The FOMC Is Plotting "Normalization"

>The Fed intends to “normalize” monetary policy and reduce the size of its balance sheet.

>There would appear to be no opposition on the FOMC to this objective.

>The doves have flown the coop.

>The outlook is for low bond yields and high equity multiples.

The big topic in monetary policy circles these days is the impending normalization of monetary policy: how to unwind QE and bring  the size of the Fed’s balance sheet back to a normal, pre-Crash level.

This is from the FOMC’s April minutes: “Participants generally agreed that starting to consider the options for normalization at this meeting was prudent, as it would help the Committee to make decisions about approaches to policy normalization and to communicate its plans to the public well before the first steps in normalizing policy become appropriate.”

Professor Alan Blinder, a former Fed governor, wrote in the WSJ this week: “The FOMC will have to figure out how and when to exit from two main policies: its near-zero interest rates and its bloated balance sheet.”

In this discussion, the debate is between those who want to normalize now, and those who want to normalize later. There is no debate about why the Fed should normalize policy; normalization as a compelling policy desideratum is just a given. In other words, normalization is being prioritized over less important  policy goals such as growth and employment.

The performance of the economy, and the ability of the economy to provide remunerative employment to the American labor force, are to be subordinated to a technical objective for “good housekeeping” reasons. The Fed’s balance sheet is “bloated”, and that is unattractive.

This way of thinking is nonsense. First of all, how does anyone know what the optimal size of the Fed’s balance sheet is without reference to desired macro policy outcomes? Is there an optimal balance sheet independent of desired policy outcomes? Of course not. Who in the world cares how big or small the Fed’s balance sheet is?

Second, the bigger the Fed’s balance sheet, the smaller the national debt which is good for our nation’s credit. Federal debt held by the Fed is extinguished unless and until the Fed sells it back to the public. Why would the Fed want to sell it back to the public when it doesn’t need to, and when doing so might be contractionary?

Thirdly, if the Fed’s balance sheet is indeed bloated and must be reduced for some reason, why not simply have the Fed forgive most of its holdings of Federal debt? Since the Fed is owned by the Treasury, the forgiveness of the Treasury’s debt would be “eliminated in consolidation” as the accountants say: a meaningless book entry. Oh, but that would reduce the Fed’s “capital”, the ignorant would argue, entirely missing the fact that the Fed prints dollars and doesn’t need a penny of capital, and that the goodwill value of the license to print money is infinite, and thus the Fed cannot be insolvent in dollar terms.

But to return to Planet Earth: Only a fool would subordinate the Fed’s statutory mandates to the shibboleth of “balance sheet normalization”. QE had the effect of creating massive excess reserves. In the event that at some point these excess reserves started leaking into the money supply (which looks doubtful), the Fed has many tools to limit the impact, such as increasing required reserves or open market operations.

The bottom line is that there are no longer any doves on the FOMC.  They are all Austrians now, to paraphrase Richard Nixon. The doves have all capitulated to the siren song of normalization. Like the Fed of the Hoover years, technical concerns will subordinate such trivial matters as growth and employment: above all, the Fed must keep a tidy balance sheet. The fact that every prediction made by the hawks since the Crash has proven false does not diminish the allure of their comfortable useless conventional wisdom.

Investment Conclusion:

Monetary policy will continue to tighten. Growth and inflation will remain low. Bond yields will continue to reflect a low real interest rate and low inflation expectations. Equity multiples will continued to be supported by low bond yields.

Why Bond Yields Are Falling

• Bond yields have been falling since January
• This has nothing to do with monetary stimulus
• Falling yields are a signal of declining inflation and growth expectations
• Stocks are the only option for today’s investor

As usual, the financial media is deeply confused about the relationship between monetary policy and bond yields. Bond yields are falling, and the public demands an explanation! Today’s WSJ gives it a stab:

“Bond yields are – once again — plunging worldwide. The reason for this revived buying among fixed-income investors is that central banks are – once again – signaling their intent to ease monetary conditions in yet another bid to kick-start sluggish economies and forestall a downward spiral in prices, or deflation. The prospect that central banks will continue to inject money into the world's bond markets...has acted as a green light for the world's bond buyers.”

Bond yields are declining because central banks are pursuing inflationary policies. Wasn’t it just yesterday that we were being told that quantitative easing would cause hyperinflation and double-digit bond yields? Now we are supposed to believe that monetary stimulus causes bond yields to fall. Inflation is deflationary.

