The prevailing mantra in many of today’s investment commentaries reminds me of the satirical plot to the 1964 Stanley Kubrick movie Dr. Strangelove, in which a deranged United States Air Force general orders a first strike nuclear attack on the Soviet Union, convinced that the Soviets have been adding fluoride to the United States’ water supplies to pollute the “precious bodily fluids” of Americans.
Today’s grumpy bears likewise allege that our central banks have been adding funny stuff to the world’s money supply via QE and have polluted the sanctity of the market pricing mechanism. As a result we have (too) high asset prices despite low growth and no inflation. In this pessimistic interpretation of the global economy the biggest complaint is the incapacity of central banks to raise interest rates; they have now been kept unchanged in the US for longer than during the Great Depression.
If only those dastardly public officials had not averted a 1930s style policy of mutually assured destruction, when the world’s monetary authorities stuck rigidly to the mantra of “hard-money” to the profound detriment of the real economy! Then, so they reason, we could have had the cathartic effects of a depression and by now, seven years later, a recovery would be in full swing, signs of inflation would be emerging and we could start raising interest rates…we would be saved! Strange days indeed…and now, like the mad Brigadier General Ripper, they pin their hopes on the first strike attack policy of creative destruction via unnecessary rate hikes, deluding themselves that such a disastrous course could possibly promote innovation, growth and prosperity.
Never mind that such a policy is most unlikely. To us, this is no way to build anything spectacular. An appropriate analogy perhaps is to compare the economy to the Amazonian rainforest – more complicated than we can possibly imagine. To us, the notion of not intervening, or worse the policy of pursuing tight monetary policy to ignite creative destruction is no way to protect and encourage a truly diverse ecosystem. Instead, we favour the modern orthodoxy whereby policy makers protect the system with their fire breaks allowing the disrupters like Uber and the explosion of free services ranging from Google Search to Skype to Wikipedia et al. to thrive and Forcibly redirect capital and labour elsewhere within the economy. Given enough time and a generous prescription of QE, and shorn of the tail risk of MAD policies, the global economy will eventually recover most of the diversity, durability and growth it once had.
But as it stands right now, macroeconomic presentations seem to have been lifted straight from the pages of religious pamphlets and science fiction novels which overwhelmingly present a future that is mainly worse than the present; a similar mood was evident in the first Jack Schwager Market Wizards book published, not surprisingly, after the calamity of the October 1987 crash. The best minds back then, like today, were convinced that our future was very bleak. We can only conclude that capital markets seem to hoard innately pessimistic desires and that therein lies the opportunity for risk takers like us.
Such anxiety has very much been to the fore again this year, something we found reassuring during the particularly tough months like August when the VIX spiked above 50 and again last month when we were subject to a vicious countertrend re-pricing of the year’s winners and losers. This angst is perhaps the true disease of the 21st century. Cancer and diabetes will most likely be cured in time (preferably by the European drug stocks that we own in our portfolio) but anxiety seems more deeply rooted in the human psyche. In markets, of course, it can be useful, especially if you become anxious before others; we have some good form here. Indeed, it is ironic that we are perhaps best known for advising “that you panic”. However, if you are anxious at the wrong time it can prove very painful. Today, we would advise that you don’t panic!
For markets do not crash when we are collectively so worried; it is like Hyman Minsky’s adage that stability destabilises except that today the reverse is more apt. In our minds it is as though quantitative easing and the zero lower bound of policy rates have replaced the capital markets’ airbag with a dagger protruding from the steering column. Market participants are hugely uncomfortable with today’s elevated prices and the lack of an obvious orthodox policy response should the global economy weaken further. Unsurprisingly there is little appetite to drive fast and the brakes are applied at the merest hint of danger. In short, by withdrawing the “Greenspan put” and using their asset purchase schemes to eviscerate any notion of value, the authorities have paradoxically created a safer yet more paranoid market.
The market’s fear of crashing has seen it thrash around looking for the merest hint of danger. First it was Europe, then the high yield credit space with the vulnerabilities of the shale oil issuers, and then it was back to Greece and then the mother of them all, China, with its falling property and stock prices seemingly knocking economic growth and making a sizeable devaluation inevitable. And yet nada… the weeping prophets have failed to force a crisis after one hell of a go. There have been no observable widespread bankruptcies in China, the shale oil sector is still pumping and despite the huge EM devaluation we haven’t exposed large fragile dollar debts which can’t be repaid or rolled over.
Perhaps we are being premature and the cards are about to fall. Or perhaps there simply are no dead bodies in the system and the global economy has proven itself much more resilient to shocks. We certainly believe that if we had been forewarned two years ago that the dollar would rise versus selected EM currencies by 50% and that important commodities such as oil and iron ore would fall by 50% we would never have been able to predict just how orderly things have turned out at both the company and sovereign level. The turmoil it seems has remained contained within financial markets in a very curious way. Like we said earlier, perhaps it’s time to stop worrying and love the bomb?
Tim Duy dissects the latest FED speak:
"Notice a theme above? Fed officials have little faith in any of their alternatives. They want to pull back from quantitative easing, fearing that the costs will turn against them soon, yet have little to offer in return. Not good - it is almost as if the Fed is beginning to believe that they are near the end of their rope.
