A must read summary from Scotiabank’s Guy Haselmann
Summary of Current Situation
After 5 years of zero interest rates, negative real yields, trillion dollar annual fiscal deficits, trillions of dollars of asset purchases by the Fed, and hundreds of stimulus measures by foreign central banks, the global economy just limps along. It is counter-factual to know what the state of the global economy would be without these measures, but isn’t there a point when the actual benefits of doing ever-more is questioned? As Einstein said, “Insanity is doing the same thing over and over again and expecting different results”.
Let’s assume for the moment that after the Fed cut rates to zero and established various liquidity facilities that QE1 and QE2 were still necessary to stabilize markets (QE1) and then to combat deflation (QE2). It could be argued that after those actions, the Fed could have refrained from beginning the open-ended asset purchase program without causing any adverse market reaction.
When QE-infinity began, inflation was stable, equities were higher by over 15% (70% above 2009 lows), and the unemployment rate had moved in the right direction from 10%+ to 8.2%. The Fed was already so highly-accommodative that staying put may not have been criticized, especially after the extraordinary actions it had taken. Furthermore, at the time, the Fed was just starting to be accused of complicating its exit strategy and enabling fiscal polarization.
Doesn’t the Fed’s continued expansion of its balance sheet risk doing too much? History is full of Fed-induced boom to bust cycles. Once signs of asset bubbles or inflation appear, it is often too late. The US economy is like an oil tanker where it takes over 5 miles to stop and requires a turning circle of over 2 miles. Therefore, the idea of micro-managing via “data dependency”, or via Rosengren’s “dimmer switch” analogy, makes little sense to me. Moreover, investors are now unproductively hyper-sensitive to each economic data point.
Policy today may not fully filter into the broader economy until 12 to 18 months from now. The overly easy policy of Arthur Burns (‘70s) never successfully lowered the unemployment rate, but instead caused destructive inflation that was only contained a decade later, after the harsh medicine of Paul Volcker.
As the Fed begins the ‘tapering’ process, investors may soon be able to discern whether or not its policies have been beneficial for the long run, or whether little has been achieved other than a temporary turbo-charging of asset prices. Unintended consequence and ‘collateral damage’ may begin to appear. It seems that should another financial crisis arise, the ability for governments to respond is compromised, as the easy bullets have been expended.
Many of the factors that led to the 2008 economic crises – high debt levels, global imbalances, unfinanced social entitlements – are at even higher levels today. Economies are still too reliant on debt-driven consumption. Reductions in household debt levels have been replaced by public sector borrowing. Banks deemed too-big-to-fail are now even bigger. Speculation in financial assets has reached new highs. NYSE Margin Debt is at an all-time high level.
Policy officials believe that growth and inflation would fix the problem of large debts, but growth fueled by public spending that is financed by debt or central banks is not sustainable. Like most Ponzi schemes, it doesn’t end well. Reducing total debt was always a better solution, but it would have resulted in even slower economic activity and lower living standards. However, in the long run, the system would have been purged of unsustainable excesses.
‘Short term pain’ for ‘long term gain’ is often shunned for fear of electoral defeat and lobby group pressure. Now, we are stuck with financial repression. Investment is being directed toward funding the public sector. Policy rewards debtors over creditors. Such policy cannot go on forever. In reality, “unlimited” rarely means unlimited, because imbalances become too great. The Fed’s current quagmire has aspects resembling the Triffin Dilemma.
The recent adverse spillover from Fed policies in emerging market economies and currencies may be the first hint of cracks in the global monetary system. At a minimum, foreign central banks have deviated from good policy in order to prevent sharp destabilizing fluctuations in the value of their currencies and to arrest volatile inflows and outflows of capital.
Time to buy vol and replace some financial assets with real assets.
“And if you go, no one may follow. That path is for your steps alone.” – The Grateful Dead