Irreversibly Broken and Dysfunctional
With global “risk on” back in full swing, the focus of U.S. monetary policy belatedly shifts back to fundamentals. October’s 271,000 was the largest jobs gain since last December. The unemployment rate is down to 5.0%, the low since April 2008. Average hourly earnings were up 2.5% y-o-y in October, the strongest performance since July 2009. The private sector added an eye-opening 268,000 jobs during the month, with Services employment up 241,000. Indicative of an extraordinarily unbalanced economy, no manufacturing jobs were created during October.
Existing home sales are on track for the strongest year since 2007. Automobile sales are booming as well. Monthly auto sales last month posted the strongest October since 2001 (from Dow Jones), with annual sales poised to test the all-time record. Kelley Blue Book is expecting 2015 sales 12% above 2014.
My point is not that the U.S. economy is robust - or even sound. From my perspective, booming home and auto sales reflect the upshot from years of ultra-loose financial conditions and a resulting “Bubble Economy”. Importantly, the Federal Reserve’s extreme monetary accommodation is grossly inappropriate considering U.S. financial and economic backdrops.
The Yellen Fed is now expected to raise rates next month. And, suddenly, there’s some trepidation that “one and done” might not suffice. From a traditional analytical perspective, the Fed has fallen behind the curve in historic fashion. In the past, it would take a series of hikes and a period of time to temper the intense impulses to borrow, lend, spend, invest and speculate. Especially if monetary conditions were held loose for too long, some real pain was required to impose some restraint.
Granted, traditional monetary management and system behavior have little to do with the present. Rarely do I encounter the phrase “behind the curve.” The Yellen Fed threw another big monkey wrench into the analysis when it delayed the expected September rate lift-off due to global considerations (China & EM). Markets have been increasingly confused by central bank thinking, with little clarity as to what factors will be driving policy decisions. At the same time, market participants have remained comforted that global financial fragilities ensure the Fed will hold in the vicinity of zero, with no real “tightening” contemplated. Moreover, the ECB and BOJ will (at the minimum) stick with current QE purchases. The PBOC will surely continue on a course of much lower rates (to zero?). U.S. fundamentals have mattered little because of the view that the Fed’s attention was directed elsewhere. Friday’s booming non-farm data were too strong to ignore. The U.S. economy appears to have found a head of steam after the summer slowdown.
The S&P500 gained 1%, a strong but unremarkable week. Below the surface remarkable thrives. The Banks (BKX) surged 5.5% and the Securities Broker/Dealers 6.3%. The Biotechs (BTK) rallied 4.4% this week. The small cap Russell 2000 jumped 3.3%. It’s worth noting that the banks, brokers, biotechs and small caps have been popular sectors for short positions. Trading activity in many highly shorted stocks has been wild. Meanwhile, the Utilities sank 4.1% and gold stocks (HUI) were hammered 10.8%.
Below the pleasant exterior exists vicious market internals – and it’s not just stocks and not only in the U.S. Italian yields surged 31 bps this week. Chinese stocks rallied 6.3%. Crude (WTI) sank 4% this week. Gold fell 4.7% and silver sank 5.1%. Currency market violence reemerged this week. The New Zealand dollar sank 3.7% (against the US dollar), while the Brazilian real gained 2.3%. The euro and pound fell 2.4%, and the Swiss franc and Canadian dollar lost about 1.8%. And Thursday from Reuters: “US Swap Spreads Hit Unchartered Negative Levels.” There’s something not right in global markets.
Friday evening from the Financial Times: “Central Banks Confuse With Mixed Messages.”
Today’s dilemma – for financial markets and central bankers – is that pushing back against nascent “risk off” unleashes another forceful bout of “risk on.” At this point, it’s either Bubble on or off – destabilizing either way. The global Bubble has grown too distended and the market backdrop too dysfunctional. Central bankers over the past 25 years have created excessive “money,” while incentivizing too much finance into financial speculation. There is now way too much “money” crowded into the securities and derivative markets, and the upshot is an increasingly hostile backdrop for leverage and speculation.
