Bloomberg Radio/Television’s Tom Keene, Wednesday June 14, 2017: “Professor, what is the question you want to ask chair Yellen at the press conference here in six minutes?”
Narayana Kocherlakota, former president of the Minneapolis Fed: “I think the question to ask is ‘Why are you continuing to hike rates in such a low inflation environment?’. There doesn’t seem to be any risk to keeping rates low and lots of benefits to it.”
Torsten Slok, chief international economist at Deutsche Bank: “What are their arguments why this move down in inflation is only temporary?”
Bloomberg’s Keene: “Krishna, what do you want to know? Please keep the stock markets up?”
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Krishna Memani, chief investment officer of Oppenheimer Funds: “I want to know what would it take for you to get off the path of tightening? What would the data have to show you to get off the path you have set the Fed on?”
Bloomberg’s Keene: “Do you agree with vice chairman Fischer that we are still ultra-accommodative even with the low inflation…?”
Memani: “Yes we are, and there’s no downside because despite ultra-accommodative policies there’s no uptick in inflation. So we can press on the pedal as much as we want without it effecting the economy negatively.”
Bloomberg’s Keene: “Professor, do we have a good understanding of where we are in our technological economy – do you have a belief in the data that the good PhDs at the Fed are coming up with on productivity, on the measurement of price change, on GDP? Do you have faith in the numbers?”
Kocherlakota: “I have faith. It’s definitely a difficult job to be doing – to be measuring productivity in the kind of changing economy that we’re in. But I have faith in that. I look at the data, I try to keep track of not just what’s going on at the aggregate level but individual price changes and I think we’re living in a low inflation world and that gives the Fed a lot more room to stay accommodative.”
Bloomberg’s Scarlet Fu: “Is there any central bank that’s doing it right, Torsten? You’re an international economist. Is the ECB doing it better? Is the BOE doing better? Is the Bank of Canada doing it better?”
Slok: “There are important nuances, but I actually think that central banks have done extremely well. They have supported the economy as good as they can; they have invented new tools and instruments. We can debate if they were the right tools at the right time – the right dose. But I still will argue, at the end of the day, that what else should they have done, if we had been sitting in their chairs? I think we would have done the same thing. You can’t invent new tools and [do] Monday morning quarterbacking again without having another framework that’s better. This has proven again and again that this was the right way to look at. And you need to come up with some other reason or some other model, and there really is no convincing model other than what the Fed is saying.”
It’s not as if we don’t learn from history. It’s just that more recent history has such a predominant effect on our thinking and perspectives. Nowhere is this truer than in the financial markets.
It’s been going on nine years since the “worst financial crisis since the Great Depression.” We’re now only two months from the 10-year anniversary of the Fed’s August 17, 2007 extraordinary measures: “To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 bps reduction in the primary credit rate to 5-3/4%.”
This extraordinary inter-meeting response to a faltering market Bubble marked the beginning of unprecedented global central bank stimulus that continues to this day. It’s worth noting that the Fed’s August 2007 efforts did somewhat prolong the Bubble. The S&P500 traded to a then record 1,562 on October 12, 2007 (Nasdaq peaked in November). Extending “Terminal Phase” mortgage finance Bubble excess, 30-year mortgage rates dropped below 5.7% by early-2008, down about 100 bps from early-August 2007. And trading at about $72 a barrel in August, crude oil then went on a moonshot to surpass $140 by June 2008.
Memories of the devastating effects of Credit and asset Bubbles have faded from memory. The disastrous aftermath of the Fed aggressively stimulating mortgage Credit – as the centerpiece of its post-“tech” Bubble reflation strategy – has been wiped away by the cagey hand of historical revisionism. The consequences of loose financial conditions – i.e. speculation, malinvestment, maladjustment, deep structural economic impairment, financial system fragility, wealth redistribution – no longer even merit consideration. Instead, it’s accepted as fact that central bank stimulus has been a huge and undeniable success. With inflation so low, central banks “can press on the pedal as much as we want without it effecting the economy negatively.” “There doesn’t seem to be any risk to keeping rates low and lots of benefits to it.” This never has to end.
