'..The monetary policy approach that evolved from serial boom and bust dynamics has been to backstop marketplace liquidity, while assuring participants that central banks will respond aggressively in the event of market or economic instability. By extending boom phases, this policy doctrine has created the allusion of stability for an innately unstable system.''Powell's Wednesday presentation was titled, "The Federal Reserve's Framework for Monitoring Financial Stability" (with a reference to Hyman Minsky!). The Fed's introductory Financial Stability Report had been published the previous day. "This report summarizes the Federal Reserve Board's framework for assessing the resilience of the U.S. financial system and presents the Board's current assessment. By publishing this report, the Board intends to promote public understanding and increase transparency and accountability for the Federal Reserve's views on this topic. Promoting financial stability is a key element in meeting the Federal Reserve's dual mandate for monetary policy regarding full employment and stable prices."
I appreciate the Fed's attention to financial stability, stating explicitly the central role it plays within its broader mandate. Powell's speech offered a definition of "financial stability:" "A stable financial system is one that continues to function effectively even in severely adverse conditions. A stable system meets the borrowing and investment needs of households and businesses despite economic turbulence. An unstable system, in contrast, may amplify turbulence and prolong economic hardship in the face of stress by failing to provide these essential services when they are needed most."
It's a commendable effort to craft such complex subject matter into a characterization accessible to the general public. However, I would broadly argue that unfettered contemporary finance - dominated by securities markets, derivatives and speculative trading - is an "unstable system." Conditions will gravitate to excessive looseness during booms, only to tightened dramatically come the inevitable eruption of "risk off." The monetary policy approach that evolved from serial boom and bust dynamics has been to backstop marketplace liquidity, while assuring participants that central banks will respond aggressively in the event of market or economic instability. By extending boom phases, this policy doctrine has created the allusion of stability for an innately unstable system.
Significant thought and effort went into crafting the Fed's 37-page document. It is full of important data and insight. And, from my perspective, it as well illuminates key holes in the Fed's approach to monitoring financial stability. There's certainly a "generals fighting the last war" predisposition embedded within the Fed's analytical framework.
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Throughout this Bubble period, I have referred to the "Moneyness of Risk Assets." A "run" on money-like Credit instruments sparked the collapse of the mortgage finance Bubble. Runs unfold when holders of perceived safe and liquid instruments suddenly recognize risk is much greater than previously appreciated. Past crises have typically originated in the money markets. But never have central bank and government policies so fostered the perception of safety and liquidity ("moneyness") for risk assets - equities and corporate Credit, in particular. I would argue the proliferation and massive growth of index fund products poses a major risk to financial stability. And when it comes to policy-induced distortions, already extraordinary risks to financial stability are only compounded by the proliferation and growth of derivative trading strategies, both retail and institutional.'
- Doug Noland,
Framework for Monitoring Financial Stability, December 1, 2018
'Put simply, the extraordinary and experimental policies of quantitative easing and zero interest rates have not been “good” except in the myopic sense of encouraging a short-term burst of very bad choices and misallocations of capital. While it’s unfortunately necessary to tolerate cartoonish rants on CNBC about a potential Fed “policy error” as it normalizes interest rates, the fact is that the policy error is way, way behind us, and the Fed already made it.
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..Once interest rates hit zero, so did the collective IQ of Wall Street. Even responding to the most overextended warning flags was detrimental. A year ago, I resolved that while sufficiently extreme conditions can put us in a neutral stance, we would no longer adopt a bearish outlook unless market internals had deteriorated explicitly – no exceptions. That’s why I’ve looked “smarter” since then. I became content to identify the presence or absence of speculative pressures, and completely abandoned the belief that reckless speculation has “limits.”
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The completion of this cycle will be challenging for conventional wisdom. One of the dangers of the recent speculative episode is that investors have come to believe that Fed policy and easy money always supports the financial markets. They forget that the Fed eased persistently and aggressively throughout the 2000-2002 and 2007-2009 collapses, both which cut the stock market in half.''Of all the delusions that have infected the minds of economists, central bankers, and the investing public in recent years, perhaps none is as short-sighted and pernicious as the idea that aggressively low interest rates are “good” for the economy and the financial markets.