The ECB has been widely criticized for raising rates 25 bps in early July 2008. In hindsight, the world at the time was on the precipice of a bursting U.S. mortgage finance Bubble. It’s forgotten that eurozone inflation was then running at 4%, fueled by crude that had spiked to $145. The Fed’s aggressive policy response to 2007’s subprime eruption had stoked powerful Bubble excess throughout the markets. And I believe strongly the world would have been better off to take the medicine in 2007 rather than have the Fed further destabilize the situation.
It appeared in August that global financial and economic tumult would hold rate hikes at bay indefinitely. After three months of further central bank accommodation, the turbulent global market recovery has the Fed believing it’s safe to move off zero. Market participants are having a difficult time discerning the backdrop. Have the issues from the summer been resolved and a new bull run commenced? Or are markets in the calm before a more powerful round of “risk off”? Importantly, one scenario has the Fed commencing a “tightening” cycle. The other has no hikes, more QE and perhaps even negative short rates. Extraordinary complexities and uncertainties abound: in the global economy, throughout global markets and with central bank policies.
An interesting debate has unfolded between the tandem Nobel Laureate Michael Spence and former Fed governor Kevin Warsh and Larry Summers. Spence and Warsh last week penned a quite insightful WSJ op-ed, “The Fed Has Hurt Business Investment.” From the article: “We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”
Former Treasury Secretary Larry Summers was not impressed. He titled his response (on his blog), “This critique of the Fed isn’t backed by logic nor evidence.” “What arguments do Spence and Warsh offer for their heterodox conclusion? They note rightly that monetary policy has been easy and investment has been weak in the current recovery. This is a little like discovering a positive correlation between oncologists and cancer and asserting that this proves oncologists cause cancer. One would expect in a weak recovery that investment would be weak and monetary policy easy. Correlation does not prove causation.”
Spence and Warsh responded with a second WSJ op-ed, “A Little Humility, Please, Mr. Summers.” “First, Mr. Summers mischaracterizes what he calls the ‘Spence-Warsh doctrine.’
This is a crucial debate, and I side strongly with Spence and Warsh. Summers refers to their “heterodox conclusion.” From my analytical perspective, over the years I’ve used the “Financial Sphere” versus the “Real Economy Sphere” framework when discussing divergent policy effects. I have no doubt that various monetary policy tools – rate manipulation, market liquidity backstops and QE – have created major distortions. Importantly, QE has overwhelmingly incentivized the acquisition (investment, leveraged speculation and stock buybacks) of financial assets (stocks, bonds and derivatives). Over the course of Trillions of QE and years of cumulative structural distortions, the consequences have been profound. I fear interminable global financial fragility is the most momentous.
Spence and Warsh focus astutely on QE’s real economy effects. My deepest concern lies within the “Financial Sphere.” As lunatic fringe as it sounds to the emboldened bullish consensus, I believe QE and contemporary central bank doctrine have left global markets Irreversibly Broken and Dysfunctional. The damage is masked only so long as markets remain in “risk on” mode (unless one examines below the surface).
As noted above, there’s something wrong in the markets. Clearly, there are serious struggles unfolding in the hedge fund community. And I believe market instability and policy uncertainty have forced an initial bout of de-risking/de-leveraging. Yet when markets go into (policy-induced) face-ripping, short-squeeze melt-up mode, the pressure to unwind short positions and bearish hedges turns intense. The bulls giggle, not appreciating the ramifications. These chaotic, volatile markets are hard on leveraged speculating community returns. Everyone is forced to over-commit on the long side, ensuring there will be a lot of selling, shorting and hedging when the next “risk off” flares up. Poor performance dictates a heightened state of risk aversion during the next downdraft. Poor performance begets poor performance – and pressure to de-risk and de-leverage.
I recall similar dynamics prior to both the 1998 and 2008 crisis episodes. Friday’s payroll data reinvigorated King Dollar. Energy and commodities prices were under pressure. EM currencies stumbled. And I’m sticking with the view that the global Bubble has been pierced, though central banks have gone to incredible measures to keep pumping. The Fed at this point faces a very serious dilemma.