What's Next For Central Planners And Their Kale Smoothie Economy?
Posted on Top Stories at 12:54 pm on July 18, 2016 by admin
By Chris Ciovacco :
A Logical Question
Casual market followers, along with many seasoned Wall Street veterans, may have recently had an internal voice ask:
What the heck is going on in the financial markets?
The short answer is everything we have come to know over the past 20 years about the latter stages of economic, interest rate, and market cycles, changed in early 2016. The shift is clearly evident in the odd behavior seen across numerous asset classes, which the tweet below captures:
The tweet above basically says stocks (NYSEARCA: SPY ) and bonds (NYSEARCA: IEF ) simultaneously experienced record-inducing demand. Is it uncommon for stocks and bonds to rise together? No, in fact it is quite common. The extremely rare part of the equation is that maximum confidence (new record high in growth-oriented stocks) occurred, for the most part, simultaneously with maximum fear (new record low in bond yields). Common sense tells us that maximum economic confidence and maximum economic fear should not occur in the markets on the same day, but that is exactly what happened on July 8.
How Did The Market’s Narrative Change In 2016?
After all, the 2016 New Year’s confetti was cleaned up, the Federal Reserve was talking in a very unfriendly tone from an asset price perspective (NYSEARCA: DBC ), as evidenced from the January 6 headline below ( full Reuters story ):
The Fed’s intention to raise rates as the economic data improved fits the script we have all come to understand over the past 20 years. Often bull markets and periods of economic growth come to an end after the Fed hikes rates a few times in an effort to keep inflation (NYSEARCA: TIP ) in check (or to restock their policy toolkit).
January 2016: Market And Fed Were Following Traditional Script
All things being equal, the financial markets frown upon Fed rate hikes. The S&P 500 (NYSEARCA: VOO ) responded to the hawkish and “old-script” Fed with the worst ten-day start in U.S. stock market history. During the January plunge in risk assets, the financial markets were reading from the deflation/weak economy/bear market script, as depicted by the chart of silver (NYSEARCA: SLV ) relative to defensive Treasury bonds (NYSEARCA: TLT ) below.
Today, the same silver:bond ratio looks quite a bit different, reflecting the market’s reaction to the Fed’s new and recently communicated late economic cycle script.
Debt, Helicopter Money, And The Fed:
This week’s video expands on the concepts covered in this post. How did we get to a point where central banks are seriously talking about helicopter money? What does it mean for the markets and investing?
After you click play, use the button in the lower-right corner of the video player to view in full-screen mode . Hit Esc to exit full-screen mode.
Debt And Valuations Make Raising Rates Difficult
Why has the Fed adopted a new late economic cycle script? Given extremely high levels of global debt and elevated valuations , central bankers are terrified of inducing anything remotely approximating a Japan-like deflationary spiral . The Fed is concerned if they follow the traditional late-cycle script, asset prices could experience a significant and sharp reset, which could ignite a wave of bond defaults and/or a recession. From the Los Angeles Times :
Eight years ago, unsustainably high debt was the root cause of the worst recession since the Great Depression. Yet, world debt overall now is far above 2008 levels …The overstretched include plenty of governments. Total government debt outstanding worldwide was worrisome in 2008. It has since doubled to $59 trillion, according to Economist Intelligence. But that is just one slice of the global debt pie. Add in household, corporate and bank debt and the grand total was a mind-boggling $199 trillion in mid-2014, up 40% since 2007 , according to a study last year by McKinsey Global Institute.
Inflated Asset Prices Reacted To Threat Of Rate Hikes
The Fed was given a taste of what a global reset might look like after they raised rates in late 2015. The S&P 500 (NYSEARCA: IVV ), as of January 20, 2016, is shown below.
What Markets Were Anticipating In Early 2016
For illustrative purposes, the S&P 500 is shown below from 1997 to 2004. The old script says central banks raise rates near the end of a bullish cycle (1999); the economy eventually slows, and risk markets eventually fall (2000). Sometime during the bearish/recessionary period that follows, the Fed starts to ease policy again (2001) and eventually a new bullish cycle begins with an improving economy and a new bull run in risk assets (2003).
How Did Central Banks Flip The Playing Field?
After the Fed’s early 2016 deflationary spiral scare, central banks slowly started delivering a message that they have gone down a policy road (zero/negative rates) that is very difficult to reverse using the traditional late economic cycle playbook.
The dated headlines below, along with links to each article, illustrate the shift that took place between early January 2016 and the present day. The first headline aligns with the traditional late economic cycle script. The last headline aligns with the new “too much debt and valuations say asset prices are vulnerable” late economic cycle script.