There is, of course, a certain truth to that idea, roughly equivalent to proposing that snorting amphetamine-laced cocaine is “good” for one’s energy, or that walking into a bar and randomly choosing partners while wearing a blindfold is “good” for one’s love life. In each case, however, the validity of the claim comes from subverting the word “good” to mean nothing more than a short-lived burst of very bad choices.
Back in 2003, Alan Greenspan mixed the soap of what would become the housing bubble by holding interest rates to just 1%. Investors responded to the uncomfortably low yields on Treasury bills by looking for alternatives that offered a seemingly safe “pickup” in yield. They found that alternative in mortgage securities. Wall Street was more than happy to satisfy the demand for more “product,” as they called it, by creating more mortgage bonds. But see, creating a mortgage bond requires you to actually make a mortgage loan to someone, which is how we got zero-down, no-doc, interest-only loans. “No credit? No problem!” Well, no problem in the short-term. Over the next few years, that bubble of Fed-induced yield-seeking speculation would reach its peak, and then collapse, producing the worst financial crisis since the Great Depression.
In my 2003 piece outlining that developing bubble, I began, “T.S. Eliot once wrote ‘Only those who risk going too far can possibly find out how far one can go.’ It seems that the U.S. financial system is bound and determined to find out… the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That’s the secret. The borrowers don’t actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.”
In the Federal Reserve’s attempt to bring the U.S. out of the crisis of its own making, the Fed has produced conditions that make another collapse inevitable. Unfortunately, the scale of the present bubble is far grander, and the consequences are likely to be more severe. By the completion of this cycle, I continue to expect the S&P 500 to lose roughly two-thirds of the market capitalization it reached at its September 20 peak. Mountains of covenant-lite debt and leveraged loans, this cycle’s version of “sub-prime” mortgages, will go into default. Worse, “covenant-lite” means that lenders have much less protection in the event of defaults, so recovery rates will plunge to levels that investors have never experienced.
After 8 years of Fed-induced yield-seeking speculation, financial valuations have been driven to the most offensive extremes in history, with the most reliable equity valuation measures recently matching or exceeding their 1929 and 2000 peaks. Accordingly, prospective long-term investment returns for stocks and bonds have been driven to strikingly low levels.
At the September peak, we estimated that a conventional portfolio mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills was likely to produce total returns averaging just 0.48% annually over the coming 12-year horizon. The only time passive investors faced lower expected 12-year returns was during the 3 weeks immediately surrounding the 1929 market peak. After a recent increase in bond yields and a mild -10% decline in the S&P 500, that estimate increased to just 1.29%. With most pension funds assuming expected future returns on the order of 7% annually, the coming years are likely to include a rather severe pension funding crisis.
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Put simply, the extraordinary and experimental policies of quantitative easing and zero interest rates have not been “good” except in the myopic sense of encouraging a short-term burst of very bad choices and misallocations of capital. While it’s unfortunately necessary to tolerate cartoonish rants on CNBC about a potential Fed “policy error” as it normalizes interest rates, the fact is that the policy error is way, way behind us, and the Fed already made it.
The financial markets have already experienced years of aggressive yield-seeking speculation, record valuation extremes, and eager issuance of new “product” – in the form of covenant lite debt and leveraged loans – to satisfy the need of investors to “earn something greater than zero.” Now all we have is an unfortunate situation. With the total capitalization of U.S. corporate equities recently pushing $40 trillion, I continue to expect that $20 trillion or more of what investors count as “wealth” will vanish over the completion of this cycle.
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Quantitative easing wasn’t about creating more “liquidity,” or encouraging more bank loans, or any of the other excuses tossed around for it. What quantitative easing really did was to replace interest-bearing Treasury bonds held by the public with a mountain of zero-interest money that was so uncomfortable to hold that it drove investors
absolutely crazy. But they couldn’t get out of it in aggregate. Whoever held it could only toss their hot potato to someone else by trading it for some other security, regardless of the price. Every time someone used their zero interest money to buy stocks, they got the stock, and the sellers of the stock got the zero-interest money. So the cycle continued, until every asset – stocks, bonds,
everything – was priced to deliver long-term returns remarkably close to zero. And here we are.
