The Albatross Of Debt: Why The Fed's Wall Street Based Steering Gear No Longer Drives The Main Street Jalopy, Part 6

The heart of the Fed's monetary central planning regime is the falsification of financial asset prices. At the end of the day, however, that extracts a huge price in terms of diminished main street prosperity and dangerous financial system instability.

Of course, they are pleased to describe this in more antiseptic terms such as financial accommodation or shifting risk and term premia. For example, when they employ QE to suppress the yield on the 10-year UST (i.e. reduce the term premium), the aim is to lower mortgage rates and thereby stimulate higher levels of housing construction.

Likewise, the Fed heads also claim that another reason for suppressing the risk free rate on US Treasuries via QE was to induce investors to move further out the risk curve into corporates and even junk, thereby purportedly boosting availability and reducing the carry cost of debt financed corporate investments in plant, equipment and technology.

In a word, the modus operandi of Keynesian central banking is to replace free market prices on bonds, loans and other financial assets (including equities) traded on Wall Street with administratively set prices designed to stimulate increased levels of real activity in targeted sectors of main street.

The giant flaw on the whole enterprise, however, is that the central bank does not operate in a vacuum in either space or time. Nor does its crude steering gear of administered financial asset prices have any reliable connecting rods to the main street economy.

That's especially the case because under conditions of Peak Debt in households, cheap mortgages aren't efficacious; and owing to Peak Speculation on Wall Street as described below, cheap debt gives rise to financial engineering in the corporate C-suites and pure, undisciplined gambling on Wall Street.

With respect to what we have called the "spatial" dimension, for instance, the artificially suppressed yield on the benchmark UST can easily transmit through the risk curve to cheap junk bond funding for an LBO rather than enhanced investment in capital equipment.

The latter would tend to improve efficiency or capacity and therefore boost broadly based wealth. By contrast, the LBO would tend to actually retard GDP by encumbering existing productive assets with much higher interest expense and also with short-run needs to slash capital and operating costs---even if that diminishes long-run productivity and growth capacity. Having spent 15 years in the private equity business, in fact, that is one thing your editor is especially sure about.

Needless to say, LBO's also essentially strip-mine financial resources from main street businesses in order to re-cycle them to Wall Street. So doing, this form of financial engineering concentrates existing wealth by transferring income from workers and other factors of production to private equity operators and investors at the top of the economic ladder.

Similarly, even when yield suppression on the UST finds its way into lower mortgage rates via spread-based mortgage pricing, that does not automatically stimulate new housing construction. In  fact, due to the unique embedded put option in fixed rate mortgages (i.e. ability of borrowers to pre-pay without penalty), monetary repression on a long-term basis tends to stimulate a refi treadmill rather than new production: As rates continuously fall, the stock of outstanding mortgages churns at accelerating rates.

As shown in the red and green portions of the bar chart below, refi (including home equity lines) has accounted for 55% to 80% of new mortgage originations during the last decade of heavy-duty Fed rate repression. And while some of the "cash out" proceeds or monthly payment savings from typical mortgage refis go into spending for other consumption items, there is considerable leakage: Some proceeds go into debt reduction on say over-extended credit cards, or get arbitraged into purchase of stock or other investment assets or funds the purchase of foreign made goods, which actually subtracts from GDP.

Image result for data on share of mortgage originations accounted for by refi versus new homes

As discussed later, the powerful yield suppression (or falsification of term debt prices) during the Fed's post crisis QE binge resulted in real interest costs for 10-year debt that were 80% below historical norms. But that did not stimulate a housing construction boom because households were already tapped out at Peak Debt. Nor did it stimulate a corporate investment boom because financial engineering offered far more compelling short-term returns to top executives, boards and Wall Street speculators.

In the case of new housing construction, which has been the objective of Fed "stimulus" operations for decades, the chart below is dispositive: Drastically repressed term debt costs produced a tidal wave of joy on Wall Street and in the financial engineering joints domiciled in the corporate C-suites, but not much on the construction sites.

Thus, the 877,000 annual rate of single family housing starts posted in January 2018 amounted to only 49% of the peak rate reached during the Greenspan housing boom, and barely equaled the start rate way back in September 1991 at the tail end of the 1990-1991 recession. And that's notwithstanding that the US population has grown by 69 million or 27% during the period and aggregate real personal income has expanded by 25%.

In other words, there is a huge disconnect in the steering gear. When our monetary central planners sitting  on their august perches in the Eccles Build tweak the money market rate (fed funds) directly or the 10-year yield indirectly via massive bond purchases with fiat credit (QE), the old jalopy on main street does not necessarily respond as intended.

