Too Many Worship At The Alter Of The Federal Reserve
It seems there is a tremendous amount of hope the Fed is going to save the equity markets, the housing markets and the global economy. In fact, I've already decided that the Fed should be responsible for saving my soul. Many believe the Fed is omnipotent. In the end, I hope the Fed can save us from the imbalances we face, but I don't invest based on hope. I tried that. I hope my stock goes back up. That never worked for me. For all the hope I mustered, I could have saved the world but I couldn't save my investments from going down. Hope is an investor's worst quality. Hope will get you a wish sandwich .
The reality? The Fed has an awful track record of saving the economy. Of course, the Fed did, for the most part, save the economy in 2000. One of the shortest recessions in modern times. Did the Fed save your stock portfolio too? The economy is not the stock market. It never has been and it never will be. Those who confuse this fact are called economists. And, for some reason we look to economists for validation as to whether we should be invested in equities. Maybe that's why nearly all of them kept telling us the economy was great as the Nasdaq declined 75-80% odd percent.
In this cycle, the Fed is in a box and there is little wiggle room. I'm not going to write a thesis but it will be interesting to see how central bankers react when the economic data continues to weaken. If the Fed cuts rates, the dollar could drop out of historical bands to new lows. That would create unknown circumstances and the associated fear in financial markets. Of course, I'm not convinced the Fed and the G7 nations aren't attempting to ease the dollar lower as they did in the 1980s. Cutting rates would also likely push up the long end of the yield curve as would a falling dollar. That would put pressure on housing.
If the Fed does nothing, the economy will continue to slow and the world's inflated assets, including housing, will start to deflate. So, what's the answer? It's time to take your medicine and it isn't likely to taste like cherry soda either. The best we can probably hope for is the Fed with one foot on the accelerator and one foot on the brake as we saw in the 1970s.
Here's the fundamental problem. Most modern day economists, including the Fed, don't have a strong belief in cycle theory or the need to purge long wave excesses and dislocations that develop. They drink from the trough of knobs and dials. Maybe they are right but there is a reasonable argument they add to the misery by fiddling. That fiddling may prolong the cleansing process and take away one of the advantages of said process which is lower prices for consumers. When modern day economic theory came to the forefront, most economists prattled on of how their theory would make the business cycle a relic. Of course, that was before we saw nearly twenty years of stagnation in the late 1960s to early 1980s. At that point they had to eat those words. I believe economics is less about knobs and dials and more about the basic irrational aspects of the human mind. (Ultimately, most economists do understand this but most aren't armed to deal with it.) Thus, it is my concern that any Fed attempts to save the economy will simply be met with more severe dislocations.
If you look at history, we have two outcomes that could develop. One is a long wave secular bear market for bonds. In other words, higher and higher interest rates. The other is a long wave of deflationary pressures and very low interest rates or even negative real rates. (Ever try to get a bank to loan money with negative real rates? That would be swell for the economy.) The future is really dependent on the past, present and future action of central bankers as much as anything. I firmly believe the Fed can only inflate the economy so far. At a certain point it becomes throwing gasoline on the fire.
In the end, I believe there is more and more evidence that we are reliving the 1930s for many reasons. That is opposed to reliving the 1970s. There is a caveat to my statement. That caveat is this is the 1930s revisited with the Fed instituting perceived lessons learned from the 1929 fiasco they helped create. In other words, this is the great Bernanke experiment and you have the pleasure of living through it. We should all hope for his success. There I go with hope again. For those of you who don't know, Bernanke is likely the foremost economic authority and the foremost central banking authority on the Great Depression and the role the Fed played in creating it. Regardless of where we are comparatively, the Fed cannot and will not save us from ourselves at all times. Nor can save asset repricing.
Here's why this isn't the 1990s where the Fed was able to avoid recession. The Fed can create liquidity but it cannot direct it. So, when the Fed cut rates post 2000, they couldn't demand it go into capital equipment, research & development, manufacturing or technology as happened in the 1990s. It went the excess liquidity pot from hell including commodities, private equity, emerging markets, etc because the capital goods sector was and still is in a contraction and they had no demand for money as I've said ad infinitum. Look at the multiple studies done by attempting to calculate the GDP effect of mortgage equity withdrawals. The end result is the economy contracted or grew marginally grew for the last six years without MEWs. The estimates depend on how the calculation is done and how much of an assumption you make for MEW's being spent. (See the Calculated Risk link to the right for more on this.)
