The five-year anniversary of the Lehman Brothers bankruptcy has elicited all sorts of recollection and reflection about what caused the financial crisis and whether it can happen again. The conventional wisdom sees the financial crisis as a product of twin bubbles in real estate and credit, which were financed on the highly leveraged balance sheets of the traditional and shadow banking system for which Lehman was the poster child.
Identifying the bubbles was not difficult. There were plenty of warning signs and many shrewd investors from Mark Hart to John Paulson to David Einhorn that profited from the unwind. However, to better understand how a slow-moving mean reversion in prices can turn into a collapse that brings the financial system to its knees, we need to identify the trigger for what was a mass liquidation. The consensus cites the real estate bubble popping as the catalyst, but I find this a shortsighted view, especially since housing prices topped years before Lehman collapsed. The financial crisis didn't happen because housing topped or people quit paying their mortgages. There was a trigger. There was a catalyst.
When Ben Bernanke gave his famous " helicopter speech " in 2002, he probably never dreamed it would haunt him the rest of his career:
What has this got to do with monetary policy? Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Market participants rightly ridiculed this speech and Bernanke was soon referred to as Helicopter Ben for his reference to Milton Freidman's helicopter drop of money to stimulate inflation. So when Bernanke first took the helm in 2006, he no doubt wanted to refute this dovish perception and prove his inflation-fighting moxie. Despite the peak in housing and an obvious deceleration in growth, Bernanke went on to tighten 75bps into an inverted yield curve, citing inflation as the primary risk. This was critical.
In August of 2007, just after the Bear Stearns' hedge funds collapsed, the Bernanke FOMC took a pass at easing policy despite a financial system that was obviously under duress. The policy decision was to keep the funds rate at 5.25%, keeping the Fed's policy bias towards inflation risk.
After emergency meetings with former Treasury Secretary Robert Rubin, macro hedge fund manager Ray Dalio, and mortgage market titan John Meriwether, the following week the Fed suddenly had a change of heart and immediately lowered the discount window rate, changing the direction of the policy bias to one leaning toward growth.
Over the next six months, the Bernanke Fed would launch a historic easing campaign in an effort to provide liquidity to the banking system. The market responded by raising inflation risk premiums. The dovish Bernanke they thought they had in 2006 had finally emerged. Helicopter Ben was back.
2008 Yield Curves
Once the market got a sense that a massive easing campaign was forthcoming, the dollar collapsed and commodities rallied. In August 2007 the Fed funds rate was still 5.25%, the EURUSD pair was 1.35, and the price of oil was $70/bbl. By March of 2008 as Bear Stearns was collapsing, the Fed accelerated their easing, slashing the funds rate to 2.25% -- well below the 4.0% rate of inflation.
Crude Vs. PPI
With the Fed pushing overnight rates below inflation, risk premiums exploded, which manifested itself in the slope of the yield curve. What was a flat curve from the 2-year through the 30-year in August 2007 soon steepened rapidly with spreads blowing out across the curve. This was a key development because a steep yield curve translated into a steep risk curve.
2008 Inflation Risk, Interest Rate Risk, and Credit Risk
In April the Fed took the Fed funds rate to 2.0%, over 300bps lower than it was in August. By July 2008, the dollar remained under pressure and oil was going vertical to $140/bbl. This was having a profound impact on rates of inflation. The June report of PPI and CPI saw the year-over-year growth rate spike to 9.0% and 5.0% respectively. This was a huge burden on a deteriorating economy, and in fact relative to the economic growth rate, these spikes in inflation were higher than the inflation spikes in the 1970s.
CPI Vs. NGDP
It is my belief that this spike in inflation was the catalyst for the financial crisis, not real estate imploding or mortgage delinquencies. The Fed was behind the curve, and they panicked. The market was not going to wait around to see what Helicopter Ben was going to do. Collateral and credit deflation was Bernanke's worst nightmare and he had already defined what he would do to combat it. The market knew this and did what would be expected by immediately pricing in the most inflationary monetary policy.
This inflation spike was the proverbial straw that broke the camel's back. It's not oil that caused the crash, it was a shock to a weak system. Inflation risk premiums became interest rate risk premiums, which became credit risk premiums and eventually equity risk premiums. These exploding risk premiums meant collapsing dollar prices of highly leveraged securities on highly leveraged balance sheets, which meant collapsing book value of equity. These exploding risk premiums triggered a financial crisis.
