policies likely will continue to support the expansion. And, fourth, the outlook for economic growth abroad remains solid despite greater uncertainties in several parts of the world. What I have just described is what we see as the most likely path for the economy. Of course, the economic outcomes we experience often turn out to be a good deal stronger or weaker than our best forecast. For example, it is difficult to predict the ultimate outcome of current discussions over trade policy as well as the size and timing of the economic effects of the recent changes in fiscal policy. Overall, we see the risk of the economy unexpectedly weakening as roughly balanced with the possibility of the economy growing faster than we currently anticipate.”
Chairman Powell demonstrated little concern for the unwind of the Federal Reserve’s balance sheet in his testimony. But is it likely that our financially sophisticated Fed Chairman (who was likely just as sophisticated in 2012 as he is in 2018) changed his view dramatically between now and then? Of course not. But what else can he really say? Should he instead say, “Our system is fraught with risk and I hope this works out. If it doesn’t, we face financial calamity”? It does not take a large leap of faith to suggest that he is likely as concerned now as he was then. The only path to avoid a catastrophic outcome is if everyone keeps dancing as the various forms of policy accommodations come off. As I noted earlier, I believe such a sanguine outcome is unlikely.
The Federal Reserve Is Fast Approaching Insolvency
Adding to the uncertainty created by a lack of good monetary policy options, the Federal Reserve’s balance sheet is nearly insolvent. As of end of Q1 2018, the Fed had $4.4 trillion of assets but only $39 billion of equity, or a total assets-to-equity ratio of 112 to 1. In addition, the Fed is funding itself with short term funding mechanisms and has used that funding to purchase long duration assets, effectively engaging in a carry trade. The duration of its assets is approximately 7.8 years. That is exactly the wrong portfolio to have in a rising rate environment. As interest rates rise, the fair market value of the Fed’s assets will decline materially, likely rendering the Federal Reserve insolvent on a mark-to-market basis. I suspect that this will happen very soon.
Is that a concern? Technically, no. Practically, yes.
Mitigating an insolvency issue for the Fed are two considerations. First, the Fed does not mark their assets to market, so while it could be insolvent on a market value basis, it will not be recorded as such. Second, and more importantly, the Fed can print money as needed to meet any of its obligations so will never have an explicit liquidity or solvency issue.
The bigger issue for insolvency of the Federal Reserve is related to its impact on credibility and independence. If (when) the Federal Reserve becomes insolvent on a market value basis, there is likely to be a real discussion as to whether the Federal Reserve is a stable and functioning body. It’s not an understatement to suggest that any uncertainty about the Federal Reserve as an organization is likely to have a significantly negative impact on financial markets. I suspect that the public and government officials from both parties will begin to question the Fed’s mandate, its role in the financial markets, and its governance structure. Once those questions become politicized, as they inevitably would be, and the independence of the Fed is thrown into real doubt, market uncertainty could reach new heights. If you thought the Federal Reserve board made bad choices regarding monetary policy, wait until Congress gets a hold of it.
As a result of these political issues, the Fed will also be hesitant to crystalize mark-to-market losses on its assets with outright sales or raise rates that could result in losses on its portfolio. Thus, they’ll be forced to keep their balance sheet in runoff mode as they’re doing now, further demonstrating that the policy options of the Fed are constricted, and casting additional doubt on the credibility of the Fed’s power to manage the monetary policy of the world’s largest economy.
Conclusion
Given all of the above, it’s clear that the Federal Reserve is approaching unprecedented challenges in its history. All paths ahead of it are fraught with significant risk and uncertainty. As these challenges manifest themselves, the markets may respond swiftly and violently downward. While it’s unclear what the end result will be, one thing is clear. The market is entering a period of significant chaos and risk should be reduced accordingly.
