“There’s a Lot of Zombie Companies Out There”: Will Trump Bully Jerome Powell Into Blowing Up the Economy?
08/29/2019, 10:51:42
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Dangerous as it is, cheap money is the key to Trump’s re-election. Which is why he’s been treating the Fed chairman like Jeb Bush.

Whatever his vast ignorance in other areas crucial for his current job, Donald Trump knows a thing or two about interest rates. Simple things. Big borrowers, like Trump, love cheap money. They believe it’s the rocket fuel of economic growth—you can build casinos, Fifth Avenue towers, whole cities with your name on them. The more money they can borrow from other people at low interest rates, the better. And now that Trump presides over a national debt of more than $22 trillion, he knows that rising interest rates will materially increase the nation’s cost of borrowing, which will in turn increase our annual budget deficit, projected to grow to $1.1 trillion by the end of September. In other words, Trump has realized that keeping interest rates low is his best chance of keeping the leveraged buyout known as the U.S. government from going nearly bankrupt under his watch, just as so many of Trump’s companies did back in the day, and it’s his best chance of keeping his job in November 2020.

One person who could stand in the way of Trump’s fever dream of a land awash in cheap money: Trump appointee Jerome Powell, the chairman of the Federal Reserve Board. Which is why Trump is resorting to his usual bullying tactics, not so different from the ones he used on Jeb Bush and Hillary Clinton. Since the beginning of the year, Trump has been throwing a temper tantrum when it comes to Powell. First the two sat down for a White House dinner in February. Then, according to Bloomberg, Trump went so far as to explore whether he could fire Powell, the kind of unprecedented step that only someone like Trump could consider seriously. (Remember Trump and Jeff Sessions, his first attorney general?)

In the end, Trump decided he couldn’t fire Powell except “for cause,” nor is it clear that he could demote him, as he has also mused about doing. Now Trump just belittles Powell on Twitter and in his clipped, nonsensical public statements. Asked about all this on Tuesday, Trump said, “Let’s see what he does” at the June Fed meeting, leaving the sword of Damocles hanging over the Fed chairman. Could a condescending nickname be in Powell’s future? “Low-Energy Jerry,” perhaps? Trump is like a four-year-old holding his breath until he gets what he wants. And what he wants from Powell are low interest rates.

Unlike Trump, Powell seems like a nice enough guy—calm, measured, avuncular, thoughtful, if a little cerebral. He’s very much in the mode of past Fed chairmen, except that Powell is not an economist. In fact, he made his money first as an investment banker at the old Dillon, Read (long since absorbed into UBS, the big Swiss bank) and then by doing leveraged buyouts of industrial companies at the Washington powerhouse Carlyle Group. He has a net worth estimated to be as much as $100 million. Powell knows the debt game with much more nuance than Trump, but his current job may require him to be a pugilist, to defend his territory aggressively. And the signs thus far are that he may not be up to it.

The struggle between Trump and Powell will likely determine which of the two poisons Americans will have to swallow: the distasteful choice between a recession next year and a full-blown financial crisis in the years beyond. “Several indicators suggest a recession could take place in one year,” according to Jeffrey Gundlach, the CEO of DoubleLine Capital, a hedge fund with more than $130 billion under management, in a June 13 investor webcast. Gundlach, one of the most respected authorities on debt and its risks and rewards, said he believes the chances of a recession in the next six months have risen to between 40% and 45%, and will increase to 65% within the next year. Consumer indicators, he said, point to “the front edge of a recession.”

Trump, of course, doesn’t care about a financial collapse later. “Yeah, but I won’t be here,” he reportedly said about the country’s massive $22 trillion debt. He wants to avoid a recession now, or at least one that occurs between now and November 2020.

Trump has put Powell in a vise. If Powell does the right thing, and raises interest rates to where they should be—in order to better compensate investors for the risk they are taking in the bond market—then he could lose his job. But if he lowers interest rates—as most observers, including Gundlach, believe will happen later this year—then he will look like he has caved to Trump’s political pressure, further eroding the Fed’s claim to independence. Given that the Federal Reserve remains one of the few trusted institutions in Washington these days, appearing to be a pawn of the president of the United States will not exactly inspire confidence in the Fed’s ability to do what is best for the economy at any given moment. “It’s too late to be bullish,” Sophie Huynh, a strategist at Société Générale in London, told Bloomberg. “At this stage of the economic cycle, you’re either going to have a recession next year or a cyclical slowdown. If the Fed cuts rates, do you think we’ll see a global growth recovery? It’s not the case.”

