I have friends with whom I discuss financial developments daily, and there are enough unusual developments in domestic and world markets to confuse even the most seasoned of us. None of us are economic advisors or economists; we are old but students of economics and markets with decades of work and observation under our belts. We have the scars from living through many economic cycles.
If all the Economics Ph. D.s at the Treasury Department and the Fed struggle with these conditions, neither we nor you should feel bad. Financial and economic confusion is the order of the day.
The Mayo Clinic defines schizophrenia as:
“Schizophrenia is a serious mental disorder in which people interpret reality abnormally. Schizophrenia may result in some combination of hallucinations, delusions, and extremely disordered thinking and behavior that impairs daily functioning and can be disabling.”
Everyone in the world, not just America, could be at the tipping point of a financial schizophrenia diagnosis if some sanity does not return to the markets.
The Federal Reserve Bank
The Fed has a “Dual Mandate,” which refers to its responsibility to maintain maximum employment and stabilize prices and long-term interest rates. This means the Fed must balance the need for a healthy job market with the need to control inflation and keep interest rates at a level that supports economic growth.
Until today, the Fed was leading the confusion charge and had alternately signaled that it would raise rates, cut rates, cut rates a little, or wait on the data. The Fed spokesmen and spokeswomen need help speaking with one voice. Their confusion leads pundits on various network shows to latch on to the latest information and spin their interpretation of the Fed briefings. Every sentence, word, comma, and pause are analyzed repeatedly. Chairman Powell was careful today to say a little, not say much about the future, and to comment only briefly on the horrible data they use to make decisions.
The “TV financial spin doctors” think the Fed will cut rates three times this year, once this year, or raise rates once before year-end. Some believe the Fed is relevant, and others think it is irrelevant. If you can make sense of this, you are more intelligent than any of them and less likely to become financially schizophrenic. I constantly remind myself that most of these spin doctors are there to pitch a product or get you to buy into their viewpoint. Factual analysis takes a backseat to spinning the news.
The Treasury Department and Congress
Janet Yellen is even more confusing and maybe senile, often undermining the Fed’s direction and ability to make changes. Her proclamation that the economy had achieved a “soft landing” long before the Fed determined how they might define one indicates the confusion that reigns. Like many in Washington, she is well past retirement age, and her confusion and uncertainty are showing.
While the Fed is working to shrink its balance sheet and slow the economy, the Treasury and Congress are working to keep the cash flowing with the rollout of fiscal stimulus from bills passed in 2022 and 2023. Unfortunately, this lag effect has an unpredictable timeline and unpredictable outcome. Some believe the Treasury is directly countering the Fed’s efforts to shrink the money supply with their programs.
The logical thing to do would be to cancel any unspent program funds and use the savings to help contain the deficit. But logic and schizophrenia do not go hand in hand. So, the Treasury will keep printing bonds that the Fed will buy to support the ill-advised programs approved by Congress and the President.
But with younger voters believing the earth is about to heat up and die, our major industries now offshored, melting glaciers, stranded polar bears, and all manner of organized foreign protesters, how can all the politicians be expected to act rationally? Their number one goal is reelection, not sound governance.
The Bureau of Labor Statistics
Much of the data that the Fed relies on for its confusing proclamations originates with “facts” from the Bureau of Labor Statistics (BLS). Chairman Powell is now famous for wanting to wait on data to make difficult decisions. Under normal circumstances, this might seem wise. But it appears to many that the data he is waiting on is known to be flawed.
Since much of the Fed’s mandate is focused on employment and unemployment, the accuracy of their data is critical. However, month after month, the BLS issues employment data that they and everyone at the Fed know to be flawed. They even admit their forecasting models are flawed and repeatedly issue revisions to their data. For some reason, the Fed cannot seem to step forward and clearly say it needs new and different data sources to make good decisions.
It seems odd that a government that spends trillions of dollars needs help figuring out how to get accurate, timely data on mundane economic items. Gathering data on food, housing, vehicles, interest rates, mortgage payments, and unemployment is not like flying someone to the moon. A well-spent dollar here or there to improve decision data would be wise. For sure, they could cut a hundred economists and pay for it. If you want to be data-driven, accurate data must be a priority. Chairman Powell was cautious today about praising those who produce inaccurate data, fearful that criticism would bring even worse data.
