Thursday, July 18, 2019

How Fed Chair Jerome Powell Could Create The Biggest Asset Bubble In History With A Rate Cut

Fed Chairman Jerome Powell, will almost certainly approve a quarter point interest rate cut at the next Federal Reserve policy meeting later this month  This could engender the largest asset bubble in U.S. financial history.

"The facts have changed but the Federal Reserve sure doesn't seem like it's changing its mind. The central bank has signaled it's  all but certain to cut interest rates at its policy meeting later this month." ('Rate Cut Plans Don't Compute', WSJ, p. B14, yesterday)

It's a fair bet that few Americans, in the midst of Dotard's continuous assault on their mental health - via his chaotic "governance' -  have any interest in the Federal Reserve.   This is unfortunate, as the Fed may well be on the cusp of creating the biggest asset bubble in U.S. finance history.  And we all know (most who pay attention to finance) this didn't end well in 2008, with the credit crisis spawned by a ginormous asset bubble building for years.

At issue is the wisdom of doing a rate cut now at all, given conditions have changed significantly from when the Fed first broached the possibility.  From the WSJ article cited in the top quote, we learn those changed conditions include:

- The Commerce Dept. reported that retail sales rose 0.4% in June, from May. This was better than the 0.1% economists had expected.

- Consumer spending now looks to have grown at a 4.3 % annual rate in the 2nd quarter according to forecasting firm Macreconomic Advisers.  This is the fastest pace since 2014.

- Meanwhile, the Fed reported that manufacturing output increased by 0.4% in June from May.  This allays any concerns from trade uncertainty and weakness oversees.

Even before these recent reports there were suspicions that a Fed rate cut might be a knee jerk move, appeasing mostly Maul Street investors and borrowers. And perhaps Donnie Dotard too, who has been on Jerome Powell's case for nearly a year.

Barely a week ago, for example, we learned ('Fed Could Light A Fire Under Stock Prices', Business and Finance, p. B4) that:

"The Federal Reserve is nervous enough about the economy to cut interest rates. By the time it stops worrying, stock prices could be so high they present a whole new problem for the central bank to worry about."

That is, that such easing - even by 1/4  point - during a time of low unemployment risks creating an "overvalued market".  In other words, an asset bubble - which if one checks P/E ratios for a bevy of stocks, is already upon us (most S&P 500 trades are at roughly 17 times earnings).   To use an old and hackneyed metaphor, the Fed is about to throw gasoline onto an existing low level fire.    As the author of the cited piece observed:

"The high level of stocks along with the strength of the job market, make the Fed's plans to ease policy just a bit curious."

Which is an understatement if ever there was one.  This is also barely a year after The Financial Times reported on the IMF's growing concern about exploding global debt ('IMF Sounds Alarm On Excessive Global Borrowing'), noting it now tops $164 trillion. And given leverage is used so often to purchase stocks, "fiscal stimulus is no longer the priority to stimulate demand."  In other words, the last thing the Fed should be considering is a rate cut.

An added risk was noted in a followup piece in the WSJ Business & Finance section ('Lower Interest Rates Hold A Hidden Danger') wherein we learned that while higher interest rates helped corporate pension funds last year, including a "rush to contribute to pensions ahead of tax changes", these could go into "reverse" this year.   That would be on account of a Fed interest rate cut.

Added to the incipient risks noted above, including of an asset bubble, is the enhanced debt especially arising from $1.6 b of enhanced collateralized debt obligations (CLOs).   E.g. 'Wall Street Finds A New Way To Bet On Climbing Debt Risk', July 17,  p. B12)  The risk arises because the enhanced CLOs are "set up to hold a much larger amount of loans with extremely low credit ratings than typical CLOs"

Why the emergence of these "enhanced" permutations?

Well, they "underscore investors' growing belief the U.S. economy is due for a recession after more than a decade of expansion."

In addition (ibid.):

"It reflects concerns about corporate loans, starting with a decline in their average credit ratings. Since 2011, the amount of loans rated B or B-minus  has ballonned to 39 % of the market from 17%, according to LCD, a unit of S&P Global Market Intelligence."

Anyone see a parallel here to the growth of lousy CMOs (collateralized mortgage obligations) backed up by bogus-rated credit default swaps in 2007-80?    The salient point here is the corporations are again trying to have it both ways, adding to the $164 trillion global debt cited by the IMF, and also trying to get as much of a free lunch as possible from the Trump-GOP corporate tax cut.

The combination of the massive debt together with an ill-advised Fed rate cut to stimulate an already inflated asset environment, does not bode well.  The WSJ piece cited at the very top did note arguments for a cut, then added:

"Whatever the merits of those arguments might be, cutting rates now seems out of step with what the Fed has done in the past."

People should take  note.

Despite Trump's blizzard of bombast and Twitter -roid rages,  citizens should also be paying attention to the Fed's upcoming moves.  Even if one may not read the WSJ or The Financial Times, every daily newspaper has a business section - and it is a good practice now to keep track of what's reported there.  That is, if you care about your money, investments.

No comments: