A Faulty Tap & Two Men in Nebraska
Milton Friedman argued that long and variable lags following changes to monetary policy made it an ineffective tool to fine-tune the economy. Following detailed research with Anna Schwartz, Friedman likened it to a tap that takes nine to twenty-nine months to operate after turning. Having started turning the tap off about twelve months ago, the Federal Reserve and other central banks are now in limbo regarding the speed at which the water will stop flowing and its likely impact. Meanwhile, the early stage lags of its tightening policy have already presented themselves. But there is more to come, and two men in Nebraska await.
Once implemented, any changed monetary policy must work through a series of transactions between market participants. Economic and capital market structures are critical to the resultant policy transmission. But there are also unforecastable uncertainties which affect things more than policymakers care to admit. Serendipity also plays its part.
Big Turn Off
Central banks turn off the money tap by increasing their policy rates. Criticised for their delayed response, the Fed swiftly turned the tap off last year. The Fed Funds Rate (FFR) was hiked from 25 bps to 500 bps, a 20-fold increase in twelve months. Legendary inflation fighter Paul Volcker, and Jay Powell’s hero, took three years to raise the FFR four-fold to its 1980 peak.
The FFR is the rate at which banks borrow and lend the reserves, which the law requires them to keep at the Fed. A guided rate change is a vital determinant of the economy’s financial condition, the ease with which money is available to its participants. But critically, not all market participants are equal regarding the impact of policy changes. The speed and severity of its implications are related to each participant’s proximity to the banking system and the degree to which its asset market is liquid and debt-dependent.
Friedman was an exponent of the importance of monetary aggregates in controlling inflation. In the UK, the recently departed Nigel Lawson was as Chancellor, a Monetarist adherent with his medium-term financial strategy. To Keynsians, Friedman was a free market radical who believed that government should create stable monetary conditions and, beyond that, leave its participants Free to Choose. However, members of the Austrian school, such as Freidrich Hayek, regarded Friedman as a closet Keynesian statist because his prescriptions operated in the aggregate. The Austrians studied the business cycle, its causes and effects, and were suspicious of government monetary and fiscal policy.
Austrian economist Joseph Schumpeter described the capitalist ideal as being creatively destructive. Policies that prevent the market from allocating resources, including its capital assets, have harmful unintended consequences, often more damaging than the policies’ intended targets. The Austrian argument against monetarism was that controlling interest rates misallocated resources and changed relative values, distorting the market’s core messaging function. Hayek thought Friedman’s monetarism was inherently unstable, leading to radically different outcomes for different market participants.
The consequences of the Fed’s rapid tightening are now becoming apparent. First in line were government bonds, underpinning all other financial assets. Both equities and bonds have interest-rate-sensitive liquid capital markets. The many buyers and sellers allow for rapid transmission and price adjustments. 2022 was a bad year for these assets. The standard 60/40 (equity/bond) diversified wealth management portfolio had its third worst year since 1867. As the year unfolded, private equity owners, real estate investment trusts and alternative asset managers appeared relatively unscathed. But eventually, values declined as precedent transactions filtered through under the weight of external opinion. The lack of liquidity caused lags in the value adjustment. These lags are ongoing.
US regional banking and the UK’s LDI pension funds were reliable buyers of government bonds that became forced sellers realising losses risking death spirals in their respective government bond markets. The secret gambling habit of the UK’s pension funds might have gone unnoticed if it hadn’t been for bad luck. A new government was trying to upend accepted Treasury orthodoxy in one budget proposal with unfortunate consequences for the UK’s financial standing. Similarly, Credit Suisse might have avoided being forced into the same fate as Silicon Valley Bank if its largest shareholder hadn’t used those fateful words, “definitely not”, when asked about his appetite for refinancing the troubled lender.
If UK politics had been more stable; if the Silicon Valley VCs hadn’t told all their unprofitable dog-walking app investments to move their payroll money; if the head of the Saudi National Bank had said, when asked, that “Credit Suisse is a fine bank”, then these things might never have happened. But, of course, other things would have happened instead. Such events reflect the fragile nature of asset markets with destabilised foundations. The US commercial real estate (CRE) market might be next.
As regional bank deposits drain into money centre banks and higher-yielding money market funds, regional bank balance sheets are rapidly contracting. Figures released last week show the most significant two-week fall in US bank lending ever. In a rerun of the 1980s Savings & Loan Crisis, funding for doctors’ offices, self-storage units, strip malls and business parks has just evaporated. With large real estate investment trusts gating redemptions, a queue of sellers is developing for these illiquid debt-funded assets. Jay Powell acknowledged the impact of this credit contraction doing the tightening job for him. But he raised rates by an additional 25bps anyway, just to let us know he could. The CRE market resembles Mr Creosote in Monty Python’s Meaning of Life. Powell might have just fed him one more tiny wafer-thin mint.
Don't Bank on Banks
Bond yields have fallen sharply as the markets square up for a recessionary credit contraction, boosting long-duration tech shares and well-financed dependable growth companies with pricing power. Amid all this apparent asset contagion, listed equities have remained relatively resilient. Unless that is, you own financials, particularly banks or REITS. Investors have relearned that rising interest rates are not actually beneficial for banks. And no one knows the true value of real estate or private equity debt at this stage.
Here Comes the Rain
But public traded equities are forward-looking, and the highest returns come from buying when things are at their worst. Napoleon said his most valuable general was the man who could do the average thing when everyone else around him was losing his mind. The best investors buy when Mr Market screams for the exit. After consecutive weekend bank rescues last month, there was widespread speculation about the number of private jets swarming to Omaha, Nebraska home of the world’s largest ($125bn) private rainy day fund. But no big rescue deals emerged. While happy to look at what was on offer, Warren and Charlie expect Mr Market to bring them better opportunities, and maybe soon.
NB Prices are as at the previous day’s close.
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