In the absence of useful economic news, begin with a little political-money stuff, then remembrance of the 10th anniversary of the beginning of the credit disaster, the advent of QE, and now its reversal, RQE.
Nobody can handicap the DPRK/Trump engagement. But to say it doesn’t matter... bull byproduct. Ray Dalio, billionaire founder and top dog of Bridgewater, the world’s largest hedge fund, who very rarely comments on investments or politics: “The emerging risks appear more political than economic, which makes them especially challenging to price in.” But then he described them: “Two confrontational, nationalistic, and militaristic leaders playing chicken with each other” and “the odds of Congress failing to raise the debt ceiling rising.” Dalio then advised all to expand their holdings of gold.
The DPRK/tweet effect has been clear in real time, the stock market cracking, bond yields falling close to the lows of the last year, and gold rising.
The biggest political event of the week got lost in DPRK noise. Trump’s assault on McConnell makes more dangerous the debt-limit vote in September. Be as even-handed as possible: each political party has a road-rage wing -- angry and irrational with its own set of fantasy-facts. The Republicans hold the congressional majority, but their minority ragers demand accommodation. The recurrent debt-limit issues in the House finally forced John Boehner to leave in exasperation, replaced by empty-suit accommodator Paul Ryan. Now Republicans control the Senate as well, and McConnell is as boxed as Boehner.
McConnell will need as many Democrats to pass the debt limit as Republicans. The ragers in each party will demand hostages: mutually exclusive riders to the limit bill.
The security team is obviously well-along in an effort to encapsulate the president. There is no comparable team or effort in domestic affairs. The Republican right (just like the Democratic “progressives”) is self-enraptured, unable to process that two-thirds of the nation is opposed. The harder the ragers in each party try, the more opposition rises.
There is a lot riding on McConnell’s skill, head-and-shoulders above Ryan’s. If the debt limit increase fails, Dalio again: “...Leading to a technical default, a temporary government shutdown, and increased loss of faith in the effectiveness of our political system.”
Now look back on a superb reaction to crisis by US leadership. Yes, the Fed, SEC, FDIC, Comptroller, Treasury all had missed the rise of the crisis, and it took 18 months after the explosion to fully react, but react we did and with extraordinary success.
The greatest bank run of all time began in late July 2007 -- a wholesale run, banks on banks, not old folks in lines out front. The Fed reacted, injecting cash and trimming the cost of money, but did not perceive the systemic meltdown underway. From a Fed funds crest at 5.25% in July 2007, Bernanke had cut to 4.25% by year-end (the onset of recession by retrospective technical measure). In January 2008 he saw the greater magnitude of trouble, and in panicked steps by February 6 cut to 3.00%.
Bernanke’s book on the Great Depression identifies the key marker of any economic disaster: yields on ultra-safe Treasurys fall and fall, while yields on everything else rise, markets locking up altogether.
In July 2007, typical 30-fixed mortgages were 6.70%, and the benchmark 10-year Treasury traded at 5.16% -- the spread of 1.50% a reasonable historical one. By October mortgages were down to 6.38%, but Treasurys were falling faster, to 4.68%, spread opening to 1.70%. In March of 2008 Bear Stearns failed in a Fed-assisted collapse, briefly reassuring to markets thinking a firewall might be in place. But then 10s nosedived to 3.34%, safety-buyers in mass, mortgages to 5.97%, the spread now blown open to 2.63%.
The Fed cut its rate in May to 2.00%. In false security, 10s by June 2009 rose to 4.25%, but so did mortgages, up to 6.32%, and typical loan fees had doubled. By late summer most of us in markets felt the ground moving again: Treasurys in August fell again to 3.79%, but mortgages rose to 6.48%, the spread opening to 2.70%, mortgage markets closing altogether, housing collapsing.
Then heaven-help-us September... the Treasury seized Fannie and Freddie on the 6th, Lehman took bankruptcy on the 15th, and the Fed set another firewall, over $100 billion in guarantees to AIG. 10s fell to 3.47%, mortgages at last down to 6.04%, but the spread still oceanic. TARP passed on October 3, 10s up to 3.99% in hope of a lasting firewall. Not: by November 24, 10s were down to 3.35%, mortgages 6.09% but nobody applying.
At Thanksgiving... salvation. Bernanke announced that the Fed would buy long-term Treasurys and mortgages, the Fed for the first time ahead of the curve of disaster. 10s kerplunked to 2.08% in two weeks. Mortgages took longer, to 5.29% in December -- spread 3.20%!! -- then down to 5.00% and below. As fear faded and QE took hold, 10s by summer rose back to 3.91%, and the spread down toward 2.00%, mortgage markets functioning.
Skip forward ten years. It’s till easy to find idiots and crazies who think the Fed should have let everything go -- the “Austrian” creationists and right-side ragers.
The Fed has since it stopped QE buying in 2014 owned a surplus $1 trillion in Treasurys, but has already bled off the long-term ones. In the immense global market for Treasuries ($14.4 trillion), letting these extras run off is likely not a big deal.
But the Fed also owns $1.6 trillion in MBS, one-quarter of that market. The Fed will confirm in September the beginning of RQE, the monthly rundown at the outset to be $4 billion. In a time of tepid borrower demand, hence few new MBS, and huge global demand for high-quality IOUs, nothing to worry about. The Fed does intend to increase the runoff to $20 billion monthly, $240 billion annually, 15% of its QE holding now, and that might push rates up a bit.
Of all the things to worry about today, don’t add RQE to the list. The Fed and all in markets will watch the Treasury/MBS spread, and if it begins damaging widening, then the Fed will stop or slow the rundown. If you’re worried today, look back at that 2007-2009 story and consider what we can do if only one man in the whole government is on his “A” game.
US 10-year T-note in the last year. The recent downtrend partly reflects inflation failing to rise, but don’t underestimate the political influence:
The NFIB’s monthly survey confirms its post-election pattern. NFIB members are heavily right-side Republican. After the election its optimism survey exploded upward as never before in its 45-year survey history. And without any economic foundation: the second chart, by components shows that nothing has changed in actual business, as in every actual-condition NFIB survey since:
The next charts illustrate the trip down memory lane in the copy above, 2007-2009. First the Fed funds rate, then the 10-year, then mortgages (Freddie Mac’s survey).