Beware the Ides of March?

On October 19, 1987, two months into his tenure as Federal Reserve Chair, Alan Greenspan was aboard a flight to Dallas to deliver a keynote address at an economic conference. While he was in the air, stocks crashed by 22.6% in what remains to this day the worst one-day routing in U.S. history. He never made it to the podium. By the next day, Greenspan was back in Washington, D.C. whereupon he issued the following statement: “The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

In the weeks and months to come, Greenspan sanctioned the New York Fed’s leaking of Fed intentions to inject liquidity into the financial system to Wall Street bond trading desks ahead of said injections. The Fed put was thus born.

On February 5, 2018, on Jerome Powell’s first day in office as Fed Chair, the Dow Jones Industrials slid by 1,100 points, or 4.6%, the biggest meltdown in stocks in more than six years. The markets were in the midst of “Volmageddon,” when stock market volatility spiked by unprecedented levels leaving some investors in crowded trades with 90% losses. By the next day, Powell had done…nothing.

On February 27, 2018, just hours before his first Congressional testimony, my Bloomberg column “Powell Brings Plain-Spokenness to the Fed” was published. I had been deeply inspired by Powell’s Senate confirmation hearings. When asked if banks were too big to fail, he’d replied, “I would answer no.”

My column ended as such: “With any luck, Powell’s first semi-annual appearance in front of Congress…will prove equally refreshing. Investors will be on tenterhooks waiting for the first politician to ask what the Fed’s role should be when stocks go bump in the trading day. Powell should simply reply, ‘I would answer none.’ Let’s hope there won’t be a ‘Powell Put.’”

Later that morning, when asked about just that, Powell replied, “We don't manage the stock market,” but “it enters into our thinking. I think the general thing is that the stock market is not the economy.”

That fairy tale year, alongside publicly founding the Powell Fan Club on Twitter, crested during Powell’s first Jackson Hole speech on August 24, 2018. In his prepared remarks, he observed that, “In the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.”

Such simple logic, a tacit acknowledgement that the Fed’s preferred measure of inflation, the core PCE, that uses as its healthcare input Medicaid and Medicare reimbursement rates, couldn’t spot a recession if it up and bit policymakers in the backside.

And then came Halloween. Just two months after he’d departed Wyoming to return to the confines of the Eccles Building, the bonds of General Electric were downgraded. By November 14, 2018, high yield issuance entered hibernation where it lingered for a record 41 days. The collateral backing exchange-traded high yield funds was trading by appointment only and redemptions in these fully liquid vehicles had spiked. Spreads, or the difference between like-maturity high yield bonds and Treasuries, were gapping out enough to gain the attention of international regulators. 

Like an animal snared in a trap, Powell was finished. He had to chew off a limb to survive. This from the maverick who in October 2012, as a four-month rookie governor on the Federal Open Market Committee, dared say (out loud) that he thought the Fed was, “actually at a point of encouraging risk-taking.” And then, he sounded a warning that came back to haunt him that 2018 holiday season: “We look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You could almost say that is our strategy.” 

In response to rates coming up down that road, those “big losses” had come home to roost. Powell knew he was beat as the systemic risk lurking in the bond market threatened to spill over in God knows what form. And that was one risk he could not take.

As the credit spigot turned off, the transmission mechanism from the debt markets to the stock market – share buybacks – suffered cardiac arrest. Stocks plummeted culminating in the Christmas Eve 2018 bloodbath that left stocks 20% off their highs. Public pensions suffered their worst quarterly losses since the financial crisis. 

There is no defending what next occurred. Powell had little choice but to acquiesce to the markets gasping for assurances that there would indeed be a Powell Put to underpin grossly inflated risky asset prices. And so he pivoted. 

On January 4, 2019, on stage with his two predecessors he’d battled to bring discipline back to monetary policy in his six years at the Fed, Jay Powell apologized for being so na?ve as to criticize Quantitative Easing (QE). 

The markets never looked back, that is, until 10 days ago. On February 19, 2020, as the reality of the Coronavirus pandemic began to dawn on investors, the bubbly S&P 500 closed at 3,386. Stocks have since fallen 11% into correction territory.

This past Friday afternoon, Powell issued an unscheduled statement, ending his personal war against fully following in his predecessors’ footsteps. You only need know the statement contained three magical words. The Fed would “act as appropriate” to sustain the current economic expansion. The elixir of the same verbiage used in the Fed’s June 2019 statement to signal a July rate cut was all it took. The capitulation he successfully avoided on his first day in office has now come to pass.

But here’s the thing. It isn’t stocks’ sickening slide, as historic as it’s been. It was something even more threatening than what erupted on October 31, 2018. This wasn’t high yield, but rather investment grade (IG) issuance that had slipped into a coma. That is what forced Powell’s hand.

A brief history. The 13 days surrounding China’s devaluation of the yuan in August 2015, which forced Janet Yellen to postpone the Fed’s first rate hike of the current cycle, marked a modern day record IG issuance drought. Lehman’s meltdown saw 10 days of no sales. And then there’s this past Friday, which marked the sixth day of no IG issuance.

Stocks of companies with weak balance sheets that rely on share buybacks as a prop have been mercilessly sold, punished to a far greater extent than the broad market. Investors have long awaited this day of reckoning when these vulnerable firms would be faced with the existential threat of having to produce fundamental results rather than feign performance via financial engineering.

As bad as you think the stock sell-off has been, as you can see in this chart, credit spreads are in another universe vis-à-vis equity’s implied volatility, seemingly oblivious to the disruption in the markets. What’s specifically depicted is the VIX vs. IG spreads, which shows we’ve seen little to no reaction in the massive and fragile IG market. Nearing $7 trillion in size and dominated by ‘BBB,’ bonds rated just one rung north of junk, the potential for a calamity is anything but reflected in spreads thus far.

U.S. Investment Grade Bond Market Oblivious to Stock Market Sell-Off

Perhaps what’s most telling is a sell-side brokerage firm acknowledging the risk of a “credit event surging” as Bank of America Securities did Thursday. “The ‘ghost in the machine’ remains biggest 2020 market risk (catalyst for policy response),” the firm cautioned.

Market watchers tend to forget that Powell made his bones founding the Industrial Group at the Caryle Group. He’s not some private equity crony as social media haters purport. But he does not need the day job and joined the Fed to serve his country. In fulfilling his duties, and unlike the pure academics who preceded him, Powell does speak to CEOs throughout the country who’ve been shellacked by the trade war and now the Coronavirus. And above all else, he identifies with the credit markets.

If there’s one thing Powell knew in December 2018, and still appreciates despite himself, it’s that the Fed isn’t capable of addressing the grossly overvalued debt markets if the sleeping giant of credit market volatility awakens. 

Do the Ides of March foreshadow an insidious ending to Powell’s short tenure at the Fed? We’re about to find out. Whether it’s an emergency rate cut before the March 18th meeting or a 50-basis point rate cut if he waits out the next 18 days, history is sure to tender its judgement in very short order.

Danielle DiMartino Booth is founder and Chief Strategist at Quill Intelligence

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