The Fed Saw The Writing On The Asset Price Spiral Wall
Experienced investors would quickly label the January 2016 S&P 500 below as a “possible head-and-shoulders topping pattern.” Bull markets often end when earnings slow, valuations become extended, and stocks move sideways for a long period of time. All three were in play early in 2016, which makes it easier to understand why the Fed shifted abruptly from “four hikes in 2016″ to “helicopter money should be in our toolkit.”
A Major Bottom Near A New All-Time High?
The Fed’s flip flop on rates helped spark the current rally in stocks, which put the mini deflationary spiral fire out. Recently, pre-and-post Brexit and ultra-dovish comments helped markets come to grips with the fact that the central banks plan to extend their zero/negative rate policy experiment further, rather than reign it in as the Fed indicated in January. A July 12 article referenced an extremely rare breadth event that occurred as central banks communicated their asset-price-escalation game plans. The rare event was described via SentimenTrader’s tweet below:
In the chart/tweet above, notice the last time the rare breadth event occurred; in early 2009 after an incredible amount of bear market related stimulus had been announced (green arrow). The 2009 bottom in stocks fit into the traditional market and interest rate cycle script (stimulus came during the bear market/recession and helped create a new bull market/expansion).
Trying To Create A Major Bottom From A Major Top
As pointed out by @DowdEdward (see tweet below), notice how the first breadth event occurred near a major market low (green arrow); a low that was assisted greatly by central banks and government bailouts/stimulus. The second occurrence in 2016 (blue arrow) also followed talk of possible bank bailouts in Europe and even more stimulus from central banks. The big difference is the first rare occurrence happened near a major market low (green arrow) and the second rare occurrence took place in the context of what appeared to be a traditional end of a bull market topping pattern in stocks (blue arrow).
Central Banks Scratching And Clawing In An Attempt To Avoid Deflationary Spiral
The concept of creating a “bottom near a top” is exactly what global central banks are trying to engineer. They keep hoping the next batch of rate cuts, money printing, asset purchases, etc. will create sustainable economic growth, allowing earnings to catch up to artificially propped up asset prices. Central planners hope the next “wealth effect” program will allow them to grow their way out of the zero/negative rate mess they have created over the past nine years. If their grand policy experiments fail, central bankers will lose a considerable amount of power.
Helicopters Dropping Money?
In the United States, the Federal Reserve has gone from “four rate hikes in 2016” to “we should have helicopter drops” in our policy toolkit. With Janet Yellen and FOMC member Loretta Mester both having talked about helicopter money within the last thirty days, more and more market participants are coming to the conclusion that it is highly unlikely the Fed has entered a traditional late-cycle campaign to raise interest rates, but instead the next two or three policy moves could push the Fed’s already hyper-dovish stance into maximum hyper-dove mode. From Australian Broadcasting Corporation :
Dr Loretta Mester, president of the Federal Reserve Bank of Cleveland and a member of the rate-setting Federal Open Market Committee ((FOMC)), signaled direct payments to households and businesses to stoke spending [a helicopter drop] was an option central banks might look at in addition to interest rate cuts and quantitative easing. “We’re always assessing tools that we could use,” Dr Mester said in response to a question from the ABC about the potential use of helicopter money.
Japan Is Already In Near-Helicopter Mode
The Bank of Japan has a policy statement due to be released on July 29. The financial markets will be looking for additional stimulus. From a July 14 Bloomberg story:
Etsuro Honda, who has emerged as a matchmaker for Abe in corralling foreign economic experts to offer policy guidance, said that during an hour-long discussion with Bernanke in April the former Federal Reserve chief warned there was a risk Japan at any time could return to deflation. He noted that helicopter money – in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them – could work as the strongest tool to overcome deflation, according to Honda. Bernanke noted it was an option, he said.
“There’s a strong allergy to so-called helicopter money in Japan, though the definition of the word differs from person to person,” Honda said in an interview on Wednesday. “While looking at the BOJ’s bond purchases and fiscal policy as a package, which I see as a kind of helicopter money, it would be beneficial if the prime minister understands that there is a global leading scholar clearly advocating helicopter money,” said Honda, who was speaking by telephone from Switzerland, where he is serving as Japan’s ambassador.
The markets may not get a textbook helicopter plan from the Bank of Japan on July 29, but the degree of accommodation may be in the same money-printing ballpark. From Bloomberg :
Ben S. Bernanke earned the nickname “Helicopter Ben” for once suggesting a central bank could overcome deflation by cranking up the money presses to finance tax cuts. He’s always made clear such efforts would be a last resort, the equivalent of dropping money from the sky. So when the former Federal Reserve chairman arrived in Tokyo for talks with Japan’s top policy makers this week, bond traders, stock investors and economists had reason to wonder. Was Shinzo Abe’s economic team (Bank of Japan) ready to break the glass, pull the emergency lever and entertain such a radical shift in policy as direct fiscal financing by the central bank. While officials Wednesday played down the most extreme scenario, two of Abe’s top advisers did call for a double-barreled blitz of coordinated fiscal stimulus and money printing.
