Don’t bet on central bank remorse
August 14, 2017
Having experienced 2013’s historic “taper tantrum” up close and personal, I cannot help but notice some rather uncomfortable similarities between what transpired then and the recent decision by the US Federal Reserve to hike rates. To begin with, June’s Fed decision, in the context of the overall market reaction, feels a lot like what we saw in March 2013 — the main difference being that markets were far more adequately prepared by the Fed for this more recent move. Consequently, the reaction in actual asset prices thus far has been relatively muted, and so the “tantrum” element of this “taper” is considerably more subdued.
However, many investors may view the 2013 tantrum as a blip on the radar. So let’s take an extended look at how the drivers of Fed policy in each period differ, and also consider what it may take for a central bank to finally and willingly inflict pain on asset prices. Then let’s review reasons not to bet that the Fed will easily “blink,” wavering from its current course.
As of this writing, however, there is a growing hawkishness among major central banks. While the Fed maintains a level of concern on inflation, central banks with very low rates seem intent on moving away from the zero bound. This leads us to question: Will central banks blink — and show remorse — if asset prices start to fall with the removal of monetary stimulus? Will they recant on their hawkish gesturing? This time around, I think central bank remorse is a lot further off than markets may currently believe when it comes to supporting lofty asset prices. The taper tantrum was a dry run but it helps in exploring current central bank reactions.
Conditioned to see a bluff
Despite the muted market reaction, other parts of today’s scenario seem eerily similar to the taper tantrum of 2013. I seem to recall scratching my head because economic data weren’t overly positive, yet equities had been screaming toward questionable valuations. Then Fed Chairman Ben Bernanke, seemingly out of the blue, effectively told the markets, “By the way, we now want to abandon this policy, in which we had so much faith just a week ago.” Granted, in retrospect, Bernanke had modestly hinted prior to the event that he was starting to lean toward tapering, but it was still a shock to most investors — this author included. No one seemed to take Bernanke seriously until it was crystal clear that the Fed was operating under a totally new set of assumptions and potential concerns.
What drove Bernanke and the Fed’s change of heart in 2013? I believe the Fed’s primary concerns at the time stemmed from the one-way direction of markets, driven by a perpetual “Fed put” and resulting in asset price overvaluations. I think that, secondarily, Bernanke and global policy makers had, in a very nascent way, begun to realize that lower rates and the resulting inflated asset prices were really only benefiting the holders of said assets, and therefore driving greater wealth inequality. In the intervening years, with the distortions resulting from global central banks’ expanding balance sheets, these concerns have grown both more important and more perilous. Asset price bubbles, simply stated, have been papering over larger structural issues since the global financial crisis.
That was then. This is now.
Fast forward to the Fed’s recent decision to hike rates and start tapering its balance sheet. Globally speaking, I believe the underlying economics are a bit more convincing. However, much as in 2013, the United States seems to be going through something of a “soft patch.” It appears that assets are currently priced as though no economic downturn is anywhere in sight. The unspoken conviction that one simply must be invested or else risk being “left behind” seems to be permeating market sentiment.
While investors may be correct that a global recession isn’t just around the corner, markets feel dangerously similar to the investor sentiment preceding the taper tantrum: Buy everything; central banks will never let asset prices go down. If current market sentiment differs extraordinarily little from the prevailing tone just prior to that dramatic episode in 2013, what may differ is that this time it’s not a fire drill. There are very real reasons why central banks need to move away from zero rates and taper more quickly than markets anticipate.
Why things may be different this time
Why isn’t this phase of tapering just another drill for global central banks, including the Fed? Factors differ in many respects. First, in my view, the Fed doesn’t seem completely convinced that we aren’t seeing just another soft patch, which could paradoxically explain the rationale behind its hiking program. In some ways, it may have no choice but to hike. There is a chance that the business cycle is back from extinction, and so we may well be at the point in the story where having a smaller balance sheet, and rates as far away from zero as possible, will provide the Fed with the ammunition necessary to fight the next crisis.
Let us consider the possibility that this isn’t a soft patch in the business cycle. If you were the Fed, wouldn’t you want to stem the runaway rally in risk assets as soon as possible by hiking even more and reducing your balance sheet even faster? What if you are wrong, and didn’t leave yourself enough ammunition? If asset prices are high and economics continue to trend lower, the valuations may reconnect violently at just the wrong time for the Fed. On the other side of the coin, if this is a soft patch and asset prices fall modestly but economics strengthen, you are not only tempering asset price overvaluation but also giving the Fed future ammunition to fight a downturn. From a strategic perspective, I think there are very few reasons not to continue normalization.
This seems true of other global central banks as well. Hawkish rhetoric and overtures of normalization are all the rage across the globe lately. I think the reason is that, globally speaking, this may be central banks’ best chance to get away from zero before the next real downturn.
In short, this is a different Fed from the one we had four years ago. It seems to be one inclined to raise rates, not because of confidence in the economy, but more because it fears an impending peak in the business cycle and is concerned about future deterioration in the economic backdrop. This appears to be true of other central banks as well. By seeking lower equities, higher volatility, and higher real rates, they may be leaving themselves with more ammunition to fight a potential economic downturn if this isn’t just a soft patch. If that sounds circular and self-defeating, it is. However, this may be the best chance the Fed and other central banks have to fight a future downturn. In my view, hiking when the economy is good is the only way to ensure you can cut when things get bad again.