These folks are “charlatans” and “monetary quacks”, terminology pulled from analysis of the long and sordid history of monetary booms and busts. Today’s central bankers are destroying the sanctity of money with no meaningful pushback. And while they risk calamity, pundits claim there’s little risk in zero rates and creating Trillions of new “money.” So long as securities prices are high, all must be well in the markets and with policy.
I am reminded of a parable coming out of the late-eighties commercial real estate boom and bust. A developer walks into a bank hoping for a loan to finance a wonderful new development idea. The loan officer thinks to herself, “This guy is a visionary and surely must know what he’s doing or he wouldn’t be here.” Sitting across the table from the loan officer, the developer is thinking “she’s a whiz with the numbers and wouldn’t think of lending me a dime if this plan doesn’t make financial sense.” So the relationship is cemented, the loan is made and everyone is happy – for a while.
These days, securities markets have raged on the notion of “enlightened” central bank monetary management. Meanwhile, central bankers have viewed robust markets as validation of the ingenuity of both their measures and overall policy frameworks. Everyone is happy – for now.
The crisis put the fear of God into Central bankers back in 2008/09 – and there have been a few unnerving reminders since. It’s difficult to believe most buy into the notion that low inflation ensures there’s little risk associated with sticking with extreme accommodation. Surely they’re familiar with the history of the late-twenties. And I believe there is a consensus view taking shape within the global central banker community that monetary policy should be moving in the direction of normalization. The Fed raised rates Wednesday, and the week was notable as well for less than dovish comments out of the Bank of England and Bank of Canada. And while the Bank of Japan left monetary policy unchanged, there has been a recent notable reduction in the quantity of bonds purchased. This week also saw Finance Minister Schaeuble (among other German officials) urging the ECB to prepare to reverse course.
I do think central bankers would prefer to remove some accommodation – and they won’t this time around be as disposed to flinch at the first sign of a market hissy fit. The Fed has now raised the fed funds rate four times, and financial conditions are as loose as ever. Securities markets have grown convinced that central bankers will not tighten policy to the point of meddling with the great bull market. Such market assurance then works to sustain loose financial conditions, a backdrop that will prod central bankers to move forward with accommodation removal.
I believe passionately in the moral and ethical grounds for sound money. It is a policy obligation at least commensurate with national defense. From my perspective, one can trace today’s disturbing social, political and geopolitical circumstance right back to the consequences of decades of unsound “money” and Credit. At this point, downplaying the risks of ultra-loose central bank policy measures is farcical.
Beyond morality and ethics, there are a more concrete practical issues that seems to escape conventional analysts. Desperate central bankers resorted to a massive “money printing” (central bank Credit) operation at the very heart of contemporary finance. Not surprisingly, years later they remain trapped in this inflationary gambit. They have manipulated interest rates, imposed zero rates on savings and forced savers into the risk markets. After nurturing a $3.0 TN hedge fund industry, monetary policymaking then promoted at $4.0 TN ETF complex. Near zero rates have accommodated an unprecedented expansion of global government and government-related debt. In China, ultra-loose global finance helped push a historic Bubble to unbelievable extremes.
History will look back at these measures as a most regrettable end game to a runaway multi-decade Credit and financial Bubble. When confidence wanes – in the moneyness of electronic central bank “money”; in the ability of central banks to manipulate market yields and returns; in the perception of money-like liquid and low-risk equities and corporate debt; in China – global policymakers will have lost the capacity to control financial and economic developments. It was a epic mistake to embark on almost a decade of central bank liquidity injections to reflate and then backstop global securities markets. To believe that structurally low consumer price inflation justifies ongoing aggressive monetary stimulus is foolhardy.
We’ve entered a dangerous period for the securities markets. Highly speculative markets have diverged greatly from underlying economic prospects. Unstable markets have been fueled by central bank liquidity and the belief that central bankers will not risk removing aggressive stimulus. At the minimum, there is now considerable uncertainty regarding the remaining two main sources of global QE (ECB and BOJ) out past a few months. Meanwhile, the Fed continues on a path of rate normalization, a course other central banks expect to follow. The monetary policy backdrop is in the process of changing. Peak Stimulus Has Passed.
