The Great Unwind

(Any discussion about a great unwind must start with first pondering what it is exactly that’s being unwound. Consider this introduction to be simply the perspective of someone with a pocket calculator trying to make sense of where we are, how we got here, and where we might be going. Other perspectives are more than welcome to our discussion with the goal remaining enlightenment over argument.)

How we got here was the topic two years ago of MM 6/8/20 WTF: What The Fed i.e. how the Fed (the central bank originally established to act as the ultimate backstop lender to in times of a severe liquidity crisis) became empowered to create money. Despite the misleading name, the Fed was and is a private, not a federal government, institution. It (digitally and physically) "prints" money (called Federal Reserve Notes, just look at the back of your dollar bill) which shows up as a liability on its balance sheet.

This money is then applied to purchase various instruments which are reflected as assets on that same balance sheet. The lion's share of those assets are Treasuries (i.e. loans to the U.S. government) plus mortgage backed securities (which underpin traditional mortgages). For our purposes, the Fed has been the open market "whale" purchaser of both over the last dozen years.

That's really all you need to know when it comes to understanding the extraordinarily low interest rates that have prevailed until recently. Those massive purchases of Treasuries by the Fed had been the unnatural act driving the price of those instruments to lofty heights which, as we know (bond price is inverse to interest rate), translated to extraordinarily low interest rates (effectively zero). And it's these longer-term rates (rather than the frequently-published short term Fed Funds Rate) that count when it comes to corporate, government, and mortgage borrowings. That phenomenon was labeled “Quantitative Easing (QE).” So, what's the cost?

The "cost" of the scheme comes in the form of a massive injection of those brand new dollars into the system which enabled the purchase of all those Treasuries in the first place. This additional "float" thereby debases the value of the dollar. Another word for that phenomenon is (monetary) inflation.

We didn't initially see direct evidence of that inflation but it's been there all along. It was first reflected in the price of assets. House prices took off with that essentially free money. So did the stock market as companies used cheap money to drive share price by repurchasing and thereby reducing the number of outstanding shares. Cheap money has also enabled the government to become far less accountable for excessive spending and borrowing. In short, the scheme has enabled bad financial behavior all around.

Add, then, to that one of the worst legislative acts over the past decades i.e. the elimination of the separation between commercial and investment banking. The sleepy world of commercial banking was characterized by their 3/6/3 model (borrow at 3%, loan at 6%, hit the golf course at 3:00 p.m.). One-time banking gatekeepers then became among the financial beneficiaries of the subsidized rates. Look no further than the now-deregulated investment banking industry with access to cheap capital for the source of our massive wealth disparity.

But there is change in the air.

The recent change was forced by the now obvious manifestation of inflation in the “real” economy. Price inflation has now taken off – the official CPI is nearing eight percent, probably much higher if one applies the historical ways of measuring it. Now the inflation is so obvious that not even the Fed can hide behind its “transitory” language. This delayed manifestation of inflation came about because it takes time for the tsunami of dollars to enter the marketplace as they are “loaned” into existence through our fractional reserve system (perhaps a separate topic for its own MM discussion).

In any event, with undeniable inflation now for all to see, the question becomes how it’s to be addressed. The answer is The Great Unwind as central banks cede control of the interest rate environment to market forces (as it eventually must), thereby reversing the distortions accumulated over the last four decades. The turn-around most likely began when the Fed balance sheet peaked at 8.9 trillion dollars this past April (for reference, it was about a tenth of that i.e. less than one trillion dollars before ‘07) when Powell finally announced the inflation problem and the beginning of this balance sheet runoff (QT). This reversal has huge implications.

The reduction of that artificial Fed demand for Treasuries would first mean the government would need to look elsewhere for a large portion of its funding and who would those purchasers be? Me? You? China? The answer is someone would be but at what price? Right now the government has the benefit of its historic funding cost but as the Treasuries roll out over the average five-year maturity and the Treasury is forced to borrow at next year’s projected rate of five or six percent rate my pocket calculator reckons the annual cost just to service the country’s current 31.2 trillion dollar debt will close in on half its total annual tax revenue. That same excruciating calculation, by the way, would apply equally to most any type of floating-rate borrower e.g. zombie companies, floating rate residential mortgagors (and the mortgagee, for that matter, sitting on default risk).

Yes, one might say, but other countries might be worse off – and that might be true – but that is of little consolation as The Great Unwind would prove to be a global phenomenon in this tightly interconnected world. Most of the thirty or so global systemically important banks operate with their share capitalization either near or less than their balance sheet equity. That means they remain highly vulnerable to a risk of failure in the event interest rates rise with the concomitant reduction or outright default within their bond or other asset portfolio, more than wiping out their equity. That, in turn, underscores the risk as counterparties in the $600 trillion world-wide derivatives market.

There are so many other attendant issues we might discuss e.g. how it is that the dollar has retained its reserve currency status given the breach from the post-WWII Bretton Woods gold anchor pledge and with the petrodollar tie seeming to be fading? What might replace the dollar's esteemed status given the reckless stewardship by the Fed (this unelected Politburo) within a changing world order? Among the challenges to the dollar as the universal settlement for world trade are Shanghai Cooperation Organization, the Eurasian Economic Union, and a possible basket of real-world assets that would be suitably isolated from the dollar’s debasement.

Or, we may want to discuss how we as individuals might try to defend ourselves against some sort of reckoning, whether it be in the form of a super high interest-rate economic meltdown or a hyperinflation scenario, thus bringing forth the words of that great philosopher Woody Allen:

“More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”

Just kidding, of course, though we might want to time-stamp our discussion as we take note of history and reflect on De Tocqueville’s point that “A democracy can only only exist until the voters discover that they can vote themselves largesse from the public treasury.”