As I wrote about last month, my wife and I have been on an Avengers binge. My young son recently convinced us to watch “Thor”, and we are on the third edition of that goofy and arrogant hero’s antics. In this one, for those who don’t remember, Thor’s older sister Hela returns and amongst other things demolishes Thor’s hammer like it was made of glass.
Central banks collectively have also been acting like Thor with their monetary policy hammer. Their Hela is, of course, inflation. The mantra of central banks has been to print more and more and more money to solve any and all problems. Market participants have gotten highly addicted to these goofy policies and rising financial asset prices. As the most recent CPI reading showed 6.2% inflation rate (Source: Bloomberg), the highest in almost 30 years, the bottom began to fall out of both stock and bond markets. Hardly a surprise to anyone who has been to the grocery store lately, or filled their tank, but Wall Street investors are of a different breed.
Not only has inflation not been “transient”, it is becoming more persistent in places where the Fed said it wouldn’t. There are no two ways about it – the Fed got it wrong, period. But with their super-powers and an all-powerful hammer of money printing, central banks continue to take actions that will likely worsen inflation. Consider the $100 billion of money through asset purchases every month (this is after the 15 billion of “taper” that will begin this month). By the time they are done at the advertised pace, another half a trillion dollars of new money will be sloshing in the system. Unless, of course, the hammer is shattered by the return of their Hela – i.e. inflation, which can cause the Fed to either panic and tighten too aggressively, or risk letting the situation get further out of hand. Think of an irresponsible bartender “tapering” an obvious drunk with more booze rather than cutting the drunk off quickly and completely.
The tone-deafness of current policy stance is made even more interesting, almost laughably funny, almost like the movie series, with last week’s release of the latest edition of the Fed’s financial stability report. As is often the case, what I noticed the most was what was missing in that report. In the classic form of a self-congratulatory sales brochure it states a lot of facts, and shows a lot of pictures, but the narrative completely ignores the elephant in the room – the Fed’s own actions, to gently convince readers why things are so hunky dory.
The text tries to assure investors that there is very little real risk to the economy from current levels of interest rates and asset prices. However, just to cover all bases, the report creates a nice little hedge (p7) for the Fed with the statement that “Asset prices remain vulnerable to significant declines should investor risk sentiment deteriorate, progress on containing the virus disappoint, or the economic recovery stall”…duh! A great example of stating the obvious but without mentioning the obvious causes.
The report also talks about how banks have had a record profit and why this makes the financial plumbing safe – another obvious statement that completely ignores cause and effect – the banks have been making so much money because they are selling the Fed all the trillions of Treasuries it buys, in a well-telegraphed fashion. Just imagine if you told me that you would buy three or four billion dollars’ worth of bonds every single day. Of course I won’t know until the event which bonds you would buy, but because every bond in the market is connected through the interest rate yield curve, my best bet would be to analyze your previous patterns, step in front to buy up all the bonds in advance of your order, sell you the ones you wanted, and then hedge my risk out. Easy-peasy. Money out of the taxpayers’ pocket and into the vaults of the bank’s shareholders. In Europe, it is even more perverse – the ECB effectively pays banks to buy bonds at negative yields as long the banks do its bidding.
How’s this one from the report? “A forward looking measure of Treasury market volatility derived from options prices changed little since May, on net, and remains below the median of its historical distribution” (p11). The writer probably intended this to sound like a statement supporting the notion of financial stability. It is anything but. The Fed’s backstop of Treasurys is the reason that volatility appears low. To imagine what could go wrong one only has to look at the Reserve Bank of Australia a couple of weeks ago. After spending close to twenty billion Australian dollars to keep three year yields close to zero, and market implied volatility very low, the RBA threw in the towel, and the yield jumped almost seven fold, causing global mayhem in the bond markets. The RBA was the first central bank godlike creature to perish under the weight of the market. The Bank of England followed next, first preparing the market for an imminent tightening and then doing nothing. A gross act of miscommunication that created unnecessary bond market volatility, but also showed that the all-powerful central banks are at the end of the rope of credibility.