Bull markets create their own liquidity. Especially late in the cycle, speculative leveraging spawns self-reinforcing liquidity abundance. Even with a diluted punch bowl, the party can still rave for a spell. Yet these days the changing backdrop significantly boosts the odds that the next risk-off episode sparks a problematic liquidity issue. It’s been awhile since the markets experienced de-risking/de-leveraging without the succor of a powerful QE liquidity backdrop.
According to JPMorgan’s Marko Kolanovic (via zerohedge), an incredible $1.3 TN of S&P500 options expired during Friday’s quarterly “quad witch” expiration. I have always been of the view that derivative trading strategies played a prevailing role in the final speculative blow-off in the big Nasdaq stocks back in Q1 2000. Coincidence that the Nasdaq 100 (NDX) peaked around March 2000 “triple witch” option expiration? After trading at a record high 4,816 on March 24, 2000, the NDX sank below 1,100 in August 2001 before hitting a cycle low 795 on October 8, 2002. Let this be a reminder of how quickly euphoria can vanish; how abruptly greed is transformed into fear; and how rapidly company, industry and economic fundamentals deteriorate when Bubbles burst.
The S&P500 traded to new all-time highs Wednesday, before a resumption of the technology selloff pressured major indices lower. After trading above 12 on Monday and Wednesday, the VIX retreated into Friday’s close (10.38). Such a low VIX reading doesn’t do justice to the volatility that is coming to life below the market’s veneer. The bank stocks (BKX) traded as high as 94.85 at Monday’s open and then retreated to a low of 93.24 before lunch, then traded to 94.93 Tuesday morning and then to 92.59 mid-session Wednesday – before rallying back to 94.78 Thursday and concluding the week at 93.94. The NDX traded as low as 5,633 Monday, then rallied to 5,774 Wednesday’s then as low as 5,635 early-Thursday – before closing the week down 1.1% at 5,681.
Thursday trading was the most interesting of the week. At one point, the S&P500 was approaching a 1% decline, with larger losses for the broader indices. The NDX was down as much as 1.6%. Yet despite weak equities, Treasury yields were grinding higher (up 4bps for the session). Both investment-grade and high-yield bonds were under modest selling pressure. Meanwhile, the currencies were trading wildly. The yen reversed abruptly lower, trading in an almost 2% range during the session. It was a market day that seemed to provide an inkling of what a more generally problematic de-risking episode might look like. But it was not to be this time, not with “quad witch” approaching. A significant amount of market “insurance” (put options) purchased over the past month (Trump/Comey/investigation uncertainties) expired worthless.
Returning to earlier, “There doesn’t seem to be any risk to keeping rates low…”, I would point directly to the incredible explosion in options trading (thought it was enormous before!). The VIX is indicative of one of the more conspicuous market distortions nurtured by low rates and central bank liquidity backstops. Anyone not seeing derivatives markets – the epicenter of central bank-induced risk misperceptions and price deviance – as one gigantic accident in the making hasn’t been paying attention.
Clearly, the (distorted) low cost of “market insurance” promotes destabilizing risk-taking and speculative leveraging. Moreover, derivative-related market leverage – in sovereign debt, corporate Credit, equities and commodities – is surely instrumental in what has evolved into a self-reinforcing global liquidity and price Bubble. Furthermore, these dynamics are integral to what has evolved into a major divergence between ultra-loose financial conditions in the markets and a central bank preference for marginally less accommodation.
I have little confidence that central bankers are on top of market developments. I do, however, suspect that they have become increasingly concerned by the markets’ general disregard for economic fundamentals and policy normalization measures. Central bankers over recent years have grown increasingly confident in their extraordinary control over securities markets. At least from the Fed’s vantage point, there must be some reflecting that perhaps markets have left them behind. Fed officials still talk the inflation and employment mandate along with “data dependent.” But they’ve now got at least one eye fixed on the markets.
In a period of such profound uncertainties, there’s one thing that is certain by now: central bank accommodation exerts powerful inflationary effects upon securities and asset prices. And for the first time in a while, unstable asset market Bubbles pressure central bankers to remove accommodation. Sure, they don’t want to be in the Bubble popping business, though when it comes to market Bubbles the sooner they pop the better. Surreptitiously, tremendous amounts of structural damage occur during late-cycle excess. Markets are indicating an initial recognition of structural issues.
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