Why Is There Too Much Debt?
There are numerous reasons, but extremely low interest rates and debt bailouts are a good place to start. Recessions, like other processes in nature, help identify weak players in the public and private sector. During recessions, the rate of bond defaults increases, which is a natural way to purge bad debt from the global economy. The problem is central planners have pumped up asset prices to such lofty and artificial levels, central bankers fear that letting economic natural selection into the debt purging process could set off a hard to stop deflationary spiral in asset prices. Below are just a few examples from the central planning bailout collection:
- $17.4 Billion Bailout U.S. Auto Industry.
- Insurance Company Bailout .
- U.S. Bank Bailout.
- European Bank Bailout .
- Third Bailout For Greece .
More Bailouts Coming In Europe?
When policy makers continually prevent major debt defaults via bailouts and keep interest rates near zero, the global debt mountain just keeps getting bigger and bigger. The problems are still with us in 2016. Europe is currently debating how to prevent zombie banks from defaulting; some are calling for a $166 billion bailout . From The Wall Street Journal :
Nowhere is the risk concentrated more heavily than in the Italian banking sector. In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans. Years of lax lending standards left Italian banks ill-prepared when an economic slump sent bankruptcies soaring a few years ago.
Helicopters And Paper Currencies
How confident would you feel about the cash in your wallet if global central banks started making direct payments to households and businesses or simply printing money to retire government debts? The answer may help us understand why investor demand for hard currencies (gold, silver) has increased substantially as more and more serious chatter emerges about fueling up the money-drop helicopters. From CFA Institute :
Why has the post-crisis recovery been so disappointing? … Are we stuck in a world of diminished prospects and subdued demand? These were the key questions Lord Adair Turner, chairman of the Institute for New Economic Thinking and author of Between Debt and the Devil… “Debt has become unsustainable across the world,” Turner explained… “The trouble is,” Turner explained, “once we have these cycles of credit, asset prices, more credit, if we then get a swing from the exuberant upswing to the depressive downswing, if we get that when leverage is already high, we seem to enter an environment where the leverage never actually goes away. All it does is move around the economy.”
Debt is never paid down, in other words. It’s only shifted: from corporate debt to public sector debt, from advanced economies to emerging markets, and so on. Citing both Milton Friedman and Ben Bernanke, Turner proposed “helicopter money,” or what he prefers to call “overt monetary finance of increased fiscal expenditure.”
“You can use central bank money to finance tax cuts or expenditure increases in a fashion that does not require the government to borrow money,” he explained. “Or you can monetize existing government bonds. Central banks can buy existing government bonds and simply write them off, which frees up the government to run larger fiscal deficits in future.”
How Long Will The Prop-Up Approach Work?
Only markets can answer that question. However, history tells us that central banks tend to experience waning effectiveness when economic data begins to hint strongly at a recession (especially a U.S. recession) and/or when inflation starts to become a problem. Given recent economic data in the United States is not warning of an imminent recession, and inflation trends around the globe do not fall into an elevated category, the prop-up asset prices strategies have continued to be respected by the markets (see vertical ascent in stock prices off the Brexit lows).
Buying Bonds Is Not Supposed To Be A Risk-Free Proposition
It may be hard to believe, but there was a time when a poorly run company or country could not make ends meet, they were allowed to default on their debt. When investors buy stocks and invest in bonds, it is not supposed to be a risk-free proposition. Bond defaults are part of the risk-reward equation, or at least they used to be. And yet, we hear more and more policy makers complain about too much debt in the system; maybe they should take a look in their never-ending bailout mirrors.
The data and image above from the Los Angeles Times (full article here) .
Negative Rates Are Sending Common Sense Messages
Interest rates are set in the marketplace based on the supply and demand for money (credit). When rates are near zero or negative, it is the market’s way of saying the demand for new credit is incredibly low relative to the availability of credit. If demand for new credit was high, then lenders would have the power to charge higher interest; they do not have that power today. Zero/negative interest rates are a strong and incredibly clear signal to central banks and policy makers that the “wealth effect” approach has been pushed well beyond its useful life.
We Have Arrived At The End Of Reason
The wealth effect approach has been pushed beyond the bounds of economic common sense, and yet, instead of saying enough is enough, we may be on the verge of becoming very familiar with the term helicopter money. The tweet below from @ReformedBroker sums up just how far off track global central planners have taken the financial markets and global economy.
A Period Of Asset Price Desperation
Central banks are already buying stock-based ETFs and corporate bonds, as outlined on May 11 . When serious talk of dropping money from helicopters and fear of ” growth causing a recession ” enters the equation, it becomes crystal clear that central banks are on the doorstep of asset price desperation.
See also Coup In Turkey Repulsed, Risk-Appetites Return on seekingalpha.com