The Dividend Cafe - The Fed Chair Said What?

Episode Date: October 27, 2023

Today's Post - I closed out our annual “money manager due diligence week” last week with a luncheon put on by the Economic Club of New York with Federal Reserve chair, Jerome Powell. He surprised me by saying some things that I was not expecting, and he also said a lot that I could have predicted verbatim (okay, I did predict verbatim) before the speech. But despite all my earnest desire that the main action in markets let alone the economy not be at the whim of a few unelected academics, the Fed is the major story of markets right now. Their propensity to stay way too loose for way too long followed by a period of being way too tight for way too long is the cyclical and rotational story of our economic and market-oriented experience for 25 years. We met with nearly twenty money managers last week (across a wide variety of asset classes in both private and public markets). We did not meet with a single one who did not bring up the Fed, the state of monetary policy, the potential direction of monetary policy, and its impact on how they think (and in some cases act). So let’s jump into the Dividend Cafe where today is all about the Fed, the rubber chicken, and the radicals who stormed the stage before the speech began. Well, actually, we spend very little time talking about the rubber chicken or the people who stormed the stage and delayed the event for fifteen minutes while security and law enforcement did their thing. Those things really happened and were quite upsetting (especially the chicken). But the Dividend Cafe today is all about the actual words of Jerome Powell and what it all means. Off we go. Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to this week's Dividend Cafe. We are getting very close to the end of the month of October. We actually have a couple of market days left in October next week. But in the meantime, my team is fresh off of our annual retreat. The entire company, all seven offices of people embarked upon Newport Beach, California the last couple of days. I myself am heading back to New York City. And in the meantime,

I wanted to devote today's time in the Dividend Cafe to the luncheon I attended last week with Fed Chair Jerome Powell. There were some takeaways and an overall, I guess, both the basic premises from which he's operating and some of the conclusions that he shared, how that might affect our thinking. I thought the whole sort of A to Z of his talk was worth recapping and building a dividend cafe around. I want to start by saying that the food was terrible and that the people who stormed the stage caused security to have to rush the Fed chair out to the back stage and get him out of harm's way while they did their whole little spiel forcing a whole bunch of police and guns and security and everything. I don't think that they got a lot done.

I thought it was maybe a little ineffective for their cause. But nevertheless, it was an a little ineffective for their cause. But nevertheless, it was an experience to be there witnessing it from not all too far away and more than a nuisance than anything else. So if you did catch that on the news, it was most certainly true. There's a picture of the whole thing in the Dividend Cafe today. But yes, myself and Brian Seitel and Kenny Molina, our collaborative investment committee here at the Bonson Group, we were all there in person watching the drama. Fed Chair Powell is an interesting person.

I should point out that he's one of the first and only Fed Chairs we've ever had with capital markets experience. He worked at the private equity behemoth Carlyle for quite some time. And he was on the Federal Reserve Board in the Federal Open Market Committee in 2012. At the time, the Fed chair was Ben Bernanke. The Fed chair was Ben Bernanke, and he had proposed the idea of a third round of quantitative easing, but one that was going to just be substantially larger than both the first and second round put together. It ended up being over $2 trillion that the Fed added to the balance sheet. It was a little more controversial at the time because this was being proposed three and a half years after the financial crisis had ended, and it would last another two years, the quantitative easing, this additional bond purchases that the Fed was continually doing

with money that didn't exist. It would keep going all the way to October 2014. 2014. So at the time, Chairman Powell voiced concerns about it. And particularly around the exit, what would it look like? How do we undo this when it's time to undo it? And I think it's prescient, because even though he clearly reversed, and he became a big fan of QE, both then and of course, later when he was Fed Chair himself at the time of COVID, and he added a big fan of QE both then and of course later when he was Fed chair himself at the time of COVID and he added five trillion dollars to the balance sheet himself. But he is most certainly living through this right now. The very thing he predicted, the challenges of undoing quantitative easing and really more abstractly, the challenges of undoing experimentation, of saying that you don't know how something will end, but you feel comfortable going forward. It's not necessarily

how we used to do monetary policy. And the fact that along the way, we like some of the benefits and along the way, some of the short-term risks don't materialize. I think people need to be humble enough to admit that that's true. Quantitative easing's risks did not materialize in the short term the way some predicted. And that a lot of things did get better. Whether or not QE helped it or not is somewhat non-falsifiable. But I will say this. They haven't got off it. And I believe a lot of what we're dealing with now is related to the attempt to get off it, that there seems to be a certain cushion for pain.