I used to believe that there was a limit to that kind of speculation. I was wrong. But understand exactly what was “different.” The fact is that valuations have “worked” in the recent cycle as they always have – we’ve always known that their most reliable implications are long-term and full-cycle. Market internals (which we use to gauge when investors are inclined toward speculation or risk-aversion) have also “worked.” In fact, the entire net market gain since 2007 has occurred in periods where internals have been favorable, while the bulk of the 2007-2009 collapse, as well as recent corrections, have occurred when they were not.
The problem in recent years was that, unlike every other market cycle in history, previously reliable warning flags of overextended speculation proved useless. In prior market cycles, once an extreme syndrome of “overvalued, overbought, overbullish” conditions emerged, the market regularly ran into air-pockets, panics, crashes. Speculation always had a limit, and one could adopt a bearish stance
even before market internals deteriorated.
Not this time. Once interest rates hit zero, so did the collective IQ of Wall Street. Even responding to the most overextended warning flags was detrimental. A year ago, I resolved that while sufficiently extreme conditions can put us in a neutral stance, we would no longer adopt a bearish outlook unless market internals had deteriorated explicitly – no exceptions. That’s why I’ve looked “smarter” since then. I became content to identify the presence or absence of speculative pressures, and completely abandoned the belief that reckless speculation has “limits.”
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The completion of this cycle will be challenging for conventional wisdom. One of the dangers of the recent speculative episode is that investors have come to believe that Fed policy and easy money always supports the financial markets. They forget that the Fed eased persistently and aggressively throughout the 2000-2002 and 2007-2009 collapses, both which cut the stock market in half.
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Note that easy money is most powerful in periods where investors are already inclined toward speculation. What’s equally important is that tight money also tends to be bullish, provided that market internals are still favorable. Indeed, that’s a condition that often accompanies mid-to-late stage bull markets. In contrast, Fed easing is of little use when investors are inclined toward risk aversion. The average market return is actually about zero, and there is a substantial risk of steep market losses, which included the collapses of 2000-2002 and 2007-2009. Remember that. Finally, the worst situation is actually what we have at present – tightening monetary policy in an environment where market internals indicate growing risk-aversion among investors.
Importantly, we should not rule out the likelihood of periodic “fast, furious, prone-to-failure” rebounds from oversold conditions, even in an environment like we have today. Negative market conditions do not automatically resolve into the likelihood that every week or month will be down. Rather, they resolve into the likelihood that average returns will be poor and interim drawdowns will be steep. That’s a poor tradeoff, in my view.
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At present, we’ve got a 1.3% structural growth rate with very limited prospects of additional cyclical benefit. We can’t rule out a short-lived burst of productivity resulting from changes in taxes and regulation, and it’s possible that the unemployment rate could move slightly lower still. Yet even in an optimistic scenario, the idea of 3-4% sustained real GDP growth “as far as the eye can see” is bonkers.
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On inflationYou may note that none of our views on bonds or precious metals rely on strong expectations about inflation. The fact is that if you actually go to the data and run an enormous amount of analysis, you’ll find that virtually nothing that people say or believe about inflation is actually true. I’ve regularly argued elsewhere that the “Phillips Curve” is actually properly viewed as a relationship between unemployment and real wage inflation, but it bears repeating that there is no meaningful relationship between general price inflation and unemployment, nor will you find a strong, reliable relationship between inflation and government debt, the outstanding quantity of base money, the output gap, or virtually anything else.
The simple fact is that the best predictor of future inflation is current inflation. In my view, that’s because money is valued not based on year-to-year fundamentals, but based on psychology and long-term expectations. Inflation essentially reflects a loss of public confidence in the long-term ability of the government to restrain its issuance of liabilities. Now, I don’t believe that the Federal debt actually ever has to be “repaid” – both government securities and base money provide a stream of useful “services” that facilitate transactions and storage of wealth, so in a limited quantity, proportional and not exploding relative to real GDP, these liabilities can grow indefinitely as the economy grows, without substantial inflationary consequences.
The problem comes when the growth in government liabilities outpaces the supply of goods and services enough to cause a material loss of faith, and a break in public psychology. That’s not captured by linear relationships. It occurs in discrete shifts. As Thomas Sargent, a Nobel economist (and my former dissertation advisor) once wrote:
“People expect high rates of inflation in the future precisely because the government’s current and future monetary and fiscal policies warrant those expectations… it is actually the long-term government policy of persistently running large deficits and creating money at high rates which imparts the momentum to the inflation rate.”