Interestingly, one of the costs of quantitative easing seems to be the inability to exit quantitative easing.
Bottom Line: Clear evidence of the space we have been in for months. The Fed wants to taper, and is becoming increasingly nervous they will need to pull the trigger on that option before the data allows. That means that tapering is not data dependent. That means the policy deck is stacked with at least one wild card. And that sounds like a recipe for the kind of volatility the Fed is looking to avoid."
Send In The Clowns
BIS summarizes what I have repeatedly been saying about CBs creating systemic risk. Quoted in Hussman's latest weekly commentary.
“Originally forged as a description of central bank actions to prevent financial collapse, the phrase ‘whatever it takes’ has
become a rallying cry for central banks to continue their extraordinary actions. But we are past the height of the crisis, and the goal of policy has changed – to return still-sluggish economies to strong and sustainable growth. Can central banks now really do ‘whatever it takes’ to achieve that goal? As each day goes by, it seems less and less likely. Central banks cannot repair
the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to the real growth paths authorities and their publics both want and expect.
“What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.
“Alas, central banks cannot do more without compounding the risks they have already created. Instead, they must re-emphasise their traditional focus – albeit expanded to include financial stability – and thereby encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities. And they must urge authorities to speed up reforms in labour and product markets, reforms that will enhance productivity and encourage
employment growth rather than provide the false comfort that it will be easier later.”
I have been saying this for years. One of my challenges is that I see things many years in advance. As a friend of mine once told me, there is no corporate market for that skill.
Isn't it rich?
Isn't it queer?
Losing my timing this late in my career.
And where are the clowns?
There ought to be clowns...
Well, maybe next year.
"In this way, unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability. And this observation brings me to a key conclusion. I’ve suggested that it is likely that, for a number of years to come, the FOMC will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low. I’ve also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability. It follows that, for a considerable period of time, the FOMC may only be to achieve its macroeconomic objectives in
association with signs of instability in financial markets."
That's what I said nearly two years ago.
The central bank can create systematic risk while trying to stabilize the economy. I said this 18 months ago.‘constructive ambiguity’ needs to be reevaluated.
I picked up a copy of``` Psychology Today`` last Christmas and I came across an interesting article on road design and safety. It turns out that the flatest, widest roads are the most dangerous. Engineers are now designing roads with obstacles and making them more narrow in order to make them safer.
I had been thinking a lot, before running into that article, about this very idea wih resepct to central bank behaviour. I believe the US Federal Reserve telegraphs too much in terms of its policy intentions and the market has become somewhat addicted to the Federal Reserve bailing it out in times of trouble. I don´t think it is healthy for the market to perceive a ``Bernake put``. Furthermore, as I mentioned in an earleir post ``We are all hedge fund managers now`` the central bank is creating an incentive to market particpants to play much of the same game in selling short term risk. This is apparent from the levels of the VIX in the aftermath of the global finanacial crisis.
To me optimal central bank policy would have a level of randomnss, where interest rates could go up even in a recession even without inflation being sparked. This would have the effect of increasing volatility and cause everybody in the economy to delever because VaR models set their limits on the basis of volatility. Taken far enough it would encourage long term contracting and thus further reduce interest rate exposure to the broader economy. Clearly, this is going to be a problem as we move to higher interest rates because everyone is on the short end floating - getting to fixed is going to be tricky.
And yet as much as unpredicatable is optimal; it is very difficult to operationailze. Imagine if the Fed would say , ``our randomenss model tells us we need to set short term rates at 3% - right now``. A recent blog post highlights this tension:
Much like John Boyd, Sun Tzu emphasised the role of deception in war: “All warfare is based on deception”. In the context of regulation, “deception” is best understood as the need for the regulator to be unpredictable. This is not uncommon in other war-like economic domains. Google, for example, must maintain the secrecy and ambiguity of its search algorithms in order to stay one step ahead of the SEO firms’ attempts to game them. An unpredictable regulator may seem like a crazy idea but in fact it is a well-researched option in the central banking policy arsenal. In a paper for the Federal Reserve bank of Richmond in 1999, Jeffrey Lacker and Marvin Goodfriend analysed the merits of a regulator adopting a stance of ‘constructive ambiguity’. They concluded that a stance of constructive ambiguity was unworkable and could not prevent the moral hazard that arose from the central bank’s commitment to backstop banks in times of crisis. The reasoning was simple: constructive ambiguity is not time-consistent. As Lacker and Goodfriend note: “The problem with adding variability to central bank lending policy is that the central bank would have trouble sticking to it, for the same reason that central banks tend to overextend lending to begin with. An announced policy of constructive ambiguity does nothing to alter the ex post incentives that cause central banks to lend in the ﬁrst place. In any particular instance the central bank would want to ignore the spin of the wheel.” Steve Waldman summed up the time-consistency problem in regulation well when he noted: “Given the discretion to do so, financial regulators will always do the wrong thing.” In fact, Lacker has argued that it was this stance of constructive ambiguity combined with the creditor bailouts since Continental Illinois that the market understood to be an implicit commitment to bailout TBTF banks.