Fed says not a bubble until it sees a pop

Shares go up, until they don’t.

There are many old sayings in financial markets.

One of the less imaginative ones is that shares go up, until they don’t.

No skill there. It’s the sort of pith you’d expect from Ser Bronn in response to whether an army will be victorious or whether it can expect to be barbecued.

I was reminded of this last Wednesday night while listening to U.S. Fed Chair Powell respond to several questions from the Press.

After confirming that rates would remain at zero until after 2023 and asset purchases would continue, he was asked whether he was worried about asset inflation and bubbles in the event of continued asset purchases.

We all knew he would say ‘no’, and he could have left it at that. But he added that he sees no evidence of an asset bubble, because he hasn’t seen it pop, yet.

Hello? You won’t see it pop if you keep QE and the pandemic put guarantee in place. But it probably will pop or at least deflate if you withdraw the guarantee. That’s the dangerous corner the Fed has painted itself into.

Plus, what if the QE/Guarantee pandemic bubble is no longer round? What if it is oblong instead and surrounds multiple asset classes all at once? In that case, it might just narrow and deflate in certain areas (like big tech at present) and change shape, but overall remain intact until the secondary markets catch up with the fundamentals of the real economy (i.e., the primary market).

The problem with QE Infinity.

Last week’s small council meeting confirmed rocket fuel infinity, but the market just rolled over.

“The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labour market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time. In addition, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency mortgage-backed securities at least at the current pace to sustain smooth market functioning and help foster accommodative financial conditions, thereby supporting the flow of credit to households and businesses.
In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”

The decision was expected, no change to rates or asset purchases, although many U.S. bondholders would probably have preferred to see a signal that interest rates might go even lower. So far, no such move, and not enough to move markets, either way.

Indeed, the Fed says that current rates are appropriate, and it will keep them at almost nothing until 2024 (albeit 4 committee members of the 17 felt, potentially 2023 as per the dot plot below). The Fed says it will also continue to purchase assets at least at the current pace of $120 billion per month in net purchases. That’s around $1.4 trillion in one year.

Jerome Powell added that any change to the Fed’s view on interest rates would require:

maximum employment (which is a committee assessment, albeit in response to a reporter he did say that 3.5% unemployment is probably close);
inflation reaching 2% (which it has not reached for 6 of the past 10 years) and on track to moderately exceed 2% for a time, where he defined ‘a time’ to mean not permanently, and not for a sustained period.

You might recall I wrote about his announcement to let the economy run hot above 2% (if he can even get it to 2% in the first place) and if you missed it you can get a refresher here.

The Fed continues to distance itself from the fiscal, again coming to the landing that fiscal spending and asset bubbles resulting from zero interest rates are beyond the Fed’s wall.

But, asked whether the Fed was toast if the government was unable or unwilling to turn on the fiscal spigot, Jerome Powell quickly retorted with ‘no way, we’re not out of ammo.’

I’m not so sure. Even with guaranteeing zero rates for at least another ~3.5 years, the market just rolled over last week.

Has QE Infinity, Guarantee Infinity, and forward guidance lost its potency? In the absence of fiscal spending for growth (as opposed to welfare), yes I think it has.

There seems to be extraordinarily little if any Fed ammo left, but more importantly there are no new weapons in the arsenal and it’s clear to me the U.S. has turned into Japan.

The only way for a dovish Fed to go now, is negative interest rates. The UK is also close to becoming Japan as well. It has 5 year low inflation, a significant COVID second wave and a growing probability of a Brexit crash out which has prompted the Bank of England to consider going to zero/negative rates before year end.

Speaking of Guarantee Infinity, a few questions popped up on the Main Street Lending Program which exposed some unintended consequences of the pandemic put. The Fed seems to be incubating zombies.

Zombie companies illustrate the moral hazard of Guarantee Infinity.

There were a few good questions focused on the so far failed Main Street Lending Program.

The program ceiling is $600 billion, but it appears that not even 5% of that had been handed out as of 10 September according to Boston Fed data reported in the press. I’m loathe to quote a number because I am yet to find an accurate and defined number from the Boston Fed.

