The Bond Market and the Dollar Call BS on Warsh

After an entire professional career of railing against the “excessively large” Fed balance sheet, pantywaist Fed Governors who were soft on inflation, and promising “regime change” into a Fed that has “no tolerance for persistently elevated inflation”, Kevin Warsh rolled up into his first real presser yesterday wearing John Lennon glasses and telling people to tune in, turn on, and not hike.

The bond market was not amused.

The 10-year was at 4.47 percent when Warsh was confirmed on May 13th. It’s at 4.68 right now.

This is the bond market saying: OK, if you’re not going to raise rates, we will. (Twenty-one basis points is pretty close to a 25 basis point hike.)

The dollar didn’t like Warsh’s presser either.

Yesterday, the U.S. dollar (the DXY basket that is about 60 percent against the Euro) took an initial leg down on the no rate hike at 2pm, but then took a bigger leg down when Warsh started speaking at 2:30pm.

Unfortunately, part of my job description is listening to these Fed Chair pressers. Powell used to open up every meeting by reiterating the Fed’s dual mandate (maximum employment and price stability) and emphasizing that he was there to make the U.S. economy work for ordinary people.

You can insert your own joke here about a nine-digit net worth former Carlyle guy doing a power-to-the-people bit, but you know what - I believed him.

Warsh has come out swinging on inflation. I mean, this is literally his life’s work. He’s SERIOUS about inflation. When he speaks, the implication is that the Powell Fed was a bunch of unserious, pantywaist, girly men who let inflation run wild on their watch.

Hell yeah! I’m here for this fight! Bring it, Warsh! Slay the inflation dragon!

And to combat inflation, Warsh is going to… form five task forces.

Wait, wut?

That’s right, we’ve been running above the two percent inflation target for the past five years, and the answer is to form a Soviet-style politburo. (After the next Plenum, we make most glorious interest rate!)

OK, but what about the $6.7 trillion Fed balance sheet? Since 2008, you have written paper after paper, and given speech after speech, saying it is the greatest evil since New Coke. You’re going to run that off, correct, as you testified to in your confirmation hearing, correct?

Nope. He’s going to review it (with a task force!) to evaluate “the benefits and risks of the current ample-reserves regime and the composition of the Fed’s balance sheet”.

Oh boy.

The U.S. debt is currently $39.7 trillion and that train only goes in one direction. We’re running a $2 trillion annual deficit (six percent of GDP) and that’s just to keep the lights on. Also, that’s at full employment and GDP cooking along at two percent this year.

When we hit a recession, the deficit will explode to double digits.

The Fed’s real job is to keep the U.S. bond market functioning to facilitate debt monetization (issuing Treasuries to pay off the U.S. credit card bill).

Warsh will play his role, which means: no interest rate hawkishness (especially into the mid-term elections) and no balance sheet runoff. He’s going to run it hot now and forever because the plan is to inflate our way out of the debt.

We are in the phase of the cycle that Hyman Minsky called “Ponzi finance”: issuing debt to pay off the interest on prior debt.

It will work until it doesn’t.