Prophets

The Fed's Notion of Normalcy Is Hardly Normal

Shrinking the central bank's balance sheet will make no difference to the Fed’s effective control over financial markets.

This isn't normal.

Photographer: Chip Somodevilla

Federal Reserve policy makers keep speaking of “normalcy” as if it were present, and talking about a return to it at a time which excludes that possibility. They have invented a fantasy land for investors to contemplate and act upon. These university economists have talked themselves into an Ivy-Leagued place of make-believe that only resides in their theoretical universe and cannot be found on Main Street.

I point specifically at the efforts by the Fed and other central banks to monetize much of the bond and equity markets either through direct intervention or by providing a slush of capital created by computer entry and nothing else. Then, after nine years, dating back to September 15, 2008, when Lehman Brothers blew up, they banter about a return to normalcy as if we were in the same condition we were in prior to the Big Bang, which we are not. Just like you can't return home to a house that isn’t there, you can't return to an existence that no longer exists.

The amount of debt with negative yields stands at $6.96 trillion globally. How is that normal? Here is a huge sum of money where the investors pay borrowers for the privilege of lending them money. Try to explain this theory to your bank next time you need a mortgage. Normalcy is right next to Peter Pan's Neverland, which as J. M. Barrie tells us, is “the second star to the right and straight on ‘till morning.” We are dancing with the “Lost Boys” now, but the Fed will not admit to that.

There has been talk of Gary Cohn, President Donald Trump’s senior economic adviser and the former president of Goldman Sachs, taking over at the Fed. I am in favor of this idea. The Financial Times notes that, for the last 40 years, every Fed Chair has been an economist. That may be the center of the problem.

The Fed of today will not be the Fed of tomorrow and reliance upon what is now present will be a mistake. Trump -- America's Peter Pan -- is going to appoint four new members to the Fed at some point. I am not sure why he hasn't done so yet except that he, too, may be unsure about what he might create. It is always so much safer to stick with what you have rather than run off on new adventures. You always have to be careful of which companions that you take with you when you begin your journey.

I listened carefully to Fed Chair Janet Yellen’s testimony to Congress this week. She spoke of the plan to reduce the Fed’s $4.47 trillion balance sheet and the markets “hoed” and “hawed” in reaction. The simple truth is that she spoke of reducing the stash by a blade of grass or a piece of straw. Her rhetorical cut will make no difference to the Fed’s effective control over financial markets. What she offered was not manna from heaven for a “return to normalcy” but rather a Wendy-type prescription to get the little Darlings back to their beds.

I was also interested to hear that the Fed will be going back to a Treasury-only portfolio. This has two implications. First, Treasuries don't have call dates and so the duration of the portfolio will extend as a result. Second, agency mortgage bond yields will now widen versus Treasuries.

I add to this comment my prior warnings that something is going to happen with Fannie Mae and Freddie Mac -- some type of privatization is in the works. I have been avoiding their debt for months and my position hasn't changed. With the Fed exiting the mortgage arena, and the possibility of some type of privatization of the mortgage agencies, there is way more risk in owning their securities than reward at present yield spreads. Most seem to be ignoring this warning, as seen in current yield spreads to other agencies, but safe is better than sorry.

I also point to another impact of Yellen’s comments. If the Fed is going to a Treasury-only portfolio then it means that the Fed will be buying more Treasuries. This should then compress Treasury yields and flatten the yield curve even further, as the Fed seeks to hold down the cost of the government’s borrowing like all the rest of the world’s central banks.

The flip-side of this equation is Trump’s difficulties in getting his legislative agenda passed by Congress. The time-line keeps extending for getting things done, which means that the government’s borrowing needs are lessened. More buying of Treasuries by the Fed and less borrowing by the government could result in significantly lower yields once again.

“Of course, Neverland had been make-believe in those days; but it was real now, and there were no night-lights, and it was getting darker every moment, and where was Nana?” J. M. Barrie, Peter Pan

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    Mark Grant at mjgrant@bloomberg.net

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