Jawboning the Fed?

Leo Kolivakis  |


Greg Robb of MarketWatch reports, It’s been decades since the White House has warned the Fed the way Kudlow just did:
It has been a long time —the early 1990s in fact— since a White House tried to influence Federal Reserve policy the way Trump economic advisor Larry Kudlow did on Friday.

In an interview with Fox Business Network, Kudlow jawboned the Fed, saying: “My hope is that the Fed, under its new management, understands that more people working and faster economic growth do not cause inflation.”

“My hope is that they understand that and that they will move very slowly,” he added.

It was the senior advisers to President George Bush, particularly Treasury Secretary Nicholas Brady, who pushed the Fed to cut rates at a faster pace in the run-up to the recession that lasted from July 1990 until March 1991.

In fact, Bush blamed former Fed Chairman Alan Greenspan for his defeat to Bill Clinton in 1992.

Financial markets were roiled by Brady’s warnings, said Lewis Alexander, chief economist at Nomura.

“The sense that the Fed was being criticized by the administration undermined the market’s confidence in the Fed’s ability to anchor inflation expectations,” Alexander said. This was reflected in higher interest rates.

In light of this experience, Robert Rubin, Clinton’s Treasury secretary, instituted the practice that administration officials should not comment of Fed policy.

This gentlemen’s agreement lasted, on the whole, through the George W. Bush and Obama administrations.

To be fair, most of this period Fed interest-rate policy during this period was trying to support economic growth, not take away the punch bowl.

The Fed is now attempting to slow the economy down with steady rate hikes but has said it will move at a gradual pace.

Robert Brusca, chief economist at FAO Economics, said Kudlow has probably noticed that Fed Chairman Jerome Powell “has moved a little bit more to the side of the hawks than Yellen.”

Powell has signaled the Fed will continue to hike rates at a once-per-quarter pace, despite warnings from doves at the central bank that the market is signalling caution.

In particular, the yield curve has been flattening, with the spread between 2-year notes and 10-year notes at the lowest level since 2007.

The curve is a line that plots yields across all debt maturities. It typically slopes upward. A flatter curve can signal concern about the outlook. An inverted curve is an accurate predictor of recessions.

Powell and other Fed officials have said that times are different and the yield curve may not be the signal it once was.

But St. Louis Fed President James Bullard on Thursday said he didn’t know why the Fed wanted to “test this theory” by continuing to push short-term rates higher.

Brusca said Kudlow was trying to “guide the Fed’s eyes” to the yield curve signal.

“I’m sure Larry was trying to send smoke signals. He’s trying to explain it to them,” Brusca said.

I agree with James Bullard, don't ignore the yield curve, but the Fed seems to think this time is different (it most certainly isn't) and it will continue to gradually hike rates as it wrongly focuses its attention on the rise in core inflation.

Meanwhile, outside the US, things are degenerating fast as the European yield curve just collapsed on reports the ECB is considering "Operation Twist" and the IMF just warned that global growth will fade.

And even within the US, there are plenty of reasons to worry. Thomas Franck of CNBC reports, Debt for US corporations tops $6 trillion:

The debt load for U.S. corporations has reached a record $6.3 trillion, according to S&P Global.

The good news is U.S. companies also have a record $2.1 trillion in cash to service that debt.

The bad news is most of that cash is in the hands of a few giant companies.

And the riskiest borrowers are more leveraged than they were even during the financial crisis, according to S&P's analysis, which looked at 2017 year-end balance sheets for non-financial corporations.

On first glance, total debt has risen roughly $2.7 trillion over the past five years, with cash as a percentage of debt hovering around 33 percent for U.S. companies, flat compared to 2016. But removing the top 25 cash holders from the equation paints a grimmer picture.

Speculative-grade borrowers, for example, reached a new record-low cash-to-debt ratio of just 12 percent in 2017, below the 14 percent reported in 2008 during the crisis.

“These borrowers have $8 of debt for every $1 of cash,” wrote Andrew Chang, primary credit analyst at S&P Global. “We note these borrowers, many sponsor-owned, borrowed significant amounts under extremely favourable terms in a benign credit market to finance their buyouts at an ever-increasing purchase multiple without effectively improving their liquidity profiles.”

The trend persists even among highly rated borrowers: More than 450 investment-grade companies not among the top 1 percent of cash-rich issuers have cash-to-debt ratios more similar to those of speculative issuers, hovering around 21 percent.

This could lead to trouble for the economy as interest rates rise. The Federal Reserve, which has already hiked rates twice so far this year, has indicated that further increases may be needed to keep the economy in check later in 2018. It has also actively reduced the amount of purchases it is making in the Treasury and mortgage markets.

I've repeatedly warned my readers that high yield (junk) bonds are the canary in the coal mine and if something goes wrong, investors need to prepare for a wave of defaults.

Lastly, take the time to read Chen Zhao's weekly comment at Alpine Macro, "Seven Steps and a Stumble". They point out that although both rising trade tensions and the Fed are to blame for the shakeout in global stocks, the Fed could be the more important and insidious reason for the spreading weakness in global stock prices.

This is why a few policy watchers are now jawboning the Fed to ignore inflation and go gently here.

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