The Yellen Put

Guest Post by Chris Whalen

New York | The term “Greenspan Put” was coined after the stock market crash of 1987 and the subsequent bailout of Long Term Capital Management in 1998. The Fed under Chairman Alan Greenspan lowered interest rates following the fabled event of default and life continued.

The idea of the Greenspan Put was that lower interest rates would cure the market’s woes. Unfortunately, the FOMC has since fallen into a pattern whereby longer periods of low or even zero interest rates are used to address yesterday’s errors, but this action also leads us into tomorrow’s financial excess. As one observer on Twitter noted in an exchange with Minneapolis Fed President Neel Kashkari:

“Central Bankers are much like the US Forest Service of old. Always trying to manage ‘nature’ and put out the little brush fires of the capitalist system, while they seem incapable of recognizing they are the root cause of major conflagrations as a result.”

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When the Federal Open Market Committee briefly allowed interest rates to rise above 6% in 2000, the US financial system nearly seized up. Long-time readers of The Institutional Risk Analyst recall that Citigroup (C) reported an anomalous spike in loan defaults that sent regulators scrambling for cover. The FOMC dropped interest rates at the start of 2001 – nine months before the 911 terrorist attacks – and kept the proverbial pedal to the metal until June of 2004.

Interest rates rose to 5.25% by 2006, but missed the previous highs of 2006 by a full point, a long-term trend reflected in lower earnings for banks and other credit market investors. Chart 1 below shows the return on earning assets for all US banks. The good news is that returns for US banks are rising after hitting a 40-year low at 0.75%. The bad news is that the peak return on assets will probably peak at 0.9%, a full 5bp below the levels of 2008 10bp below the 2000 peak of 1%.

Source: FDIC

Now 5bp may not seem like a big number, but when you are talking about $15.6 trillion in earning assets held by US banks, that number represents almost $8 billion missing from the industry’s quarterly net income of $45 billion. The unfortunate dynamic of the “Greenspan Put” has been to slowly erode the earning power of banks, pensions and other savers in our economy by driving interest rates ever downward.

But following the 2008 financial crisis, Chairman Ben Bernanke and later Janet Yellen doubled down. Call if the “Yellen Put.” Not content with merely driving short-term rates down to near zero, the committee embarked on a fantastic speculative adventure of market manipulation. The FOMC supposed that open market purchases of trillions of dollars in securities would somehow help the economy and get the heavily qualified measures of inflation like the Consumer Price Index to rise to a 2% target.

Since then, statistical measures of inflation have barely moved, but asset prices for stocks, housing and commodities have galloped along at double digits. The true goal of the FOMC was not to restore full employment much less price stability, as required by law. Instead the US central bank was and is still today fixated on preventing a general debt deflation. Thus pumping up asset prices seemed the logical idea, even if it did not fit into the Fed’s policy narrative.

The fact that overall debt levels have surged thanks to the Fed’s use of low interest rates obviously begs the question: what was really accomplished? It also proves the wisdom that the monthly payment is all that matters, both to consumers and to heavily indebted governments. The global reality for the Fed, Bank of Japan and European Central Bank is the relentless increase in public debt.

The Yellen Put has increased the debt load in the US and globally, but left the financial markets even more fragile than in 2007. A key measure of this danger was illustrated recently in Grant’s Interest Rate Observer, quoting Asset Allocation Insights, which notes that since 2008 the duration of the Bloomberg Barclays US Aggregate Bond Index has increased 62% to 6.2 years.

Simple translation: Via manipulation of the credit markets, the FOMC has temporarily suppressed growing bond market volatility measured by duration. The Yellen Put means that bond prices will likely move at a brisk pace as and when volatility returns, a pace that will stun complacent investors. But meanwhile, the weight of the Fed’s $4 trillion bond portfolio first is going to result in an inverted yield curve.

As the spread on 2s vs 10s in the US Treasury market relentlessly closes in on zero, the FOMC is grudgingly being forced to admit that open market purchases of securities may not actually impact the CPI or job creation. And remember, as Grant’s notes with understandable pleasure, that the bond market is now dominated by long-dated Treasury paper and corporate debt with minuscule coupons. And there is also a hidden duration extension risk event buried inside the $10 trillion market for mortgage backed securities, which will fall much faster in price than corporate debt. Again, the relevant terms here are volatility and option-adjusted duration.

Not only has Chair Yellen and her colleagues created a time bomb of volatility in the US bond sector when it comes to market risk, but the extended period of low interest rates has also created a hidden wave of future loan and bond defaults. By suppressing credit spreads and thus the cost of credit, the FOMC afforded interior corporate and individual borrowers access to credit at premium, investment grade prices. Now the defaults are starting to accelerate.

“For the first time since January 2017, the default rate for autos, bank cards and mortgages all rose together,” said David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices. The net charge-off rate for bank owned credit card receivables was 3.4% vs the near-term low of 2.8% in 2015, when banking industry credit loss rates troughed.

Meanwhile, loss given default for bank owned 1-4 family mortgages reached a half century low at 24% in Q3 ’17, a measure of just how far the FOMC has gunned home prices in this credit cycle. Big question: when and how much will US home prices correct downward – if at all? Is the home price inflation caused by the Yellen Put permanent?

As we noted in a post on Zero Hedge this past Black Friday, “Bitcoin & Fiat Paper Dollars,” the currency system created by Congress in 1862 was a product of the “exigencies of war,” to paraphrase the late Senator Robert Byrd. He was speaking about the Civil War era legal tender laws that force you to accept paper money in payment. By equating money backed with gold with paper money, Congress created a coercive system that allows the US Treasury to expand the currency without practical limit – so long as public confidence in the system is maintained.

A profligate Congress is eroding confidence in Abraham Lincoln’s precursor to bitcoin – the greenback. The magnitude and length of the Fed’s latest rescue for the US economy dwarfs the modest credit support provided to markets after the failure of LTCM. With the advent of bitcoin and other crypto currencies, the more independent minded members of society are voting with their feet and fleeing the post-WWII currency system created by Washington at Bretton Woods.

Given that the price tag of the Yellen Put stretches into the trillions of dollars, how big will the next Fed intervention need to be? For example, will the FOMC stand by and watch the US equity markets correct as China slows in 2018, destroying trillions of dollars in paper wealth? After all, the chief priority of the FOMC arguably is not full employment or price stability, but rather preserving the Treasury’s access to the bond markets.

So here’s the question: Does the Yellen Put imply an open-ended commitment to support the equity and bond markets, and purchase more Treasury debt in the systemic event? Answer is most definitely “Yes.” And this fact allows our national Congress to ponder tax cuts in the face of the largest spending deficits in the nation’s history, in peace time or war.