Since the Fed began raising interest rates in December 2015, financial market liquidity conditions have loosened considerably. Recall our post, Orwellian Monetary Policy, which we wrote in May.
“Tightening is Easing”
Since U.S. monetary policy began tightening in December 2015, the Fed has added liquidity to the financial system through interest payments to banks on excess reserves and has reduced its surplus to the Treasury adding to the fiscal deficit. Thus the financial system has had an effective injection of central bank liquidity and a fiscal expansion during a period of monetary tighenting. – Global Macro Monitor
The current Fed policy effectively injects liquidity into the financial system through raising the IOER rate — printing money to make interest payments on reserves banks hold on deposit at the Fed. This compares to the traditional monetary policy where the Fed drains reserves from the financial system to drive the Fed Funds rate higher. We are years off to getting back to traditional monetary policy. Maybe not in our lifetime.
Performance of Stocks, Bonds, and Emerging Markets
No wonder then markets are going bonkers. Take a look at the performance of a select list of indicators since the Fed began raising interest rates.
The S&P500 is at an all-time high, up over 20 percent since the Fed shifted to a tightening regime; the 10-year Treasury yield is only up 5 bps; the 10 minus 2’s yield curve is 32 bps flatter; the dollar index is down -3.12 percent (we expect a big rally if any healthcare bill passes) ; the VIX is down over 50 percent and closing in on its December 22, 1993, all-time closing low of 9.31 and will probably take out its intraday all-time low of 8.89, set on December 27, 1993, sometime very soon. The VIX has only traded below 9 one time. See here for how the two VIX indices were concatenated or spliced together in 2003, merging the OEX VIX (VXO) with the SP500 VIX.
Emerging Markets Hot, Hot, Hot!
More impressive is the performance of the emerging markets. Wasn’t Fed tightenings supposed to, and have historically, wreaked havoc on EM capital flows? The JP Morgan EM Bond ETF (EMB) is up over 16 percent and the emerging market stock ETF (EEM) is up almost 40 percent! The Mexican peso has rallied 20 percent since January 19, which is mainly due to the Trump slump in the polls. Stunning, nonetheless.
“John Bull can stand many things, but he cannot stand 2.0 , [-1.5 or 1.25] percent” – Bagehot
No great flop in commodities either with the CRB essentially flat since the Fed began raising interest rates.
Fed Has Lost Control
The Fed has once again lost control of a big part of monetary policy. Its ability to influence the risk taking incentives of the markets (see chart below). This is not the first time, but it has been exacerbated by the structure of the new monetary policy, of which we spoke about earlier.
No judgement, whatsoever, on the policy makers. They saved the system and kept many of us from living under freeways and have a very difficult job. They now find themselves in a real dilemma, however, with another major global asset bubble on their hands.
We believe this is why the Fed has quickened its pace to start shrinking their balance sheet. Rather than being forced to overshoot interest rates, which could adversely affect the economy, the Fed will start draining reserves through balance sheet reduction hoping to introduce some risk aversion and sense back into the giddy global markets.
Real Interest Rates
Finally take a look at real interest rates. The current level of the 10-year real Treasury yield, calculated as the nominal yield less the 1-year lagged PCE deflator, is only at the 19th percentile on a monthly basis going back to the early 1960’s. Our sense is rates are going to have to move much higher (200-300 bps) and quantitative tightening is going to take some time to really break these markets and burst the global asset bubbles.
Asset bubbles don’t pop very easy, until they do.
In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” – Rudiger Dornbusch
The first derivative trade, that is selling when the direction of policy changes, is not going to cut it this time around. Global interest rates are just too low and the flood of central bank liquidity is too high.
The bears are much too loud and adamant and the buy the dipper Algos are in control. Until they aren’t.
Nevertheless, assets are exteremly expensive, monetary policy is moving in the wrong direction and the market is very vulnerable to a sharp sell off given a Black Swan event, which we increasingly think may be some sort of geopolitical shock or a humumgous populist backlash, for example, as the wealth gap continues to widen.
Billionaire preppers. Did you ever think you see the day?
…survivalism has expanded to more affluent quarters, taking root in Silicon Valley and New York City, among technology executives, hedge-fund managers, and others in their economic cohort. – New Yorker, Jan 30, 2017
We are thinking October for a sigfinicant correction as the Fed should be on their way to getting smaller and China’s Party Congess should have concluded raising the risk of a market or policy shock in the Middle Kingdom. But everyone is looking for the same.
It is tough and sometimes a career killer to watch a runaway market waiting for Godot a market correction that doesn’t show up. That keeps a “night sweat bid” in the market. You know, when your under allocated and the market keeps ramping and you awake in the middle of the night in a cold sweat. Night sweats and migraines. We don’t miss those days.
Finally, the path of least of resisitance seems to be higher for risk assets, but as Ray Dalio says,
… keep dancing but closer to the exit and with a sharp eye on the tea leaves. – Ray Dalio