Worse still, these shameless central bankers take credit for whatever does happen on main street when they patently had nothing to do with it. For example, after single family housing starts crashed from an annual rate of 1.8 million in mid-2006 to just 353,000 at the March 2009 bottom, or by an astounding 81%, what remained of the homebuilding sector thereafter slowly dug itself out of that unprecedented hole.

But that didn't happen because mortgage rates were 200-25o basis points cheaper than market clearing levels owing to the Fed's massive intrusion in the money and capital markets. Instead, the slow, tepid 50% retracement shown above was driven by the natural forces of population and income growth on the main street economy.

Indeed, had mortgage rates remained in the 5-6% zone rather than being shoved down to 3% by our monetary central planners, it is doubtful whether the orange line (SF starts) in the above chart would have been any different.

And that gets us to the heart of the problem. Deliberate, deep and sustained falsification of debt yields and the price of other financial assets is poorly linked to main street. Yet these falsified financial asset prices do ricochet throughout the canyons of Wall Street in ways which are impossible to predict or control, and which most surely unleash the speculative juices and inventive talents of the money-shufflers who operate there.

Moreover, it also tends to militate towards the systematic breakdown of financial discipline and two-way markets. That is to say, (leveraged) carry trades were virtually cost free for eight years, and the systematic suppression of volatility meant that hedging insurance ( i.e. downside options to protect trading books) was also dirt cheap.

Beyond that, the wealth effects doctrine, which Greenspan incorporated into his noxious Bubble Finance synthesis, injected what we have called the Fed's "price-keeping" tool into the mix (i.e. the Greenspan-Bernanke-Yellen "put"), thereby generating further vectors of unintended consequence on main street.

To wit, the dip-buying robo-machines and speculators on Wall Street powerfully incentivized the C-suites to join the dip-buying stampede. That's because the picture below would never have evolved in this manner on the free market.

Between the March 2009 bottom and the January 26, 2018 peak, the S&P 500 index advanced at an 18% annual rate in an economy that grew at just 3.7% per annum in nominal terms. Yet in that trees-which-grow-to-the-sky context, there was no downside risk for C-suites which diverted cash flow and debt capacity into stock buybacks or vanity M&A projects: Their stock option packages kept getting ever fatter and there was no board or stock market punishment for buying at temporarily high stock prices which subsequently fell back to earth---even as interest expense remained permanently enlarged.
^SPX Chart

That is just another way of saying that the Fed fostered speculation on Wall Street had a huge multiplier effect across corporate America by inducing additional waves of speculation in the C-suites. In the case of stock buybacks alone, one keen observer hit the nail on the head:

Over the past decade, there has been no corporate instrument of mistruth more powerful than buybacks, an issue we have dissected in these pages for years. U.S. firms have spent roughly $4 trillion on buybacks since 2009, making corporations the biggest single source of demand for U.S. shares. According to Artemis’s calculations, buybacks have “accounted for +40% of the total earnings-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012.

Needless to say, the double-pumping motion of Wall Street dip-buyers being rewarded on upwards of 50 times over the last nine year and C-suites pumping even more demand back into the stock market didn't stop there. It also generated a whole variety of momentum based trading and chart-reading schemes that further exacerbated the general inflation of financial asset prices.

In Part 8, we will address the baleful consequences of Wall Street's worshipping at the alter of momentum, but there should be no doubt about the cause. At the heart of the financial market is the cap rate----the benchmark from which all else is priced via risk and term spreads on fixed income instruments and real estate and PE multiples on equities.

In that context, the graph below leaves little to the imagination. It shows that the average real yield on the 10-year UST during the period between 2011 and year-end 2017 was just 50 basis points. The nominal yield averaged 2.25% during this period of unprecedented Fed foray into QE and ZIRP compared to an average CPI gain of 1.75% per annum. And during extended times frames, the real yield was either negative or tantamount to zero, as highlighted by the overlay of the orange line (Y/Y CPI) on the blue line (10-year note yield).

By contrast, the historic real treasury yield prior to the turn of the century was roughly 2.5%. That means that the cap rate at the heart of the financial markets has been 80% below is historic average and market based natural tendency.

Not only did that fuel massive speculation and financial asset inflation, but it has also left the casino high and dry owing to the "time" dimension referenced above.

Even the Keynesians recognize that financial price falsification can't be a permanent condition. Yet they are clueless about the fact that its major impact has been on Wall Street, not main street, and that their current pivot back toward normalcy at long last is destined to "un-price' all the financial inflation and excess that they fostered during the last decade.

 

 

 

 

 

 

 

 

 

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