Market Insanity versus Sanity
Throw into all this the strange and unfathomable moves of the stock market. In a rational world, there is a direct relationship between a company’s earnings, earnings potential, innovation, and stock price. But with programmed trading, a quadrillion dollars in derivatives, undisclosed hedge fund assets, commercial real estate defaults, the Yen carry trade, and massive unrecognized losses in our major banks, the historical rules of the road are in the ditch.
In a sane market, performance means something. In a schizophrenic market, prices are derived from unknown and unquantifiable forces. Such a market makes wise investment almost impossible, so Warren Buffett is sitting on the sideline for now. I am not as wise of an investor as Buffett, so I will sit quietly and wait for him to give the all-clear signal.
Billionaire bond investor Jeffrey Gundlach coined the term “T-Bill and Chill,” which refers to a strategy of investing in Treasury bills, a low-risk investment, and waiting for market conditions to improve. Others have called this strategy “Buy T-Bills, collect interest, rinse and repeat.” Either description is good and seems to be wise advice in uncertain times. This strategy is particularly useful in volatile markets, allowing investors to earn a steady return while waiting for better investment opportunities to emerge.
Fed Interest Rate Control
Many headlines discuss the Fed cutting rates to ensure a “soft landing.” These discussions ignore all financial history. Over the past hundred years, when the Fed cut rates at the end of a rate cycle, it signaled that the economy is weakening and things are not good. Historically, it signals the beginning of a recession, not the avoidance of one. Often, it signals a hard landing, not a soft one. However, since most only read headlines and not the details of articles, this narrative will be copied repeatedly.
Much of the rate relief consumers need is in medium and long-term rates, not overnight rates. Those stayed stable and even hinted at rising. Consumers will still pay higher mortgage, vehicle, and credit card borrowing costs. I have a question that I have only seen discussed by a few. “How much can the Fed control?” Everyone was sitting and waiting for the Fed to cut rates, but other than signaling their intent and cutting short-term rates, does it matter?
The Fed can send signals through the Fed Funds rate, Open Market Operations, and the always popular Moral Suasion (jawboning). In recent years, the Fed has used all three tools to influence the market to the upside. However, these tools are most effective when Congress, the Treasury, the Fed, and Wall Street work together and act rationally. The Fed uses the Fed Funds rate to set all others. This works exceptionally well when the Fed needs to raise rates, and it is less effective when the Fed needs to lower rates.
The Unspoken Problem
The problem, and why the Fed has many unspoken challenges, is what the Fed can and cannot control. As I explained to a friend recently, the Fed can control the Fed Funds rate and what they are willing to pay, but it cannot control what the market is willing to pay. We have seen this play out in some recent Treasury Auctions where there were no bond buyers at the rates offered. To compensate for this issue, the Treasury must raise the rate being paid or discount the bonds to produce an acceptable yield. These actions dictate the actual rates, not the “signaled” rates.
Congress and the Treasury have acted so irresponsibly over the past four years that our credit rating is now questioned. Even if the rating agencies do not change their rating, their discussions about the deterioration of our fiscal situation act to make markets question our sovereign debt. Fitch Ratings has lowered our rating from AAA to AA+, sowing tiny seeds of doubt about Congress’ ability to act responsibly and our long-term capacity to pay our debt.
The Council on Foreign Relations included this observation in an article from 2023, making a curious reference to this issue.
“It would make sense for rating agencies to highlight those concerns in 2025, when many of the tax cuts by former President Donald Trump are set to expire—at which point, there will need to be a serious national conversation about the budget.”
In other words, we are facing a looming sovereign debt crisis. It is just around the corner and will not be discussed until 2025. This is convenient for politicians, many of whom will be gone, and the debt crisis will be left to the next administration. Our saving grace is that we look solvent relative to the rest of the world. I know of no period in history when so many incompetent people oversaw the finances of so many countries. Collective stupidity has its value as a measuring stick for the best of the worst.
The country with the world’s reserve currency has no budget to measure its spending goals, is running massive deficits, and is ignoring its leaders’ fiscal incompetence. Unless we can get our fiscal house in order, we do not deserve the designation of world reserve currency. It happened to England, and it can happen to us.
