“History doesn’t repeat itself, but it often rhymes,” Mark Twain supposedly once observed. As the Fed begins to shrink its balance sheet even as it determinedly jacks up interest rates, we would be prudent to consider where history has rhymed before and what we might learn from those instances.
This is the tenth anniversary of the launching of a criminal investigation into the collapse of Bear Stearns. Here is a link to a quick chronology of the demise of the firm: reuters.com/article/sppage014-n17240319.
Reflecting on these ten years and the history leading up to and since the financial crisis is important. At Cumberland, we attempt to learn from history, and we respect it. Among our 40-plus people we have some oldies, some not quite so oldies, and also some youngies who were still students when Bear Stearns failed. Our youngest employee’s age was a single digit when the financial crisis entered its early stages.
Let’s think about this for a minute. Anyone in the financial services industry in the United States who is under 40 has no, or only limited, experience of the pre-crisis period. True, there are now many books for those who have the time and inclination to read about what unfolded. A couple of them are ours. But time has presented us with new issues, and ten years of excess reserves in the global banking system and ten years of zero interest rates have been applied as a lubricant to ease recovery following the crisis period.
Few remember that the first primary dealer to fail was Countrywide. And few have read the Federal Reserve history to see how the Fed amended its rules to facilitate the absorption of Countrywide into Bank of America. That was the first instance in which the Fed started to pick winners and losers. As my friend Chris Whalen reminds us, Washington Mutual wasn’t a primary dealer. It was treated differently than Countrywide was. For an interesting history lesson, see this Gretchen Morgenson column from June 2016: nytimes.com/2016/06/26/business/countrywide-mortgage-devastation-lingers.
We can now read how decisions to leverage up at Lehman Brothers were probably influenced by the notion that the Fed treats primary dealers differently than it does others. There was great surprise in autumn of 2008 when market agents learned that that was no longer going to be true.
Fast-forward, and there is now a discussion about releasing AIG from the imposed structures of a decade ago. And we still haven’t addressed the issues surrounding the government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. The housing market and mortgage finance in the US have still not normalized. Furthermore, that is not likely to happen for years more, given the political deadlock in Washington.
Here is some history cited by Credit Suisse in a September 28 research report:
“In January 1966 US inflation was low. Headline PCE inflation was 1.7% (y/y), core was 1.4%. Inflation had for years been low and stable. Since the sixties began, the highest either figure reached was 2.1%, and both averaged 1.3%. The unemployment rate, which was steady near 5% in the early sixties, had recently begun to trend lower, breaching 4% in early 1966.”
More history from that report:
“By late 1966, the core PCE deflator was above 3%. It would drift higher for the next five years, reaching a peak of 5% in early 1971, two years before the oil price shock that would begin the more famous inflationary episodes of the seventies.”
At Cumberland there are four oldies for whom this history is personal experience. There are a few more “not as oldies” who were students at the time. Most of the rest of the Cumberland crew wasn’t born yet. Very few today recall Arthur Burns, who chaired the Fed during those tumultuous times. I recall two meetings with him. My colleague Bob Eisenbeis was in the early days of his career and remembers this period and Arthur Burns well.
Today we have little inflation and have seen a long period of low inflation. Are we about to rhyme over the next few years? Will the late 1960s be the metaphor?
But history has another lesson.
The following link will take you to the Federal Reserve’s policy action archives. Note that the period covered is when the Fed raised interest rates following the Great Depression and tried to ”normalize” policy: federalreserve.gov/monetarypolicy/fomchistorical1937.htm.
Here is a link to a 2011 paper from the New York Fed research website that describes the 1937 “policy mistake”: libertystreeteconomics.newyorkfed.org/2011/06/commodity-prices-and-the-mistake-of-1937-would-modern-economists-make-the-same-mistake.html.
The author, Gauti Eggertsson, opens with the following summary:
“In 1937, on the eve of a major policy mistake, U.S. economic conditions were surprisingly similar to those in the nation today. Consider, for example, the following summary of economic conditions: (1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.”
Readers please note his reference to the monetary base.
Also please note that the adjusted monetary base would be falling today were it not for the increase in currency. As frequent readers know, we believe that currency is a stagnant item and has a zero multiplier in the current world. So if US dollar-denominated currency in circulation is rising by $100 billion a year globally and the Fed is maintaining a constant balance sheet size, as it has done for the last few years, the Fed is actually engaged in a passive tightening process. Now the Fed is going to shrink its balance sheet, which means it may accelerate that passive tightening phase into an active tightening process. My friend Dennis Gartman and I have mutually agreed to talk more about this phenomenon, as it is not getting enough attention by policymakers.
Let’s go back to the original point about history's tendency to rhyme.
The 1960s metaphor is a warning about inflation increasing and higher interest rates ahead. The 1937-1938 metaphor is a warning about a forthcoming recession caused by the Fed’s repeating a mistake it made 80 years ago. And the Bear Stearns-Countrywide-Lehman-AIG-GSE metaphor is the most recent historical metaphor, from only a decade ago.
So which one rhymes?
And more importantly, how does one manage portfolios under these conditions?
We don’t know which historical metaphor to use. Neither does the Fed. We do know that all this history helps, and all scenarios must be examined every day and with high-frequency data. That is what we do to earn our daily bread.
Portfolio construction is another matter. Since we are a separate account manager, we can tailor-make a structure to take the client’s risk tolerances into consideration. And we can change quickly if we see a need to make a shift. Our view is that a flexible approach is necessary now. Simply put: That is what you do when you admit that you don’t know.
Right now, we are nearly fully invested and have been enjoying the rising stock market. We think that this long bull market that started in 2009 is not over. And as long as corporate earnings are increasing, it may extend for as much as several more years.
We have favored the high-grade, tax-free bond sector in bond management, and we continue to see value when the high-grade, tax-free debt of a sovereign state or local government pays a higher yield than taxable federal government debt. This upside-down ratio hasn’t made any sense for a decade and still doesn’t make sense.
The United States is not going to repeal income taxation. At best, the current 39.6% top federal bracket may be reduced to 35%. Any compromise tax bill will have to allow for state income taxation. So in high-tax states, we expect the current threshold of total taxation to remain around 50% for the highest tax brackets. One of our NJ clients is in a combined 52% marginal tax bracket. We do not expect tax law to change very much for him.
We will close with the words of a favored poet, George Santayana:
“Those who don't know history are doomed to repeat it.”