Notes From Underground: Seriously, It Ain’t Rocket Science

I know my readers are tired of my typical line of cynicism but it has never been more relevant than this week. On Monday, NASA succeeded in landing a space vehicle on Mars. HOWEVER, the FOMC can’t even define what the NEUTRAL RATE of interest is for the U.S. economy.

The FED has been populated by mathematical theoreticians who have FOOLED the investing world with the use of high level models based on the work of the world’s top physicists. The balance sheets of the global central banks are stuffed with massive amounts of sovereign and corporate debt purchased on the basis of authoritative models.

Yes, I know the counterfactual argument: What would the world have looked like without massive QE programs? Should policy makers have chanced it based on Bernanke’s fear of a 1937 deflationary implosion? The problem is and will be what is the exit strategy for the FED, BOE, ECB, BOJ to leave the world of wanton stimulus without causing the a massive implosion because the global debt-to-GDP ratio has exploded with the advent of negative and zero interest rate policy.

As Peter Boockvar mused on Wednesday, 40 percent of Russell 2000 stocks have high debt levels tied to floating LIBOR. Fed Chairman Jerome Powell mentioned in his very appropriate speech on financial stability that many metrics are muted and not reflecting any severe increased risk. One of his preferred measures, the forward price-to-earnings ratio, is “consistent with historical benchmarks.” My problem with this is that the ratio is well-behaved because the financial engineering of corporations to use debt to repurchase stock, shrinking the P/E ratio. It is the rising cost of debt coupled with wage increases that stand to put pressure on the ability to service the increased debt load.

Powell said corporate debt has not “faced a massive credit boom like that experienced with residential mortgages before the recent crisis.” He also noted that while corporate borrowing is above trend, “the upward trend in recent years is broadly consistent with the growth in business assets relative to GDP.” Fair enough, but when residential home buyers can’t service the debt their home is foreclosed on. Likewise, corporations cut production and close factories (see GM). The FED Chairman maintains that the risk levels in some areas are rising “overall financial stability vulnerabilities are at a moderate level.”

Maybe, but I heard the same thing about housing from Bernanke in 2008 as he deemed the situation contained. Powell has inherited a difficult situation as he has to confront the system’s massive buildup in excess reserves while dealing with the threat of rapid wage increases. The U.S. debt load as measured in this year’s one trillion-plus deficit is very emblematic of the problem. The cost of servicing the entire U.S. debt grows as interest rates increase putting political pressure on discretionary program.

The problem for the Powell Fed is that with a 3.7 percent unemployment the annual deficit OUGHT to be shrinking as it did during the last four years of the Clinton administration. Will the financial stability vulnerabilities remain moderate for long?

***Martin Feldstein asked an important question to Chairman Powell: Should monetary policy take into account financial stability or in Greenspan terminology should the Fed prick a bubble? In asking the question Feldstein criticized previous Chair Janet Yellen by noting she believed monetary policy should focus on the Fed’s dual mandate. Powell danced the question but finished by saying he believes that monetary policy is not the ideal tool to deal with financial instability or possible elevated asset prices. Bill White’s important paper about the role of monetary policy to “lean or clean” remains relevant.
Powell’s wavering provided added impetus for a rally in all asset classes as STOCKS, COMMODITIES, CURRENCIES and precious metals staged robust increases. However, I do give Powell credit for delivering a major speech on the major issue facing the global financial system.
***Powell provided historical perspective when he cited a speech that was also delivered at the Economic Club of New York by Boston Fed President William Harding in March 1929. The Fed had been attacked for raising concerns about banks leaning for stock market speculation. There were critiques arguing that the FED was out of “its sphere” warning about correct asset prices and that the “banks were so well-managed” there was nothing to worry about. Financial instability at this time was not insured against by FDIC insurance, which didn’t come into law until June 16,1933, the same day as Glass-Steagall. The act was later repealed in 1999 with the passage of Gramm-Leach-Bliley.
Unfortunately, the FED is back into a position of being MORE VIGILANT because the existence of FDIC insurance has resulted in a major liability for taxpayers and savers. Sorry Chairman Powell, the use of 1929 is a flawed argument for dealing with the Fed’s role in financial stability.

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10 Responses to “Notes From Underground: Seriously, It Ain’t Rocket Science”

  1. Daniel Cohen Says:

    Great points!  PE does not include debt.  One must look at the Enterprise Value market multiple, as you mentioned the PE does not tell the whole story. As for his comments about growing assets with rising debt, one must look at the quality of those assets i.e. tangible vs intangible and goodwill.  Companies like IBM have been hugely acquisitive at crazy prices, covering up the rotting of their core businesses.  This goes on until the “recurring” “non-recurring” goodwill impairment charges are taken in order to inflate future earnings for management bonuses but still leave the mountain of debt taken on from the acquisitions.  Rising rate might lead to larger impairments due to smaller present value of earnings using a higher discount rate. Keep up the great work! Dan Dan Cohen

  2. Michael A Temple Says:

    Wonderful piece…..In your last paragraph you discuss the existence of FDIC insurance as being a major liability for taxpayers and savers.

    Did you know that so far this calendar year, the FDIC has not seen even one bank go bankrupt/out of business. Not one.

    FDIC Chairwoman Jelena McWilliams had this to say about this anomalous fact.

    Courtesy of reporting by Christopher Whalen, she recently said

    There has not yet been a single bank failure this year but as you all know that is not normal. We are in abnormally good times. Usually we have three or four bank failures per year. That happens and it is a normal part of the business cycle. We have been in what I like to call the best of times this year. This is the new abnormal. At some point we will get back to normal.

