Submitted by Taps Coogan on the 13th of June 2019 to The Sounding Line.
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Luke Gromen, founder and president of Forest for the Trees, recently spoke with Real Vision about his bullish outlook for risk assets based on increasingly dovish central bank policy. What makes Mr. Gromen’s outlook unique is that he sees the Fed cutting rates primarily due to a dollar shortage caused by overly large government deficits and not primarily due to the ‘trade war’ or a slowing economy.
For many, including yours truly, the current market expectation of multiple Fed Funds rate cuts this year seems significantly more dovish than can be justified by the Fed’s communications or by the slowdown in the domestic economy. Mr. Gromen argues that the Fed will nonetheless be forced into a dovish policy stance because of overly large government deficits that are sucking capital out of the domestic banking system and the Fed Funds market. As we noted here and as Mr. Gromen discusses below, the effective Fed Funds rate traded above the interest on excess reserves rate for the first time in March 2019. That has been interpreted by many, including Mr. Gromen, as evidence that the Fed is “losing control” over interest rate policy and the price of money.
Some excerpts from Luke Gromen:
“You got into the late third quarter of 2018 and something very important happened which was that the hedging costs for foreign investors to buy US treasuries went negative. In other words, for a Japanese or German private sector investor, and again the US government is now critically dependent on foreign private sector investors to buy treasuries, the yield, FX hedged, tuned negative… In 2018, the US government issued gross $10 trillion, with about 70% of that less than a year of maturities. This year they are on pace to issue $11-$11.5 trillion in US treasuries. Again 70% in less than 1-year maturities… What began happening in Q4 2018 was that the global private sector began being paid to not buy treasuries, or they would have to take the dollar risk on themselves… My risk there (the unhedged risk) is I get another 2017 in the dollar and I lose four or five years of coupon if the dollar goes down 12%. That’s the risk that they’re taking and they’re probably going to lose their job and assets with that. So what that did was it forced, on the margin, more of the United States deficits onto the US private sector, US banks. You can start to see, even in the Q4 2018 risk off, yes yields came down but the tails on auctions were consistently very very large… Primary dealers were having to take on more and more of this (government debt). So what this is doing is creating a dollar shortage in the US’s own banking system. This came to a head on March 20th. The Fed Funds rates rose above interest on excess reserves (IOER)… The Fed clearly was aware of it because about four weeks ago they cut interest on excess reserves rate which should have injected more dollar liquidity into the system. It did normalize Fed Funds a little bit. but it remains above IOER… The Fed is losing control of the Fed Funds rate on the short end because US deficits are growing as fast as they are and because the foreign official sector is not buying really at all on net. The foreign private sector is not buying enough. They are buying some unhedged but not nearly enough relative to the size of the deficits we are running… The Fed is losing control over the price of money in the United States… The Fed’s entire reason for existence is to control the price of money in the United States. So the Fed is going to need to make a choice very soon. They can either cede control over the price of money, in which case we don’t need the Fed anymore. Or, they are going to have to cede control over the quantity of money in order to control the price of money and that’s the choice we think they are going to make…”
“I don’t think it’s fully appreciated yet that the reason that markets are pricing the Fed is going to cut rates so aggressively in the back half of this year has nothing to do with the economy and everything to do with the Fed Funds and them losing… control.”
“The primary issue is that the US government deficits matter for the first time in 70 years. For 70 years, everybody else funded America’s deficits. Foreigners funded our deficits and so we could run deficits without tears… As of March 20th, the alarm bells started going off at the Fed. When the Fed Funds went over interest on excess reserves, that was a sign that the United State’s government’s deficits were getting so big that… we are crowding out our own banking system. If the Fed does not inject a significant amount of dollar liquidity soon, be that via repo, be that via rate cuts, and I think you are going to be seeing QE in probably six to nine months at the latest…, then you’ll have a recession probably sooner than mid 2020… We don’t think that’s going to happen (a recession) because we don’t… believe that the Fed is going to stand by and do nothing… Because of that, we are very bullish on risk…”
“In plain English, what I am saying is the Fed is going to have to cut rates to finance the US government and I think once they start doing that, people are going to see through that pretty quickly…”
“I don’t think Powell, I don’t think the Fed is going to like it but I don’t think they have a choice… These deficits are going to grow structurally for years and years and years…”
“I think you are going to see asset price inflation accelerate. Obviously, we’ve had a lot of asset price inflation for the last ten years. It’s going to continue and even accelerate…”
“It’s been 100 years since we’ve had a global sovereign debt crisis and that’s really what we are talking about here… Sovereign debt is risk free… in nominal terms, but it’s unplayable in anything resembling real terms…”
For what it’s worth, I remain skeptical that the Fed will deliver Fed Funds rate cuts quite as quickly as markets and Mr. Gromen expect. The Fed may try to improve liquidity with small cuts to the IOER first, and only make big cuts to the Fed Funds rate if that fails. The Fed has limited policy tools and I see them saving most of them for an actual recession. The Fed may ultimately end up in the same dovish place for the reasons described by Mr. Gromen, but how bumpy will the path there be?
There is much more to the interview, so enjoy it above.
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