All-in on quantitative easing — or not?
The second reason the Fed may continue to hike relates back to the taper tantrum: In 2013, not all central banks were fully committed to the quantitative easing (QE) approach. On several occasions post-global financial crisis, we have relied upon the next wave of monetary stimulus to fight this thing coming at us from the major central banks. European stimulus provided asset price stabilization and a boost to growth, then it moved to Japan, back to the US, then to China, and back again. This baton handing was possible at the time because most banks were not all-in on the QE game. As a result, this provided something of a liquidity buffer for global markets along with potential sources of stabilization if necessary.
I would contend that the more widespread adherence to QE that we see across global central banks, the more important it is, paradoxically, for one or more central banks to start normalizing. Now, with every major central bank committed to the QE scheme — and asset prices being where they are — I would argue that it is more crucial than ever for at least one player to strive to push away from the zero bound in interest rates. This isn’t to say there isn’t more that central banks can do below or near the zero bound if things get messy. It is, however, not without consequences to play this game yet again.
Federal funds rate, 1971–2017
Source: Federal Reserve Bank of St. Louis. Effective federal funds rate, monthly observations, not seasonally adjusted.
Stimulus, wealth effect, structural problems — rinse and repeat
The last and perhaps most important aspect of the Fed’s rationale for hiking is one inescapable fact: This ongoing monetary expansion is creating greater economic imbalances globally while masking structural problems. Put simply, I believe this whole experiment has done nothing to truly help balance the US or global economies or help the vast majority of people — in fact, quite the contrary. These policies of levering the wealth effect for economic improvement, in my opinion, have done precisely what they are supposed to do: They have increased the confidence of asset holders as their asset prices have crept up, and created a wealth effect.
That wealth effect has repeatedly, albeit temporarily, masked structural issues. We have seen a simple but shockingly repetitive series of events:
- A cyclical downturn, or asset price selloff, is met with central bank stimulus.
- Asset prices rally, creating a temporary wealth effect.
- Stimulus masks structural issues (in areas such as technology, demographics, globalization, and debt load).
- Unaddressed structural issues are left to proliferate, weighing on the global population of non-asset owners, creating greater economic dislocation and inequality.
- The population reacts to deteriorating economics by pursuing more aggressive political stances (rise of populism and greater left-right divides).
- It’s back to square one, as markets eventually go down and the stimulus subsides, the general population is no better off, and there is less ammunition, greater wealth inequality, and potential for worse political outcomes.
What about remorse?
In summary, I believe the Fed is left with a set of fairly obvious choices. It can discourage bad behavior in asset markets through removal of the so-called Fed put, and at the same time it can upsize its ammunition cache to prepare for the fight against the next crisis or recession. It can avoid masking structural issues at the expense of a balanced economy, and help the US — and potentially the world. The other option, which I call ”remorse,” is to back away from policy normalization the minute things get bumpy and re-engage the infinite loop of structural malaise masked by wealth-driven boomlets described above.
The most recent instance of central bank remorse (think early 2016), when the Fed went from talking about four hikes in 2016 to a single hike in December, is a perfect example of remorse-driven decision making by central banks, in my opinion. This time, however, I believe we are in a different spot. There’s no one left to pick up the pieces if we enter a recession. More negative rates? More QE? This means more of the same wealth inequality and masked structural issues.
Will these considerations drive the Fed’s decision making? Many seem to be betting on a “rapid remorse response” from central banks in the wake of tightening financial conditions and the likely subsequent asset price selloff. I think markets have this wrong — at least to the degree to which the Fed and other central banks are willing to inflict pain on asset prices. In the past, remorse has very quickly followed significant pain in markets. While I have little doubt the Fed and other central banks will blink a la early 2016, it may be further away than markets are currently hoping and pricing.
If Fed remorse leads to removing hikes from the agenda, or adding stimulus, then we could simply revert to the same damaging feedback loop. Either way, I believe the asset price face-plant will come when central banks take away the crutches. We have seen this movie before. It leads right back to square one.
The benefit of the doubt
However, I am giving the benefit of the doubt to the Fed, which knows that monetary policy cuts both ways. I think it’s possible this time around that the Fed and other central banks are seeing interest rate hikes in terms of future survival, not as short-term levers for asset price manipulation, and as a chance to start rebalancing the global economy.
In short, the Fed and other central banks seem willing to trade a larger asset price correction to gain the ability to hike in order to fight the next recession. This doesn’t mean central banks have given up on pulling the wealth-effect lever out of remorse. When it comes time, I think they will pull that lever — and hard — to stabilize asset prices. However, in the event of a downturn they need a lever to pull that is credible enough to do more than just stabilize asset prices. Only time will tell, but I think central banks get the joke this time around. They need to hike and they cannot wait. The next soft patch might not be just a patch.
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The views expressed represent the Manager's assessment of the market environment as of August 2017, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
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