But as Gundlach alluded to in his June webcast, if Powell succumbs, and the Federal Reserve votes to lower short-term interest rates, the Fed will likely hasten the day of the next major financial crisis. Here’s why: After the 2008 financial crisis, the Fed drove down short- and long-term interest rates to historically low levels in order to stimulate borrowing and help pull the economy out of the deepest recession since the Great Depression. The cheap-money strategy worked. The Fed kept at it for nearly a decade, and only decided to abandon the policy in 2017. One of the ways the Fed kept long-term interest rates low was by going into the market and buying debt securities that few others wanted to buy, driving up their prices and lowering their yields. During the time of this policy—known as quantitative easing—the Fed’s balance sheet increased to $4.5 trillion, from around $900 billion before the policy change. Investment banker Christopher Whalen, who runs his own Wall Street boutique, thinks the Fed’s bloated balance sheet is here to stay, despite Powell’s recent efforts to shrink it slightly. “Ultimately the Bernanke–Yellen inflation of the Fed [balance sheet] and asset prices is permanent,” he said. “We can’t get out. Indeed, eventually the Fed must grow its balance sheet to keep up with Treasury debt issuance.”

That’s not good news. In the past decade investors went wild looking for higher yields than they could find by owning Treasury securities and other safer securities, starting nothing less than the yield Hunger Games. Wherever investors could find higher-yielding securities, they gobbled them up—and are still gobbling them up. Junk bonds that normally should yield more than 10% annually, to reflect the risk of owning them, now yield around 6.1%. Investors are devouring risky loans and risky debt of all kinds. There is a growing consensus that risk is being mispriced across the spectrum. And that it all will not end well.

Which is why, in part, Powell raised interest rates four times in 2018. He was trying to get out from under the yoke of low interest rates that had ended up injecting so much risk into the bond market as investors searched for higher yields. He was trying to break the cycle. He was doing the right thing. But then, thanks to Trump, Powell hit the pause button on his efforts to normalize the price of money, and now he is thinking of pivoting to lowering interest rates again, which will reignite investor frenzy for higher yields and hasten the day of reckoning for the next financial crisis, as all that mispricing of risk comes home to roost. Powell said as much Wednesday after the conclusion of the Fed’s June meeting.

Jeffrey Gundlach understands the pressure that is building up in the debt markets. In his webcast he said that if the Fed would butt out of the market, not “manipulate interest rates down,” and “there [were] true free market pricing,” then the yield on the 10-year Treasury would be “6% for sure.” Right now the yield on the 10-year Treasury is 2%. (It was 2.6% six months ago.) If Gundlach is right—and he usually is—and Treasury yields back up 400 basis points, then of course the yield on other riskier debt securities, issued by corporations, municipalities, and other institutions, will also rise. That’s good news for investors buying new issues, who will finally get rewarded for the first time in a decade for taking the risks they’ve been taking without proper compensation.

But it’s very bad news for investors who have bought trillions of dollars of debt securities and loans over the past decade at high prices in search of higher yields. What people too often forget or ignore about the bond market is that when bond yields rise, bond prices fall. When bond prices fall, and billions of dollars of principal are wiped out, often forever, investors get very nervous, and upset, and pull back, sending credit markets into a tizzy of illiquidity and fear, choking off access to the very forms of debt financing that drive the economy upward in the first place. A credit freeze often leads to financial panic and a financial crisis. That’s exactly what happened in 2008.

Between now and November 2020, expect Trump to treat Powell like a political opponent—hectoring, badgering, trying to get him to blink. And if Powell loses, everyone might. “The risk is that pervasive low interest rates cover up a lot of bad performance in the real world,” one senior Wall Street banker told me. “There’s a lot of zombie companies out there that wouldn’t be alive today but for the fact that rates are so low, and they can refinance at low rates and with low debt service. When the tide rolls out, we’re going to see a lot of crippled, naked swimmers.”