The central bankers’ conceit

Christopher Joye

Coolabah Capital

August was a horrible month for anyone carrying interest rate duration risk with the benchmark AusBond Composite Bond Index suffering a decent -0.42% loss in the month as long-term yields rose. This was driven by a re-rating of future inflation and interest rate expectations as the US Federal Reserve announced it would revise its monetary policy framework to allow for sustained periods of inflation running above its official 2 per cent target in order to make-up for past misses. I wrote about this at length in the AFR, which is excerpted for your benefit below (click on that link to read the column over at the AFR):

On Thursday night the world’s most powerful central bank – the US Federal Reserve – ushered in a revolutionary change to its monetary policy framework because it believes it has consistently missed its core consumer price inflation target. This new regime, which will allow the Fed to keep borrowing rates lower for longer, and tolerate periods of what would have been unacceptably high inflation, could have profound consequences for the price of pretty much everything. 

It also reveals the central bankers’ essential conceit: that they don’t want markets to clear, or asset prices to gravitate to their natural levels in the absence of extreme policymaking interference. With a 24-hour news cycle and real-time information transmission, this is too politically painful. No, the central bankers increasingly want to control the price of everything from the goods and services you consume to the stocks and bonds in your portfolio and the value of the home that provides a roof over your head. It’s a new form of statism that much more closely resembles Chairman Xi’s Marxit-Leninist manifesto than the unfettered capitalism that has powered prosperity since World War Two.

The central bankers’ conceit is betrayed by a contradiction in the logic that the Fed employs to rationalise ever-cheaper money, ever-greater asset purchase programs, and ever-more pervasive interference in the way markets would allocate scarce resources. The Fed alleges that the old two per cent inflation target is not working because it has undershot this benchmark. Yet core inflation has averaged 1.6 per cent over the last decade, which is indistinguishable in a statistical sense from the two per cent goal as far as the Fed’s forecasting prowess is concerned.

We know this because the Fed publishes the error bands that attach to its forecasts based on its experience over the last 20 years. In December 2019 the Fed stated that given the historical differences between its inflation forecasts and the actual outcomes over the last decade, it could be only 70 per cent confident that inflation in 2020 through 2023 would be within plus or minus one percentage point of its published projection for those years.

So the Fed was 70 per cent confident core inflation would be somewhere between one per cent and three per cent each year between now and 2023, which is the difference between what markets would perceive to be a deflationary shock and a move towards hyper-inflation. Put bluntly, the Fed cannot forecast inflation to save its life. The Fed should therefore be doing summersaults that it has managed to get inflation to within just 0.4 percentage points of its goal over the last decade.

Another sign the existing framework is perfectly fine is the fact that prior to COVID-19 the US unemployment rate was just 3.5 per cent, which was the lowest level since 1953. The Fed was in practice delivering both full employment and price stability, which is its mission. But with the cover of a 1-in-100 year pandemic that has sent unemployment sky-rocketing to over 10 per cent, the central bankers’ reflex to control everything has been given a licence to thrill in what could morph into a 21st century form of neo-statism.

A few caveats are required. First, since February we’ve argued that the central banks are fully justified in their efforts to provide liquidity bridges to markets and the real economy to help them overcome this unprecedented shock. The risk, however, is that these interventions become permanent. And with the explosion in government debt to fund ballooning deficits, that hazard is probable rather than possible.

Another rider is that I don’t put the Reserve Bank of Australia in the same camp as the Fed. To Martin Place’s immense credit, it is a very reluctant participant in the money-printing-to-disintermediate-markets party. And Phil Lowe and Guy Debelle have done a brilliant job navigating the crisis since mid-March.

A final qualification is that none of this is necessarily bad for investors in the short-term. In fact, the Fed’s moves are a huge opportunity if one can exploit the consequent pricing pertubations.

Our critique is merely an abstract, theoretical one, which points to a counter-factual where the creative destruction inherent in freely-functioning markets is allowed to unleash a productivity miracle by punishing bad businesses and rewarding good ones. The contemporary alternative involves central banks spawning generations of highly indebted, unproductive, and unprofitable zombie companies that are reliant on the availability of free money.

What then will the Fed now do? Back in March 2019 this column hypothesised that the Fed was thinking about dumping its forward-looking inflation target for a “brand-new monetary policy framework known as inflation averaging”. And that is precisely what the Fed’s chair, Jerome Powell, delivered on Thursday. It means that in the name of bequeathing a ridiculously precise two per cent inflation outcome, the Fed will make-up for historical misses by allowing inflation to run above the two per cent target for extended periods. If we have undershot by 0.4 percentage points for ten years, we can now overshoot by the same margin for years to come. Yet given the inability of the Fed to accurately anticipate the future, this is a slippery slope. What the Fed thinks might be slightly above-target inflation could transform into more serious price pressures that could take years to bring back down.

The Fed is also insouciant to the long-term distortions and financial stability costs induced by free money. This is not that surprising given it is easier to hedonistically accept short-term praise for pleasing the masses with artificially elevated prices than imposing pain today to protect faceless generations in the distant future.

The equity market’s positive reaction to the Fed’s announcement accents the point that the current free-money-forever paradigm is hyper-inflationary for assets. On this note, there are emerging signs of house price inflation around the world. And while it is too early to call in Australia, there are indications the market might be turning in key cities save for a still-shuttered Melbourne.

Last weekend Sydney recorded a strong final auction clearance rate of 66 per cent across over 1,000 properties in what is the best result since early February (when prices were climbing) according to CoreLogic. That is the third straight week of improvements and coincides with a diminution in the pace of price declines in August. While prices are still falling marginally on a national basis outside of Melbourne, the August moves have been more modest than those in July in Sydney, Brisbane, and Perth. And home values in Adelaide have actually edged-up a touch over the last couple of months. Unsurprisingly, Melbourne remains weak with prices down another one per cent in August after a similar drop in July.

Given high unemployment we remain anxious about defaults and liquidity in bonds issued by non-bank lenders in the form of residential mortgage-backed securities (RMBS) and asset-backed securities (ABS). With 10 per cent of all the banks’ home loan borrowers on repayment holidays and 15 per cent of business borrowers in arrears, credit quality in the non-APRA regulated non-bank sector could be a lot worse.

There is also clearly a huge amount of stress amongst lenders to commercial property, with many tenants not paying rents and the value of these assets falling through the floor. There is a reason APRA has for years encouraged banks to stay away from lending to commercial property and residential developers: they are extremely high-risk credits that have historically killed large lenders, almost accounting for ANZ and Westpac in the 1991 recession.

The difficulty of getting finance from banks has driven many commercial property owners and residential developers into the arms of non-banks that don’t have APRA breathing down their neck every day. And while I admire our entrepreneurial non-banks, this is a potential vulnerability that participants should be thinking about.

A final dynamic of interest is the shrinking bank-issued, senior bond market. As banks draw-down on the RBA’s Term Funding Facility, senior bonds are being allowed to mature and are not being replaced. This will create holes in portfolios that need to be filled by other assets. At the margin, it will probably drive demand for instruments down the capital stack that offer superior spreads.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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