The Unknown Unknown
There is always the problem of the unknown in a financial crisis. Rates have been a significant factor in the commercial real estate crisis, with borrowers unable to refinance at higher rates. Since private equity lenders are unregulated, the size of this multi-trillion-dollar problem is unknown. Lower rates will help, but to what extent? It seems likely that the private lenders will refinance the borrowers when they can kick the can down the road.
Hedge funds and derivatives are known and unknown. With few disclosure requirements and mysterious quantities of collateralized and uncollateralized instruments, these could be the source of the often discussed “Black Swan” event.
A Shining Light in the Darkness of Bonds
If there is one shining light in this darkness, it is the dimly lit help to our major banks. All of our banks, especially the big ten, have unrecognized bond losses that threaten their long-term survival. They dodged a bullet when the Fed relented, which allowed them to postpone the Basel III capital requirements. The banks will be required to increase their capital, but not as much as the rest of the world’s banks. Lower rates will reduce bond losses, and this will help the banks deal with significant financial challenges.
To completely solve the problem without affecting the banks, rates would need to return to near zero, which is unlikely. Declining rates seem more likely to raise bond values to a point where the banks can absorb the remaining losses and reset their bond portfolios. Rising rates, in this sense, are a shining light because they can magically erase paper losses without the banks or regulators doing anything.
The Hope of Lessons Learned
Another shining light in all of this is the progress toward the adoption of the Basel III accords. Our major banks may balk at the improved capital requirements and successfully lobby for lower rates, but this will end. Financial crises always have some silver lining, and this is another. In another article, we will write about fixing our banking system, but this is one step along that road. Today, our major banks are too highly leveraged to safely operate with so little capital. Politicians and regulators are always willing to look the other way, but Basel III may no longer give them any wiggle room, and that is a good thing for us all.
Worldwide, governments and citizens are tired of repeated bank bailouts, and this can be fixed. In November, vote like your life and future depend on the election’s outcome because they do.
Resources
Billionaire hedge fund manager says he would pull his money from the market if Harris wins election, By Breck Dumas, FOX Business, foxbusiness.com, September 17, 2024.
Bond market gets a Fed wake-up call after pricing in a recession, By Joy Wiltermuth, MarketWatch, marketwatch.com, September 18, 2024.
Breaking Down the Federal Reserve’s Dual Mandate by Matthew Johnston, Investopedia, Investopedia.com, December 12, 2023.
Credit ratings agencies like Moody’s decide the US credit rating. Here’s what you need to know about them, By Samantha Delouya, CNN, cnn.com, May 27, 2023.
Does Fitch’s Downgrade of U.S. Debt Really Matter?, By Brad W. Setser, Council on Foreign Relations, cfr.org, August 16, 2023.
Fed slashes rates by a half-point – what that means for the economy and the presidential election, By Michael Walden, The Conversation, theconversation.com, September 18, 2024.
It’s the Economy Stupid, By Taegan Goddard, Political Dictionary, politicaldictionary.com, ~2020.
Nouriel Roubini and Stephen Miran see a debt-issuance strategy at the US Treasury that is working at cross-purposes with the American central bank, By Nouriel Roubini, interest.co.nz, August 25, 2024.
Schizophrenia, Mayo Clinic, mayoclinic.org, January 7, 2020.
T-Bill and Chill’ Is a Hard Habit for Investors to Break, By Michael Mackenzie, Ye Xle, and Alexandra Harris, Bloomberg, yahoo!finance.com, August 27, 2024.
The Fed is finally about to cut interest rates. What took so long?, By Bryan Mena, CNN, cnn.com, September 16, 2024.
The Inflation Reduction Act after Two Years: Spending Estimates Reach New Heights, but Green New Deal Supporters Want More, By Travis Fisher and Josh Loucks, CATO Institute, cato.org, August 16, 2024.
The US credit rating was downgraded. Here’s what to know about sovereign credit ratings, By Spencer Feingold, World Economic Forum, weforum.org, August 9, 2023.
Today’s Millionaires Are Young and Self-Made, By Suzanne Blake, Newsweek, newsweek.com, October 23, 2023.
U.S. Treasury blocks the Fed’s inflation cooling moves, By Nouriel Roubini and Stephen Miran, The Asset, theasset.com, August 21, 2024.
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