Jun 09/15 – The Philadelphia Fed paper is your heads up

2015-06-09 10am EDT  |  #Eurostoxx #Fed #inequality #QE

A couple of weeks ago (May 2915 – Day 172 of Knife Catchers Anonymous) I suggested the long EuroStoxx was a crowded trade and due for a pull back. Although I didn’t know the catalyst, I figured the massively overbought nature of the trade made the risk reward favour at the very least watching from the sidelines.

The money had been flowing into EuroStoxx and out of the US for quite some time. Every fast money guy and his wife’s purse dog was long European stocks. The bullishness had hit a point where it was bound to disappoint.

Since then there has been a steady winding down of this trade. Over the past week, it seems like every day we wake up with European stocks dragging us lower in the morning, until they finally close and the North American stocks attempt to stabilize in the afternoon.

I don’t know if it is nervousness about Greece, or whether it was simply time, but the fast money guys are abandoning this trade at a fierce rate. Many of them had both the long EuroStoxx and short Euro currency trade on. This made sense given the ECB’s QE program. But as usual, they pushed the trade too far and now they are rushing for the exit.

The fast money guys pulled a Tony Montana and went a little overboard. Now we have both the European stocks falling and the Euro currency rallying as this is unwound.

This trade will work again, we just need to clear the decks of these over enthusiastic partiers. Give it another week. Let’s see what happens with Greece. But keep your eye on the trade. There might come a time to strap this back on when the smoke clears.

No Shit Sherlock

It was seven years ago this month, in the midst of the credit crisis of 2008, the Fed embarked on their first Quantitative Easing program. It was supposed to be a one time affair, but it ended up having four different iterations. In the process it swelled the Fed’s balance sheet from $900 billion all the way to $4.5 trillion.

I always laugh when I see this chart. The Y2K “flood” of liquidity that Greenspan unleashed on the economy in fear the computers wouldn’t handle the flip to 2000 seemed so preposterously loose at the time. It was enough to send the Dot Com bubble into the final stages of their manic frenzy. Yet, that balance sheet expansion now seems so naively tame when compared to the 2008+ experience.

Back then when the Fed started down this road, I don’t think anyone really knew how this massive balance sheet expansion would turn out. Even today, the final chapters are still far from written. But although the conclusion is still up in the air, there can be no denying the effects of the expansion so far. The Federal Reserve and other Central Banks have been in denial, yet the consequences of their actions are as clear as day. They have blown the biggest, most pervasive bubble the financial markets have ever seen. In anchoring rates so low, they have encouraged risk taking in almost every asset class out there. There are precious few reasonably priced assets left as investors (along with Central Banks themselves in some cases) have bid up prices to stratospheric levels.

Although Ben Bernanke and the other architects of this policy would argue it was done for the benefit of the entire economy, that narrative has been running thin for some time now. Here is a speech from 2012 where Bernanke spells out his beliefs:

Many savers are also homeowners; indeed, a family’s home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and–through pension funds and 401(k) accounts–they often own stocks and other assets. The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. What can be done to address all of these concerns simultaneously? The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates.

The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.

I am rarely sympathetic for Central Bank chiefs, but I think too many people assign some nefarious reason behind Bernanke’s policy decisions. He didn’t set out to enrich the 0.01%’ers at the expense of the average American. Bernanke truly believes he did what was best for the economy as a whole.

Yet for some time now it has been obvious to anyone with half a brain that the Fed’s policies were exacerbating the growing inequality problem. The balance sheet expansion was forcing up financial asset prices, with little of the so called “wealth affect’ trickling down into the real economy. When the economy didn’t bust out of the gate with the anticipated ferocity, Bernanke & Co. simply did more quantitative easing. Again this caused little real economic improvement, but it caused financial asset prices to rise even further. The rich who own the vast majority of the financial assets never had it better.

Well, over half a decade later, the Fed is just now coming to the conclusion their policies didn’t work as planned.

In an important admission, a recent Philadelphia Fed paper highlighted the growing problem of wealth inequality as the result of aggressive monetary expansion. From the WSJ:

Federal Reserve policies launched in a historic economic slump may have exacerbated wealth disparities in the U.S., according to new research from the Philadelphia Fed.

"Monetary policy currently implemented by the Federal Reserve and other major central banks is not intended to benefit one segment of the population at the expense of another by redistributing income and wealth," writes economist Makoto Nakajima in the second quarter edition of the regional central bank's Business Review.

"However, it is probably impossible to avoid the redistributive consequences of monetary policy," the paper says.

"Research focusing on the redistributive effects of unconventional monetary policy is virtually nonexistent, because policymakers started using forward guidance and quantitative easing only recently," Mr. Nakajima says.

Nonetheless, he argues the redistributive consequences are real, and should not be ignored, even if they are hard to measure and often work in opposing directions. For instance, if lower interest rates boost employment and the poor have higher jobless rates, then a loose monetary policy can be seen as redistributive in the direction of lower-income earners.

At the same time, QE has been seen as key driving force behind a sharp rally in the stock market, which benefits the wealth disproportionately.

"Whether and how much a wealthy household gains or loses from monetary policy depends on the relative strength of these different effects on the composition of its portfolio of assets and debt," the Philadelphia Fed report says.

You might say to yourself; so what? The Fed just figured this out now? We have known this for years.

But this paper is a crucial important first step in the Fed’s eventual changing of policy. Before they can change, they need to admit they have a problem. Until now too many Fed officials still clung to the Bernanke line about QE ultimately being the best way to help the little guy. Now we are seeing the beginnings of a shift in attitude.

The next step will be for the Fed to discuss alternative methods of stimulating the economy. I don’t know what this will entail. Maybe it will be direct loans to the consumer. Maybe it will be buying student loans from the government. I am not sure what scheme they will cook up. But rest assured, they will find some new ways of stimulating. They will try to bypass Wall Street and lend directly to Main Street.

When the next crisis hits, the Fed will not continue to enrich the 0.01%’ers with more standard QE. They will have some novel new method of stimulation. Now don’t get me wrong – that won’t work either. But as traders it is important to remember that the next round will be different. This Philadelphia Fed paper is your heads up – make sure you don’t ignore it.

Thanks for reading,

Kevin Muir

the MacroTourist