A second myth being retailed now is that central banks have been providing monetary stimulus since the Crash:

"The global economy hasn't fired up despite all the heavy monetary stimulus,'' said Mary Ann Hurley, vice president of trading at D.A. Davidson & Co...“We continue to stay in this ultra-loose monetary-policy environment" which supports bond prices, said Jason Brady, head of fixed income at Thornburg Investment Management. (in today’s WSJ)

It should by now be evident to any market participant who has taken Monetary Policy 101 that there has been no “heavy monetary stimulus” and that we are not in an “ultra-loose monetary policy environment”. There are a number of ways to judge a central bank’s policy stance, and almost all of them indicate that none of the major central banks (aside from the PBoC) has been providing “massive stimulus”. These measures include money growth, inflation, nominal growth, real growth, expected inflation and bond yields. For the Fed, the ECB, the BoE and the BoJ, all of these indices have been flashing “TOO SLOW” since the Crash. Fitful efforts at QE have failed to move any of the dials.

Falling bond yields are not about the prospects for more stimulus. They are instead a signal of the market’s loss of faith in the ability of the central banks to provide adequate monetary stimulus. The market looks into the future and sees very low money growth, declining velocity, less than 2% inflation, 3% nominal growth and 1% real growth. Such an outlook justifies a 10-year yield of 2.5%.

And by the way, we are not in a “new era”--we are in an old era called the mid-20th century, when bond yields remained below 3% for twenty years, from 1935 to 1956. Of course, this is all new to the baby boomers, who can only remember the inflationary era after the breakup of Bretton Woods. We will need to erase those inflationary memories and reacquaint ourselves with our parent’s era when 3% bond yields were considered high, and a 2.5% yield was considered normal. There is nothing “extreme” about low inflation and low interest rates.

What About Stocks?

Declining bond yields are bullish for stock prices. The 10-year yield has declined from 3% in January to 2.5% today. Stated differently, the PE on the 10-year bond has risen from 34 to 40. This raises the equity premium which makes equities more attractive, and justifies a higher multiple. Today, the forward multiple for the S&P is 15.8x which represents an earnings yield of 7%, which is certainly more attractive than 2.5%.

Bond Yields Fall As Fed Tapers Purchases--Markets Perplexed!

• Bond yields are falling despite the Fed’s decision to taper QE

• This is because QE has not affected the economy
• Falling bond yields are not bearish for stocks

Since the FOMC began to taper its bond purchases at the beginning of this year, the 10-year Treasury yield has declined by 40 basis points from 3.0% to 2.6%. This has caused puzzlement in the financial commentariat:

“The demand for Treasury bonds is all the more remarkable because the Federal Reserve is ending the Treasury-bond-buying program it has used to keep interest rates low. That normally would reduce Treasury demand and push yields higher. Instead, Treasury prices have risen and yields declined.” (WSJ, 05 May 14)

This amazing phenomenon does not come as news to readers of my blog. I have been calling attention to the tightening of monetary policy for the past two years. The fact that the Fed has given up on QE is a signal of even greater tightening, which is entirely consistent with falling bond yields. Today’s bond market is looking at a very subdued horizon:

• 6.0% money growth, the impact of which is further diminished by declining velocity;
• 1.2% inflation, which is 40% below the Fed’s target;
• 3.7% nominal growth, which is inadequate to sustain anything like 4% real growth--which was in fact zero (QtQ) in the first quarter;
• A complete absence of any discussion at the FOMC of taking concrete steps to accelerate money growth.

We are also told that falling bond yields are a bearish signal for stock prices:

“One sign of the current worry is the strength of U.S. Treasury-bond prices. In times of economic optimism, investors normally buy risky assets like stocks, not safe Treasury bonds.” (WSJ, 05 May 14)

It is true that the depressed economic outlook is bearish for the rate of corporate earnings growth, but this does not translate into a bearish outlook for equity prices. That is because, ceteris paribus, declining bond yields increase the relative premium being paid to stockholders. Damodaran at NYU calculates the equity risk premium at 5.1% as of May 1st. This compares with an all-time high of 7% during the Crash and an all-time low of 2% in 1998. The current level is considerably above the historical mean. Stocks offer a relatively attractive prospective return in a world of ultra-low interest rates.

The ERP is elevated because bond yields are very low, not because of the outlook for earnings growth. The threat to current stock multiples is not low earnings growth, but instead higher bond yields. Given the current subdued outlook for growth and inflation, I see little reason to expect higher bond yields anytime soon.

There is a widely-held view that bond prices have been artificially supported by QE, and that the end of QE should herald lower bond prices--that financial markets have been artificially supported by “massive monetary stimulus”. The empirical evidence suggests that bond prices were not inflated by the Fed, and that the withdrawal of QE will not result in lower bond (or stock) prices.

My view has been that, because QE has failed to increase money growth, inflation and nominal growth, it has not raised bond prices. This is because inflation expectations have declined during QE, which should not have occurred during a period of “massive money printing”. Pre-crash, 10-year inflation expectations were above 2.5%; today, they are 2.2%--despite a quadrupling of the Fed’s balance sheet. The tapering of QE is a signal that nothing more will be done to raise inflation expectations, hence the rise in bond prices. QE was nothing but a sideshow: a huge distraction from the Fed’s continuing failure to get control of money growth.