So, if the capital goods sector won't take money today at 4.5% long rates and 5% short rates, is it going to take money at 3% short term rates? Well, given the capital goods sector is less dependent on interest rates, I'd venture to say no. As an aside, while I am an advocate of the Bush tax cuts, there is a valid argument to be had that it simply made a bigger mess. One day central bankers will learn their job is more than knobs and dials. They'll understand the social nuances in economics and plan for dislocations. Then when they arise, liquidity will be targeted with coordinated government policies such as investment tax credits, or incentives for investment. And, disincentives including tougher mortgage and banking regulations to save us from ourselves. Or, maybe I'm dreaming at that won't happen. There's an argument to be had that the government shouldn't be targeting anything. Well, except for asset bubbles.
The chart below is the monthly chart of the ten year Treasury. Notice the trend for now is up for long interest rates. That is why banks have recently come to life. The markets see a return for the bank carry trade and higher profits. But, housing has been weakening as long rates have started rising. So, who's right? Banks or housing? Time to sell bonds? The bond market appears to be concerned about central bankers blinking, or the dollar, or the forex carry trade unwinding, or something. There's alot of long positions in the Treasury market. In other words, we could see some weird and rapid Treasury movements over the next year.
In June and July when people were scared to death, some wondered if 1987 was being relived. The general commentary laughed 1987 off. While I didn't have my own blog at the time, I wasn't so quick to waive 1987 off when I was bloviating on other blogs. Emerging markets were like a yo-yo and some were down 30-50% in a month. My argument was how many times in the last one hundred years how many times has that happened in the U.S.? How about once? 1987. Now, we've recovered and everyone is all happy again. So, now as more time has passed, all has been forgotten. Many emerging markets have recovered. Some even have made new highs. Now, I'm not an 1987 expert but I also know there was a feeling of invincibility because everyone had portfolio insurance. Looks like we are closing in on a similar situation today. The U.S. won't have any one day selloffs like 1987 because we have new controls in place. But, what else was 1987? The culmination of a mini mania in mergers & acquisitions driving markets higher. Markets can go to the moon on M&A, private equity, stock buy backs or whatever you wish. That doesn't mean the markets will stay there.
The net? If the Fed cuts rates, don't expect a miracle. Companies already have record cash sitting on their balance sheets. I'm not really convinced they need more access to capital since we are swimming in it. Are you? Of course, financial institutions could always lend more credit to individuals. Not likely. So where will it go if the Fed gooses the economy? No place constructive in my estimation. In other words, more dislocations.
The reality? The Fed has an awful track record of saving the economy. Of course, the Fed did, for the most part, save the economy in 2000. One of the shortest recessions in modern times. Did the Fed save your stock portfolio too? The economy is not the stock market. It never has been and it never will be. Those who confuse this fact are called economists. And, for some reason we look to economists for validation as to whether we should be invested in equities. Maybe that's why nearly all of them kept telling us the economy was great as the Nasdaq declined 75-80% odd percent.
In this cycle, the Fed is in a box and there is little wiggle room. I'm not going to write a thesis but it will be interesting to see how central bankers react when the economic data continues to weaken. If the Fed cuts rates, the dollar could drop out of historical bands to new lows. That would create unknown circumstances and the associated fear in financial markets. Of course, I'm not convinced the Fed and the G7 nations aren't attempting to ease the dollar lower as they did in the 1980s. Cutting rates would also likely push up the long end of the yield curve as would a falling dollar. That would put pressure on housing.
If the Fed does nothing, the economy will continue to slow and the world's inflated assets, including housing, will start to deflate. So, what's the answer? It's time to take your medicine and it isn't likely to taste like cherry soda either. The best we can probably hope for is the Fed with one foot on the accelerator and one foot on the brake as we saw in the 1970s.
Here's the fundamental problem. Most modern day economists, including the Fed, don't have a strong belief in cycle theory or the need to purge long wave excesses and dislocations that develop. They drink from the trough of knobs and dials. Maybe they are right but there is a reasonable argument they add to the misery by fiddling. That fiddling may prolong the cleansing process and take away one of the advantages of said process which is lower prices for consumers. When modern day economic theory came to the forefront, most economists prattled on of how their theory would make the business cycle a relic. Of course, that was before we saw nearly twenty years of stagnation in the late 1960s to early 1980s. At that point they had to eat those words. I believe economics is less about knobs and dials and more about the basic irrational aspects of the human mind. (Ultimately, most economists do understand this but most aren't armed to deal with it.) Thus, it is my concern that any Fed attempts to save the economy will simply be met with more severe dislocations.