And then when that gets exhausted, it's an unknown. And that, I think, is what Powell was talking about himself 11 years ago. in terms of his talk last week, he started off getting into just kind of macroeconomic growth, which I thought was very interesting. He predicted that GDP growth going forward, that we are more comfortable modeling 2% real GDP growth. And you could say, well, that's pretty optimistic because we've only been getting 1.6 real GDP growth since the financial crisis. So that's true. He is taking an era when we had 10 trillion of debt as an overhang and now in an era of 25 and 30 and 35 trillion as we go forward, assuming a slightly even better rate of growth. And yet I kind of was taken by the other side of it, which is it's the first time I've heard someone admit, yeah, we're kind of stuck in a 33% lower

growth environment. I mean, we've grown at 3.1% from the World War II to the Great Financial Crisis. And he is basically conceding that those days aren't coming back. And, and so the, it was, he, he got into their assessment of hours worked of productivity. They, they model this. It's very imperfect. And of course the, the actual trend line itself is imperfect because the trend line only becomes a trend line through time that, that even when it is a trend line, there was ups and downs along the way, obviously. I think that what is more interesting than just his prediction about real GDP growth is that he does seem very pleased with the fact that the economy is not revolted against the monetary tightening they've done. And there is the kind of almost cliche at this point reality that Milton Friedman himself predicted that there are various long lags that might exist between the

actions they take and it being felt. But what I am a little confused by is that if they're pleased that they've achieved a fair amount of monetary tightening, they see it in financial conditions, they see really severe disinflation, and yet wouldn't be content to kind of stop that course before it ends up having this economic impact that they're so far happy it hasn't had. I am unable to tell you if they are going, if they're insisting on doubling down until they do the pain, or if they just simply hope that they can get away with pain-free tightening a little bit more. We'll talk more about that in the end. When you look back to what Chairman Powell did during 2018,

he was trying to tighten the balance sheet and do quantitative tightening at the same time that he was trying to do what his predecessor, Chairwoman Janet Yellen, who's now our Treasury Secretary, would not do. And that is get us off the zero bound, raise interest rates a little bit for the purpose of normalizing monetary policy. And I think what Powell found out is he was able to get away with doing both at the same time until he wasn't. You add in President Trump's trade war at the time, and the markets revolted, credit spreads widened, and not just widened, but frankly, the credit markets kind of seized up. And as we all know, in early 2019, Chairman Powell chickened out entirely. So as we think about the Chair Powell who went through that, trying to normalize in 2018, capitulating in early 2019, throwing a Bernanke bazooka on steroids at the COVID problem in 2020, and then staying

hyper easy in monetary policy for two full years, all the way to spring, summer of 2022, and then now tightening beyond what anybody expected, it's really hard to extract an ideological identity from Chairman Powell. He's sort of been all over the map a little bit. And I think his talk, one of the things I want to tell you, and I don't actually write about this, I probably should have, in the written Dividend Cafe, but while it's on my mind, I'll share with those of you watching the video, listening to the podcast. I firmly believe that he's a very earnest and sincere person. And where I have areas of disagreement, those areas of disagreement have nothing to do with my beliefs about his own sincerity and intentions. I firmly believe that they believe they're doing the right thing.

And I believe a lot of my concern is not with him, but with the fatal conceit of thinking that you can do this to begin with, that you can sort of manage the cost of capital in an interventionist and, and I mean this non-pejoratively but in a manipulative way as if you have the knowledge and ability to see everything that's actually happening in the economy you can do this better than prices clearing on their own i just simply don't believe it but i do believe that chairman powell sees a need to administer monetary policy in line with their legal dual mandates. And I believe he thinks he's going to work every day trying to do that. And I appreciate that earnestness, that sincerity.

It was interesting to hear him talk about the Phillips curve, which is something I'm extremely critical of. I don't believe that this relationship between low unemployment and high inflation exists. And he talked about the Phillips curve as being a model that was really accurate in the 1970s, which I don't think it was, and that the model didn't work at all in the next few decades, and that now the model seems to be working again. And I guess I would ask you, if you guys created a Microsoft Excel spreadsheet and it gave you numbers that worked in some decades and gave you numbers that didn't work in other decades, what would you think about the spreadsheet?

Would you think maybe the model was not totally accurate? Some inputs were off or it didn't quite have, you know, you maybe don't owe that spreadsheet a rigid loyalty. Okay. I do not agree that the Phillips curve right now is working and it's indicative of a low unemployment creating high inflation. I think we've had significantly lower than normal unemployment with lower than normal inflation for a long period of time. And then when we had higher inflation, it was completely supply-oriented.

And in fact, the unemployment number got better. And now, of course, we see inflation coming substantially lower, even as unemployment has lowered itself. I don't think the Phillips curve model is working. And I think that what I heard from Chairman Powell was that he doesn't really believe in it much either. And so he's acting like, well, it kind of is working now. It worked before, but yeah, it didn't work for a long time. That doesn't sound to me like a Phillips Curver theologian. Okay. And so if they really are making decisions off the Phillips Curve, I think it's incredibly unfortunate. And if they're pretending to, that's a little different.