I won’t bother the reader with a line by line critique of the Fed’s recent report, though I do hope that econ professors in universities give that exercise to their students to see how well the students can sift fact from fiction, reality from fantasy, and more importantly conclusions made. But here is one that keeps popping up: “the difference between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities—a rough measure of the compensation that investors require for holding stocks, known as the equity premium—has increased a touch since May. In contrast to the signal from other valuation measures, this measure of the equity premium remained somewhat above its median, suggesting that equity investor risk appetite remained within historical norms“ (p13).
Seriously. The goal of this section seems to be to convince the reader that by looking at an independent set of market variables one should logically conclude that equity risk premiums and hence equity prices are at normal levels. But note that the Fed is one of the biggest owners of TIPS (Treasury Inflation Protected Securities), whose yields are used for the “real yield” component in the calculation. Real yields in the ten year maturity are at minus 1%, because the Fed has been buying them, crowding out other investors looking for inflation protection (one part of the government, the Treasury, selling inflation insurance, and another part of the government, the Fed, buying up that same insurance!). The difference between the forward earnings to price and the real yield, which the report takes as the metric of why investor risk appetite remained within “historical norms” is therefore completely misleading, because the real yields are low because of the Fed’s own buying of TIPS.
When talking about “meme” stocks, the report says (p18) “Longer-run changes in demographics, regulations, and technology as well as behavioral factors that could interact with these structural changes may have influenced recent trends in the demand for and supply of retail trading opportunities in equity markets.” The report completely ignores zero interest rates, massive liquidity infusion and all the helicopter money that is being mailed to retail investors, which has clearly been one of the main reasons for increased stock market speculation by retail traders.
So how should investors prepare themselves for what is likely to come?
There is a school of thought that the Fed is the source of bubbles and busts in our economy by initially denying any risk due to ultra-easy policy (count the number of times the report suggests that things are just fine), then plays catch-up by aggressively tightening and crashing the markets – pulling the punchbowl just when the party’s getting going, according to the saying. Which they can rescue again – to quote Thor: “that’s what heroes do”. It is possible we are at an inflection point, where bubble-forming rhetoric will be quickly replaced with bubble-bursting logic. If the experience from Australia and UK are a precursor of things to come, my guess is that we are setting up for an aggressive tightening pivot by the Fed, and possibly by the ECB.
To possibly get ahead of this pivot, investors would do well to consider following the simplest script when faith in the central banks’ credibility is erased: first do not buy any bonds that the Fed has been buying but could likely stop buying without much warning. If one has to buy bonds, shorten duration and wait for the opportunity to re-deploy that capital once the bond market gets to its natural price and yield level. Second, anything that is a beneficiary of low yields should be underweighted. This means moving allocation towards value stocks and small stocks that have actual profits and may distribute cash. Large cap growth stocks are simply another expression of a long bond position at these rate levels. Third, self-insure your portfolio using options. Whether this is via protective put options on the stock market or replacement of outright exposures with call options, low volatility levels are an opportunity to be the last one standing if the central bank asset market put is removed from the equation. Of course, there are other scripts market participants can follow and it’s important investors always consider their individual circumstances and risk appetite when considering which script to follow.
The good news is that in Norse legend Ragnarok, the twilight of the gods, was followed by a new world with humans in charge. The same will likely happen here. Once the inappropriateness of the monetary policy of the day is realized, a whole new set of more balanced policies will surely emerge (at least let’s hope so), and provide investors who have survived the opportunity to thrive. We have to remember that just like Thor was able to hold his hammer because he was deemed “worthy”, central banks have gotten to print money and buy trillions of assets because they rightfully earned credibility over the last three decades. With inflation beginning to run out of control while they stick to meaningless wordsmithing it feels that they are very close to losing this credibility – and when they do, they will likely lose the right to use the magical monetary hammer to keep markets afloat.