The Weekly Fix

Welcome to the Weekly Fix, the newsletter that wishes they did as many reps of lifting the bar as Fed Chair Jerome Powell did this week. –Luke Kawa, Cross-Asset Reporter

Powell Deadlifts

A Fed chair walks into a bar. He raises it – in both directions.

That's both a poor, niche dad-joke straight out of Alice in Wonderland and also the story of the Federal Reserve's third consecutive interest-rate reduction delivered by Chairman Jerome Powell.

The language in the central bank's statement Wednesday was left almost entirely unchanged, except for the removal of the willingness to "act as appropriate" to sustain the expansion. Back in June, the introduction of this language was proof that the Fed would indeed act, rather than be "patient," and teed up the subsequent cuts. During the press conference, Powell indicated that monetary policy is in a "good place" right now, and is "likely to remain appropriate." It would require a "material reassessment of our outlook" to boost accommodation, he added, while risks like trade and Brexit had also subsided since the September meeting.

The Fed is now putting forward the view that acting as appropriate means not acting at all. It's the kind of retort that a kid – like the one I was – might use when his parents suggest his bedroom needs tidying. But markets are taking the line better than parents might. Although two-year Treasury yields spiked on the heels of Powell's remarks, they soon calmed down. That's because he also indicated that the bar for hikes is even higher.

"We would need to see a really significant move up in inflation that's persistent before we would even consider raising rates," he said.

This is more important than you might have thought. The time at which the Fed would resume hiking rates had been pulled forward since the September meeting. Powell effectively crushed those expectations.

The ensuing result is that the dispersion in Treasury yields from three months to five years is at its lowest level on record. A flat curve is pretty much a feather in Powell's cap, even if there's little chance rates will be on hold this extent.

Powell's desire to move the Fed to the sidelines raises the question: just how long could any pause be? If history is a guide, the longest Fed pause in the past 30 years (excluding its time at the zero lower bound), was from March 1997 to September 1998. However, within the ZIRP period, one could argue that there was a longer stretch, from October 2013 until lift-off in December 2015, when policy – including balance sheet policy – was static.

To be sure, the market pricing, on its face, indicates some doubts as to whether any pause will be lengthy. In the event that traders really believed the Fed was on hold for a long time, you might expect to see the spread between January 2020 and 2021 fed funds futures compress significantly. Alas, it's actually widened since the Fed meeting, though Thursday's risk-off session on trade concerns bears some of the blame.

Morgan Stanley's Matthew Hornbach helps reconcile this seeming dichotomy.

"This guidance cuts both ways with respect to further rate cuts: 1) it means the bar is high for the Fed to cut rates again, however 2) a "material" change in the outlook may lead to a "material" reduction in the target range for the fed funds rate. This suggests that the net rate cut, should it come, could more easily be a 50bp rate cut instead of a 25bp cut. This idea should serve to keep a healthy negative term premium in the pricing of Fed policy for 2020."

Stocks Don't Care About Bonds (As Much)

The equity market's resilience this week amid the twists and turns of the Treasury market was a sight to behold.

The idea that the Fed was done on delivering easing didn't really rattle stocks much. Think back to the start of the year, when the risk rally hadn't been so reliant on lower real rates since 2012. We're clearly in a new market regime.

Such an outcome might have been expected, based on how the market's been operating in a "good news is good news" paradigm during at least the second half of this year, but it was nonetheless impressive.

For most of the first half of 2019 – and even after the first rate cut, when the notion of a mid-cycle adjustment roiled stocks – the equity market was signaling that it needed the Fed's help. Now, traders are suggesting they only need the Fed to do no harm. The S&P 500 Index closed at an all-time high on a day when the Fed cut rates for the first time since January 31, 1996.

Ultimately, when central bankers say they'll only hike on a material pick-up in inflation and such an increase is not on the horizon, that's a pretty big endorsement of risk-parity oriented portfolios.

The equity market's newfound relative ambivalence to the Treasury market continued on Thursday. Ten-year Treasury yields tumbled about 8 basis points amid a rash of underwhelming data and reports that a comprehensive U.S.-China trade deal wasn't nearly as likely as the barebones so-called phase one deal. The benchmark borrowing cost dipped below 1.68% – nearly 20 basis points off its highs of the week.

And yet, the S&P 500 Index only fell 0.3% on the day. That's tied for the smallest loss of the year for a session in which the 10-year yield posted a decline of that magnitude. U.S. stocks have dropped 1.4%, on average, during such a furious rally in rates in 2019.

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Odd Lots of Love

The Odd Lots podcast hosted by Joe Weisenthal and Tracy Alloway is well worth checking out. Their most recent edition was superlative: Brad Setser of the Council on Foreign Relations and Exante Data walked through the activity of Taiwanese life insurers and the implications for the U.S. corporate credit market. Listen to the riveting discussion, read Brad's work on the subject here.

What follows is select highlights of their conversation, lightly edited for clarity:

How did Taiwan end up with a huge life insurance industry?

I'm not sure I understand entirely what happened. I can see the end-result: the end-result is that Taiwan's life insurers now have about $900 billion in total assets, that's ballpark 150% of Taiwan's GDP. I think what happened in the broadest possible sense is that Taiwan was faced with a challenge over the past 20 years as China emerged as the region's dominant manufacturing power. One consequence of that was that manufacturing investment and investment in general in Taiwan fell, and Taiwanese savings, because of the low, relatively modest social safety net and other structural factors – rapid aging – Taiwan's savings rate stayed high. So this massive savings surplus developed, and the Taiwanese government wasn't out borrowing large sums either, so the savings had to go into some kind of financial instrument, and the lifers starting offering long-run investment products that offered a higher return than Taiwanese dollar bank deposits, and that pulled the savings surplus, in a sense, into the life insurance industry.

They needed to do something with all that money. What'd they do?

The difficulty the insurers faced was that the classic products which an insurance industry would invest in were rather small in Taiwan's case. Typically if you're pulling in a lot of life insurance policies, you would invest in government bonds or local corporate bonds. There just aren't that many though.

So over time, the insurers started

buying more and more foreign bonds. The share that they put into foreign bonds was initially capped at 45% of their total assets, which is a high number actually – much higher than is typical across other Asian life insurance sectors.

But when they hit that number, rather than stopping, a new instrument was developed. The Taiwanese allowed the insurers to invest in what are called Formosa bonds, which are U.S. dollar-denominated bonds issued in Taiwan. And those were not counted against their cap on foreign assets. It was a blatant loophole.

And a lot of financial institutions started issuing in this market. Particularly callable bonds, so bonds which have the option where the issuer can call them if interest rates fall. The lifers liked them because they offered a little more yield today, and the issuers liked them because if interest rates fell, they had the option of reducing their borrowing costs. And this became a really big market. It goes from like zero to $150 billion in a couple of years. And then the regulators put a cap on the insurers' holdings not just of foreign assets, but foreign assets plus Formosa bonds at roughly 65% of their total assets. Again, that is a huge number. No other insurance sector in the world, at least to my knowledge – maybe some in a tiny country – has put two thirds of their assets in a foreign currency. Particularly when most of their policies are still in Taiwanese dollars.

But then they've kind of blown through that 65% cap as well with a new product. The hot new product is local exchanged traded funds, which in Taiwan are invested entirely in foreign bonds, sold entirely to the life insurers, and are considered a Taiwanese dollar asset. So, obvious regulatory arbitrage. The net effect is that close to 70%, close to $600 billion dollars, of life insurer money is invested in foreign assets.

So basically Taiwan's future retirement savings have been invested abroad, through life insurers, and the flow has been so big that it impacts particular parts of the global markets.