Likewise, Sargent argues that stopping an inflation, once underway, requires “a change in the policy regime: there must be an abrupt change in continuing government policy, or strategy, for setting deficits now and in the future that is sufficiently binding as to be widely believed.”
The massive inflation of the late-1960’s and 1970’s involved discrete changes in public perception, beginning with Johnson’s Great Society programs, and wholly unleashed after Nixon ended the convertibility of dollars into gold in 1972. That inflationary episode also ended because of a change in public perception. Volcker broke inflation by shifting the monetary policy regime and sending a credible signal that government debt would not be financed through money creation. Neither money creation nor government deficits actually stopped (nor did they after the German, Austrian, Hungarian, or Polish hyperinflations). What changed was public perception about the long-term policy regime.
So is the possibility of inflation a concern? Absolutely, particularly given increasingly profligate fiscal policies, coupled with deranged monetary policies that enable explosive deficits. In my view, the whole “modern monetary theory” faith in the endless capacity of governments to print money, without consequence, is an artifact of a long disinflationary period. To date, the public has retained its faith in price stability much in the same way that speculators in a market bubble retain their faith in permanently rising prices.
At some point, that faith may break, but as with the financial markets, the best measures of that change in psychology will be a shift in market behavior across a wide range of inflation-sensitive securities. Since we are not passive investors, and have the capacity to shift our investment stance as the evidence shifts, we have no particular need to predict when that sort of shift will occur. It’s enough for us to align ourselves with the evidence we observe at each point in time.
Current viewOverall, market conditions for bonds and precious metals shares appear reasonable even here, though I’m inclined toward a moderate stance, using price weakness to nibble at additional exposure until we observe signs of emerging economic weakness.
In stocks, I continue to believe that the market is positioned for rather violent losses over the completion of this cycle, though undoubtedly punctuated by periodic rebounds that are fast, furious, and prone-to failure. These tend to emerge in the form of what I call “clearing rallies,” which relieve short-term oversold conditions. They should be used to make any needed portfolio adjustments. While I don’t herald every tactical response to those conditions, the important consideration at present is to maintain a safety net in any event, because when those rebounds fail, they can fail spectacularly. This comment from December 4, 2007 offers a good sense of how I view these periodic recoveries.'
- John P. Hussman, Ph.D.,
Bubbles and Hot Potatoes, November 28, 2018
'..Roughly one-third of the companies that make up the Russell 2000 small cap index don’t make any money. There are many zombie companies living on the generosity of unknowing investors who have poured trillions into corporate bonds funds, high yield bond funds and leveraged loan funds.''I was in Dallas this week for meetings. One was with a well-established family office. Asked what we see ahead, we talked about Mauldin’s “Great Reset.” We added, “We have tripled down on the very same things that caused the last crisis, the economy is late cycle, overleveraged and overpriced. Zero interest rate policy has forced investors into higher yielding products and all that liquidity has enabled companies the liquidity to borrow at terms favorable to them and unfavorable to investors.” Friend Mark Yusko was on CNBC this week saying, “14% of the companies in the S&P 500 Index don’t have three years of EBITA (earnings before interest, taxes and amortization) to cover the interest cost on the bonds they have issued.” Roughly one-third of the companies that make up the Russell 2000 small cap index don’t make any money. There are many zombie companies living on the generosity of unknowing investors who have poured trillions into corporate bonds funds, high yield bond funds and leveraged loan funds.
We’ll discover who’s swimming naked when the next liquidity tide rolls out. If you have the conviction and the chutzpah, The Big Short Part II is here. Well managed family offices, like our friends in Dallas, have the talent in place, the capital and the ability to be patient. Raising cash, staying liquid and positioning for the opportunity that will present in the next crisis. The win will occur when the liquidity switch is turned off. Coming soon to a theater near you.'
- Steve Blumenthal,
The Big Short, November 30, 2018
Context'..the inanity of monetary policy today..'November 19, 2018 - European Banks Are Taking Lending Risks Like It's 2007, ECB Says'..The Quest for Sound Money and Good Government..' - '..the Fed's total incompetence in understanding inflation..'