It can be said that the financial crisis was the product of monetary policy error. The policy error in overly tightening with inflation risk falling and a yield curve inverting in 2006 and a policy error in overly easing with inflation risk rising and yield curve steepening in 2008.
This past week, Bloomberg's Stephanie Ruhle and Eric Shatzker interviewed macro hedge fund titan Stanley Druckenmiller who, under George Soros, broke the Bank of England. The man knows a thing or two about interest rates and monetary policy. While various Fed members, economists, and Wall Street strategists focus ad nauseum on the impact of tapering and forward guidance, Druckenmiller gave you all you need to know about interest rates in one sentence:
RUHLE: Well I want to go back to QE. If you think about QE and what asset class has been manipulated most because of it, would you say stocks or bonds?
DRUCKENMILLER: I would say stocks. I have been really wrong on the bond market in the last three or four months.
RUHLE: How?
DRUCKENMILLER: I -- I have been waiting for this decline for two years and I completely missed it because, first of all, the stuff we were talking about earlier in the show, that's -- that's too far down the road in my opinion for the bond market to pay attention to. But I have always found in bonds if you can predict a relative change in the economy relative to consensus, you'll make money in bonds if you get that equation right. And --
SCHATZKER: Even in a world of QE?
DRUCKENMILLER: Yes. And two or three months ago, I thought people were overly optimistic on the US economy. It's my judgment that that assessment turned out to be correct, but bonds went down anyway for non-economic reasons because we have the unwind going on. And for whatever reason, while I anticipated it down the road, I did not think it would happen while the economy was softening.
Druckenmiller is not some pundit sounding off on his opinion, nor is he a bond mutual fund manager talking his book. Druckenmiller knows the market as well as any participant and also has access to the best market intelligence. He knows when interest rates are reacting to shifts in economic expectations or to forced shifts in positioning. As I emphatically stated in Bond Market's Memo to the Fed:This Is Not a Misunderstanding, This Is a Blow-Up , the reaction to tapering was not a misunderstanding of monetary policy, it was a leveraged carry trade blow-up:
By focusing on the price movement as a misinterpretation, Fed officials are making it clear they don't understand there is a liquidation going on and this is a growing risk factor. They don't get that it's not the size the market reaction that's relevant; it's the size of the trade. Ironically, just as they confused QE flow for an easing discount when yields fell, they are now confusing a tightening discount for QE carry trade unwind flow.
Druckenmiller knew there was a pervasive carry trade that was going to unwind, and he wanted to front run the carnage but didn't think it would happen as growth was slowing. Interest rates are rising for uneconomic reasons, not because they are discounting Fed rate hikes, but because of a QE carry trade blow-up -- and its happening as growth decelerates. This is unprecedented in modern market history and sets the stage for a financial accident. The question is where the breaking point is. Is it a 3% 10-year? Four percent? Or has it already been triggered?
The Fed committed a policy error when they introduced forward guidance of an inflation target de facto nominal GDP target in the context of a new round of QE and then immediately reneged despite a decelerating nominal growth rate. The market was long this inflation target via various carry trades and the Fed blew them up.
The Fed is about to make another policy error by removing accommodation of asset purchases in lieu of solely relying on forward guidance for rate hikes in order to stimulate inflation expectations. The Fed will tell you that tapering isn't tightening, but the evidence suggests otherwise. Loan growth has all but ceased since rates started rising in May, and the term structure of the front of the eurodollar curve for three-month LIBOR futures is near record steepness, richening forward rates for term borrowing. This tightness is undeniable and is happening as growth decelerates to the slowest growth rates of the recovery.
No one thinks we are on the precipice of another financial crisis, and positioning for statistical fat tails can be hazardous to your portfolio. But policy errors tend to preclude such events, and I think we are seeing the Fed commit multiple policy errors as they pull accommodation into decelerating growth and low inflation. I don't think it will be a catastrophe, but markets have become accustomed to a world of excess liquidity for a long time, and if the move in the bond market is any indication, this excess liquidity can evaporate rapidly. It's impossible to know the catalyst ex ante, but odds are it will be bond market related to a monetary policy error.
Twitter: @exantefactor
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
