Investors are simply going to have to learn to live with a new reality. And we may finally get to see what they are made of. Proof positive, one way or another, whether this is all merely a financial bubble or not. The global economy may experience periodic ups and downs but what monetary policy makers are beginning to form a consensus around is things just aren’t as bad as official interest rates suggest.
That’s from a Thursday missive penned by former trader Richard Breslow who writes a daily column for Bloomberg.
Implicit there is the notion that central banks (and especially the Fed) are no longer intentionally moving the goal posts. They are no longer intentionally chasing an elusive target in the interest of avoiding the possibly unpleasant consequences that may go along with normalizing policy.
Everyone (i.e., institutional investors all the way down to Joe ETF) remembers vividly how, for years, policymakers obfuscated at every post-meeting press conference. Academic acrobatics were employed in the service of explaining why accommodative policy was still necessary no matter how good the data seemed. One of the great ironies of the post-crisis monetary policy regime was that naysayers and those of a doomsday persuasion saw policymakers turn the tables on them. “The economy is not as good as the numbers suggest!”, the skeptics would shout. The tacit answer from central bankers was: “You’re right and that’s why we’re going to keep policy accommodative.”
Of course the rejoinder from the skeptics was that policy accommodation was leading to bubbles, but at that point, they were talking themselves in circles; either the economy isn’t good and needs stimulus or it is good and it doesn’t need stimulus. If the economy isn’t good and fiscal stimulus isn’t an option because austerity is en vogue, well then either you pull the monetary policy lever, or else you get a deflationary spiral and a depression. If you choose the latter, the world is running an experiment in creative destruction and if that experiment goes awry, well then see Hobbes.
As you can probably surmise from the above (and as regular readers are aware), I think we need economists running the show and I think we need to at least pretend like they know what they’re doing. I also firmly believe we need to allow Wall Street to layer financialization on top of a system run by economists. I know that sounds dangerous and I’m fully aware of the extent to which that setup has, in one way or another, precipitated every horrific bust in the history of modern finance. But there is no better expression of why we need that system than the following classic quote from the film Margin Call (this is from a scene in the film that finds a senior trader explaining to a junior risk management associate why the current system is necessary):
Listen, if you really wanna do this with your life you have to believe you’re necessary and you are. People wanna live like this in their cars and big houses they can’t even pay for, then you’re necessary. The only reason that they all get to continue living like kings is because we’ve got our fingers on the scales in their favor. I take my hand off and then the whole world gets really fair really quickly and nobody actually wants that. They say they do but they don’t. They want what we have to give them but they also wanna, you know, play innocent and pretend they have no idea where it came from.
That is the cold, hard reality of things. The problem is that, as alluded to above, this setup invariably leads to ever larger booms and busts. The larger the busts, the larger the policy response needs to be. The next bubble has to be large enough to subsume the bust that resulted from the previous bubble, so what you end up with is a kind of spiraling bubble machine.
Eventually, we’ll get a bust so large that policymakers will not be able to engineer a new bubble large enough to completely subsume it and some form of forced creative destruction will play out. But what I would encourage you to remember is that people have been predicting that after every bust for as long as I’ve been around, and we haven’t gotten there yet. Policymakers and Wall Street have always engineered a new bubble large enough to make everyone forget the last one, and that’s where we found ourselves headed into 2018.
The ‘ammo’ problem
The issue, though, is that the unprecedented nature of the monetary policy response to the 2008 crisis involved pushing rates to zero and below and monetizing everything from risk-free assets to corporate bonds to, in Japan’s case, ETFs. The question, then, was whether we had reached the theoretical limits of monetary policy.
At the same time, the post-crisis regulatory regime left Wall Street hamstrung in its capacity to mitigate certain adverse scenarios. There is no better example of this than the enormous disconnect between, on one hand, the amount of duration parked in funds, and on the other, dealer books. Here’s one representation of that:
Investors have, to quote Goldman, “leaned into the liquidity premium” as the central bank-inspired hunt for yield gathered steam over the last five years. But if Wall Street isn’t willing to lend its balance sheet in the event illiquid holdings need to be sold to raise cash in a pinch, there will be no market for some of the illiquid assets accumulated as a result of the now decade-long hunt for yield.
Also bear in mind that prior to Donald Trump’s election, the Western world had developed an affinity (almost an obsession) with austerity. That was the legacy of the European debt crisis. There wasn’t much reason for central bankers to believe things were likely to change in that regard.
Realizing all of the above, developed market central banks went into 2018 with a mind towards normalizing policy (in the U.S., the passing of the baton to Jerome Powell meant the Fed would accelerate the normalization process that was already in the works). The distortions brought about by years of accommodation were starting to become too glaring to ignore and the frustrating part for the Fed was that the 2017 equity rally had conspired with still accommodative policies in Europe and Japan to push U.S. financial conditions to the easiest on record despite multiple rate hikes.
The risk headed into this year was that in the event something went “wrong” (where that means either a bubble burst somewhere or the economic data started to roll over), central banks would find themselves confronting an acute situation without much in the way of ammunition. The ECB got an unwelcome dress rehearsal of that in Q1 when the eurozone economic data suddenly took a turn for the worst, raising the specter of “quantitative failure.”
It was always a financial bubble
There really isn’t much ambiguity about whether “this is all merely a financial bubble or not” (to re-quote the above-mentioned Richard Breslow). The whole point of post-crisis monetary policy was to create a financial bubble large enough to subsume the crisis that was itself the result of the previous financial bubble.
Obviously, the global reflation effort was ultimately aimed at resurrecting the real economy, but this was always – always – dependent upon the fabled “wealth effect.” The assumption was that if you unleash a liquidity tsunami and inflate the value of financial assets, that will filter through to the real economy. And it did. Only not on a one-for-one basis.
Policymakers grossly underestimated the efficiency of the transmission channel from accommodative policy to financial assets and grossly overestimated the efficiency of the transmission channel from asset price inflation to the real economy. At some point (probably around mid-2016) it became readily apparent that waiting around for more robust real economic outcomes was an exercise in futility – a hopeless effort to deny the law of diminishing returns. Meanwhile, financial assets continued to inflate, and the disconnect between those assets and real economic outcomes widened further.
The delay in normalizing monetary policy wasn’t so much the result of central banks believing the global economy was bad enough to justify current policy rates and ongoing asset purchases. Rather, the delay was attributable to the overriding tendency to avoid relinquishing control until it was absolutely necessary.
The ultimate irony is that the urgency inherent in current efforts to give up control of markets (i.e., to normalize policy) is a reflection of policymakers’ desire to ensure that they have the capacity to retake control later on the way to engineering another, larger bubble spectacular enough to swallow the fallout when the bubble they just finished inflating finally bursts.
So when folks tell you that as an investors, you’re “simply going to have to learn to live with a new reality”, you can at least take solace in the fact that this “new reality” (where that means less accommodation) is only a temporary state of affairs, necessary only to the extent it gives policymakers the capacity to retake the reins later.