I kind of think that's unfortunate too, but I would take that over really doing it. That's a little different. I kind of think that's unfortunate too, but I would take that over really doing it. There was a lot of talk about whether or not the Fed owed me a culpa from what they did during COVID. Did they implement too much monetary policy and now we know it was not necessary

and there's sort of a hangover effect? And I think Powell's view is they did what they believed was the right thing at the time, but that, yeah, only with the gift of hindsight, you could conclude that perhaps on the margin, there was more monetary policy interventions than were necessary. I kind of think that's a red herring because I'm not so much interested in Monday morning quarterbacking what they did in March of 2020 and what they knew at the time and what things were like at the time. I'm interested in how long they stayed there to the degree they stayed there, a 0% interest rate for two calendar years, $5 trillion of quantitative easing, continuing to be buying that massive tens of billions of dollars per month of treasury bonds all the way up until

mid-2022. I think that's really the issue that probably warrants Fed criticism, as opposed to what they did right in the heat of the moment in the spring of 2020. The long end of the curve is really the whole issue right now. I like the way I've presented it, that you basically have a buyer problem. Currency driven who are rate agnostic buyers are not really the market makers. That's China, Japan, and those that are actually buying for the purpose of lowering yields. The Fed, they're not the key buyer. And so that leaves you with buyers that are yield focused. the key buyer. And so that leaves you with buyers that are yield focused and that ends up

creating higher demand as yields can move higher. And that's investors and banks and mutual funds and people like us. But another way to say a similar thing, my friend Willie Gov wrote a piece about this this week, is that there's a forced seller in the market. And we're used to thinking of a forced seller as a hedge fund is blowing up or an over levered investor, or a liquidity crisis. It's none of that. It's that the Fed has told you

we're reducing our holdings by $80 billion a month. It's a trillion dollars a year. And so it has enabled upward pressure on prices because there are buyers who know that there is a forced seller and they can stop being, they're not forced in the sense of they have to do it, but they have announced they're doing it. And therefore people may as well push yields higher. And that's what has been happening. I think that you will see a reversal of this if and when they reverse QT, the quantitative tightening. But his conversation about the long end of the curve was fascinating to me.

He doesn't think that there's a lot of defection from foreign buyers, and they have that data points as clearly as we do probably more so but he just is really astute about the fact that this is the term premium going higher like i mentioned he knows capital markets bonds and stocks are non-correlated and bonds have always served as a hedge against stocks And they are so incredibly correlated right now, as opposed to their historical non-correlation, the bonds are not working as a hedge for stocks, which is causing the term premium to increase.

When you get a supply shock, you don't have bonds to rally and yields to drop while stocks go the other way. They're very correlated together, and yet it isn't inflation expectations. And we get to measure this, as I've talked about before, with tip spreads, that you have 100 basis points of increased yield in the 10-year this year, and only 17 basis points increase in inflation expectations.

That means it's real yields that are increasing. And one either believes that that's pricing in years and years ahead of greater economic growth, or it has to do with the factors we've been talking about. And to hear Powell talk about it, it was extremely clear to me that he understands as well. So on the practical side of things, he essentially didn't really get into China's weakening economic growth. I was surprised he didn't. If China's going to have 2% to 3% come off of their GDP, then global bond yields are going to come down. And he didn't get into anything to do with China's economic health. He mentioned the regional banks. They think

that the regulators are watching with this concentration risk. He doesn't believe there's a broad or systemic, he used the word broad, problem with commercial real estate at regional banks. He knows the home builders are in a lot of trouble. He doesn't know what they can really do about that, but there's sort of collateral damage in this. And he talked about just small companies overall being kind of collateral damage that small businesses suffer from rising cost of capital a lot more than big businesses do. They know that, but I didn't get the impression he was drawing a particular conclusion from that.

The final thing I'll leave you with just in terms of various takeaways was I definitely got the impression he's at odds with his vice chair of supervision at the Fed who's really looking to tighten capital standards for the big banks, force them to hold more regulatory capital. And hearing Powell say, our banks are so well capitalized, they're so well capitalized. And then when he was pushed on this issue, well, why are you guys trying to get them to hold more capital then? Saying, well, that's out for comment right now. That's in a review period. So I got the impression he doesn't think it should happen. And that could be interesting. So very simply put, you're really

dealing with a kind of almost binary. I don't think most things in finance and I don't think most things in life are usually binary. There's usually more nuance and optionality around things, but more or less, and I'll read it to you the way I wrote it in Dividend Cafe. The Fed has all but told you they're not going to raise rates again, but they have also postured themselves as being prepared to stay high, tight for a long time. It has not blown out bond spread yet. It has not impaired jobs yet. It has not impaired real GDP growth yet.

The Fed is right about all that. But the question is really simple. Will they be content to take the victories or will they hold on to a point of destroying them? Pal didn't give us the answer last week. And that is really, I think, what most people in financial markets are waiting to see. Is the Fed determined to let another boom cycle they created create another bust cycle? I'm going to leave it there. I do appreciate you listening to Dividend Cafe. I sure hope you'll subscribe. And if you're listening to the podcast, put it into your feed. If you'll write us a review of this episode, it helps quite a bit. Thumbs up on YouTube,

all that kind of stuff. Those things help drive our traffic. Thanks for listening. Thanks for watching. Thanks for reading the Dividend Cafe. Those things help drive our traffic. Thanks for listening. Thanks for watching. Thanks for reading the Dividend Cafe. I'll see you next week from New York City. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC,

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