    In my view, if the pendelum has swung so far to the right side that 2018 has ABNORMALLY produced no bank failures, when the pendelum swings back to the left (no stopping as it passes through equilibrium) what will the NEW NORMAL look like in 2019/2020 and beyond once we see a recession and rising bad debts, which even Powell finally acknowledged publicly today.

    Christopher Whalen then adds his observations to Williams’ comments with this

    What is most striking about Chairman McWilliam’s comments is that they could apply to many sectors of the debt and also equity markets. The premium pricing seen for many assets and, as one reader put it so well, the “velocity of collateral” moving through the financial system, makes us wonder if the target for the next crisis has moved from asset quality to the operating and market stress caused by excessive competition on price.

    I have kept a very open mind to the possibility of a year end Santa Claus rally. Powell did his part yesterday (it is already tomorrow here on the East Coast). Trump has the opportunity to send stocks SOARING even more this weekend.

    But, the financial rot and death by a thousand cuts has already been set in motion by the tightening of the past year. And while Powell is being feted for his dovishness by the market, the continuation of QT is still an effective policy of tightening….Some say the current annualized pace of the QT translates into approximately 35 bp of tightening. Not good.

    And will any of today’s Fedspeak/potential new dot plot reverse the fact that, as you point out, 40% of the Russell Index companies are already suffering from the current tightening to date…Or, will sales now rebound for Tiffany’s and Chico’s and other such retailers? Is GM about to rescind its 15,000 layoffs?

    Still some very troubling signs pointing to a slowdown next year for the economy. What is the over/under date for the first FDIC bank takeover of a failed bank? Because when it happens, it will not stop at just one….Cockroach theory will prevail.

    Great article. Now, good night.

  3. David Richards Says:

    Whether or not he actually did so, there exist optics of Powell caving to Trump’s numerous tweets very recently. Very third worldly.

    In fact, Juliette DeClercq nailed it last spring when she showed in great technical and fundamental detail how the US economy and Fed would begin a major pivot in 4Q. Same for the dollar as the buck will eventually collapse, as the release valve for the monumental, growing problems that Yra has long discussed.

    While there are huge problems in Europe too, those are largely discounted, whereas the US has been optimistically priced for perfection with massively long USD positioning accordingly. It’s all about sentiment, misguided sentiment. So the buck can falter even against fiats from other troubled jurisdictions. But there’s a better bet.

    In this environment, the best currencies will be the ones not issued by governments intent on devaluing them and holding real interest rates at zero or negative. Gold and perhaps even out-of-favour bitcoin (although I don’t fully understand bitcoin and remain concerned that governments are intent on killing/banning private crypto in favor of their own crypto forthcoming in an attempt to increase government control – as history shows that government never goes away quietly in the night without a fight).

    The buck has been in a trading range since peaking mid-August, and as every trader knows, the longer a consolidation, the more powerful the breakout when it comes. Question is, will the buck break higher or lower? Don’t bet against Juliette… Dollar down. Got gold and silver? (Final sugg: look up the gold:silver ratio chart).

    • yraharris Says:

      David–thanks for another wonderful post and I am also glued to watching the Gold/Silver ratio and had this discussion with a very smart 84 year old gentleman on Monday–metals won’t rally until this begins to fall and presently at 86 and making recent highs but I continue to watch especially as copper gets a strong bid when equities gain their footing
      I think the dollar has a negative tone relative to the fundamental of interest rate differential but Europe is a major uncertainty which keeps pressure on the Euro—the ECB is caught in the Draghi trap and I care not a lick what the house paper of the EU has to say—Martin Wolfe is as static as many econometric models.CNN doing a piece on the rise of anti-semitism in Germany was a narrative that misses the rise of populism due to the financial repression crushing German savers.Inflation running above 2% is crushing the Bavarian Burghers–where does a German citizen invest.I would like to believe the DAX but it is woefully weak relative to other markets as the German financial industry is zombie like and the great German autos are struggling due to fear of Trump tariffs

  4. Tader 1 Says:


    I’ve often wondered how many Central Bankers around the world subscribe to 2+2=5?

    There EGOs would never allow them to admit it, of course.

    Why isn’t interest rate policy tied to Eurdollar Futures with millions of Open Interest vs being set by few people sitting around a table?

  5. Chicken Says:

    Wall Street no doubt made a ton of money yesterday, with a little help from friends.

  6. kevinwaspi Says:

    Another very engaging post, and thoughtful discussion, “Notes” and its readers comments stimulates great thought!
    As for the “Powell Put”, I’m agnostic. I didn’t see his words as caving, any more that seeing them as acknowledging.
    I WANT to like this guy. Hell, he’s not a frustrated physicist running the central bank, and THAT IS REFRESHING! (hat tip to Yra for banging the drum of “not rocket science”)

    What did he acknowledge?
    Let’s all re-read a piece from the WSJ, “Bernanke’s Exit Dilemma” by George Melloan, Aug. 4, 2009.(

    Chairman Powell, Welcome to your inheritance! I have this piece cut out of the paper, framed with two Reserve Bank of Zimbabwe one-hundred trillion dollar notes hanging above my desk. Students who look at it ask, “what is THAT?” I hesitate, and answer, “hopefully, not your future”.

  7. Richard H Papp Says:

    Since 2012 or so with the Industrial : Gold ratio, equities have had their way. A sustained move below 20 would be helpful for gold to advance.
    And a good look at the $USB:GOLD ratio also tells a tale

  8. Anthony Crudele Says:

    Excellent post Yra. I’m in Japan at the moment coming from Singapore and headed to Hawaii tonight so just catching up on my reading. Hope all is well my friend.

    Anthony Crudele

    AnthonyCCrudele SKYPE

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