If you look at history, we have two outcomes that could develop. One is a long wave secular bear market for bonds. In other words, higher and higher interest rates. The other is a long wave of deflationary pressures and very low interest rates or even negative real rates. (Ever try to get a bank to loan money with negative real rates? That would be swell for the economy.) The future is really dependent on the past, present and future action of central bankers as much as anything. I firmly believe the Fed can only inflate the economy so far. At a certain point it becomes throwing gasoline on the fire.
In the end, I believe there is more and more evidence that we are reliving the 1930s for many reasons. That is opposed to reliving the 1970s. There is a caveat to my statement. That caveat is this is the 1930s revisited with the Fed instituting perceived lessons learned from the 1929 fiasco they helped create. In other words, this is the great Bernanke experiment and you have the pleasure of living through it. We should all hope for his success. There I go with hope again. For those of you who don't know, Bernanke is likely the foremost economic authority and the foremost central banking authority on the Great Depression and the role the Fed played in creating it. Regardless of where we are comparatively, the Fed cannot and will not save us from ourselves at all times. Nor can save asset repricing.
Here's why this isn't the 1990s where the Fed was able to avoid recession. The Fed can create liquidity but it cannot direct it. So, when the Fed cut rates post 2000, they couldn't demand it go into capital equipment, research & development, manufacturing or technology as happened in the 1990s. It went the excess liquidity pot from hell including commodities, private equity, emerging markets, etc because the capital goods sector was and still is in a contraction and they had no demand for money as I've said ad infinitum. Look at the multiple studies done by attempting to calculate the GDP effect of mortgage equity withdrawals. The end result is the economy contracted or grew marginally grew for the last six years without MEWs. The estimates depend on how the calculation is done and how much of an assumption you make for MEW's being spent. (See the Calculated Risk link to the right for more on this.)
So, if the capital goods sector won't take money today at 4.5% long rates and 5% short rates, is it going to take money at 3% short term rates? Well, given the capital goods sector is less dependent on interest rates, I'd venture to say no. As an aside, while I am an advocate of the Bush tax cuts, there is a valid argument to be had that it simply made a bigger mess. One day central bankers will learn their job is more than knobs and dials. They'll understand the social nuances in economics and plan for dislocations. Then when they arise, liquidity will be targeted with coordinated government policies such as investment tax credits, or incentives for investment. And, disincentives including tougher mortgage and banking regulations to save us from ourselves. Or, maybe I'm dreaming at that won't happen. There's an argument to be had that the government shouldn't be targeting anything. Well, except for asset bubbles.
The chart below is the monthly chart of the ten year Treasury. Notice the trend for now is up for long interest rates. That is why banks have recently come to life. The markets see a return for the bank carry trade and higher profits. But, housing has been weakening as long rates have started rising. So, who's right? Banks or housing? Time to sell bonds? The bond market appears to be concerned about central bankers blinking, or the dollar, or the forex carry trade unwinding, or something. There's alot of long positions in the Treasury market. In other words, we could see some weird and rapid Treasury movements over the next year.
In June and July when people were scared to death, some wondered if 1987 was being relived. The general commentary laughed 1987 off. While I didn't have my own blog at the time, I wasn't so quick to waive 1987 off when I was bloviating on other blogs. Emerging markets were like a yo-yo and some were down 30-50% in a month. My argument was how many times in the last one hundred years how many times has that happened in the U.S.? How about once? 1987. Now, we've recovered and everyone is all happy again. So, now as more time has passed, all has been forgotten. Many emerging markets have recovered. Some even have made new highs. Now, I'm not an 1987 expert but I also know there was a feeling of invincibility because everyone had portfolio insurance. Looks like we are closing in on a similar situation today. The U.S. won't have any one day selloffs like 1987 because we have new controls in place. But, what else was 1987? The culmination of a mini mania in mergers & acquisitions driving markets higher. Markets can go to the moon on M&A, private equity, stock buy backs or whatever you wish. That doesn't mean the markets will stay there.
The net? If the Fed cuts rates, don't expect a miracle. Companies already have record cash sitting on their balance sheets. I'm not really convinced they need more access to capital since we are swimming in it. Are you? Of course, financial institutions could always lend more credit to individuals. Not likely. So where will it go if the Fed gooses the economy? No place constructive in my estimation. In other words, more dislocations.
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