Nonetheless, at that generally anemic level, Main Street Lending is a whimper from a dungeon in stark contrast to the massive corporate debt issuance that’s been roaring over the past few months. Just under $1.5 trillion in investment grade issuance has occurred as of 10 September.

In contrast, Main Street loans are not getting out to wildling firms and restaurants, cafes and small services businesses are shutting shop. For them, winter arrived in March when physical distancing and taxes turned fire into ice.

Many larger businesses don’t need Main Street. Even bad or challenged businesses can easily raise debt through corporate bond issuance because those wishing to invest in those bonds can rest secure in the knowledge that the Fed will have their backs if the issuers turn into zombies.

So yes, this is the problem with Powell’s pandemic put/Guarantee Infinity. It has created moral hazard on a massive scale and is the reason why debt issuance has sky-rocketed and zombie bonds (and to be fair, obviously some good bonds as well) are being issued on every street corner, along with an ample supply of the blue pill.

Main Street and other similar programs need to be redirected to where they are needed. And that, like in Australia, is small to medium services businesses. Until that happens more bankruptcies are expected in most economies, other than for a fast recovering China.

Asset prices, air pockets and snowflakes.

It’s fair to say the Fed has created the current irrational secondary market exuberance.There’s no hiding from that fact.

Sure, there will be downdrafts and air pockets in certain sectors along the way with continued peppering of volatility, but nonetheless if you don’t accept almost zero bank returns, you need to put your money where it will make a return.

While this still smells of rocket fuel for equities in particular, there is equities fatigue and profit taking in some sectors at present. This is probably a sign that some investors/traders are starting to look elsewhere along the oblong bubble spectrum for trades; and for others, the reality that the real economy recovery is not V shape is starting to be acknowledged.

But there are exceptions. The recent IPO of snowflake (SNOW) is a great example of one component of the bubble that’s being driven by the convergence of tech, the Fed, FOMO and wholesale equities demand. It’s a great poster child for the oblong bubble of 2020.

Firstly, the $120 IPO price was set well above the mooted price of $75 per share (top end). Next, you might have heard that Warren Buffet (who publicly states he regrets missing amazon) and Salesforce (the platinum standard of SaaS) had taken large chunks of the cloud data aggregator, and Buffet also committed to investing more cash at $120 per share.

Well, the stock didn’t even see $120 when it came on, and I first spotted it trading at around $272 per share. It traded up to $319 per share last Wednesday. It’s now trading around the $220 to $240 per share range.

As an equities underwriter in the 1990s, I would have expected an angry call from my corporate client, accusing us of under-pricing that deal. Not so these days because you pretty much know IPO price discovery is going to be wrong (and under-baked) thanks to the Fed.

But this won’t last forever. Maybe it will take a leadership change in the U.S, for policy makers to go beyond the monetary wall and repair the reserve currency.

Beyond the Fed.

Equities as a class is still over-priced on many measures, across many sectors. This is a consequence of the convergence of the rise of the cloud, fintechs, QE Infinity, Guarantee Infinity and COVID.

As mentioned before, there seems to be some weakness in equities at the moment across tech and the more reflationary stocks and precious metals, like Silver.

On the downside, either the realisation of a long Japanese style period in the absence of more fiscal stimulus and a viable vaccine; or a high profile insolvency or shock are probably two key risks starting to get baked into the investment narrative.

But a third and much more interesting risk is a slow and gradual venting of QE Infinity bubble gas as more people get serious about the ongoing economic effects of the pandemic (and new lock-downs) that had not been factored into the V shaped equities recovery. This third risk might be difficult to see or track if the bubble is oblong and wrapped around multiple asset classes, each expanding or contracting at different times.

In the meantime, and according to Jerome Powell, it’s not a bubble until you see it pop.

Also, the Fed has your back, until it doesn’t.

Mike.

Next Level Corporate Advisory is a leading independent advisory firm with a multi-decade track record. We specialise in transformative M&A, IPO, growth capital, special situation and strategic corporate advisory solutions designed to take your business to the next level, in and out of Australia.

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Image attributions: HBO.