Jun 19/15 – How long can they leave rates at zero?
2015-06-19 9am EDT | #Fed #FOMC #Greece #Magnum #Nasdaq #stocks #Yellen
If you are older than forty years old, then you probably remember Magnum PI. For my younger readers, Magnum was a popular TV show from the 1980’s about a private investigator who lived on the Hawaiian estate of some elusive millionaire (a million dollars actually meant something back then).
It was a good show, and I think it has aged well. There were lots of great episodes, but I bet there is one that sticks in your mind better than others. For some reason most people seem to remember the “treading water” episode. The rest of the different stories all blend into some derivative of the typical TV show plot, but the one where Magnum treads water for the entire episode is permanently etched into many Magnum fans’ brains.
In the episode Magnum is kayaking in the open ocean when a bunch of yahoos in a power boat almost run him over. Of course the kayak is ruined and he is forced to tread water for what ends up being 24 hours. There are a bunch of flashbacks to when Magnum was a younger boy and his father taught him to swim. It turns out that Magnum’s father was killed in the Korean war, and his memories of learning to tread water for 30 minutes straight is what he remembers most vividly.
The trauma of receiving the news about his father’s death while he was practicing treading water leaves a big emotional scar on the young Magnum. Just like the credit crisis of 2008 left a huge gaping wound on the psyche of most financial market participants. And the members of the FOMC committee were on the front line of that disaster. They knew better than most how close we were to the whole financial system coming completely unglued. They will never admit to the direness of the situation, but many other big name financial players have been more candid:
Mohamed El-Erian: Hit the ATMs “On the Wednesday and Thursday after Lehman filed for Chapter 11, I asked my wife to please go to the ATM and take as much cash as she could. When she asked why, I said it was because I didn’t know whether there was a chance that banks might not open.”
Neel Kashkari: A real-life, terrifying experiment “We were now forced to live a real-life, terrifying, financial-markets experiment: Would the failure of a major investment bank really lead to the catastrophe that we feared?”
Meredith Whitney: Shouldn’t have let Lehman fail “Little did most people on the street that day appreciate how much panic was going on behind the scenes. After all, we hadn’t addressed the fate of Washington Mutual and Wachovia yet.”
I don’t know if I should include Meredith Whitney in the list of big name financial players, but at the time she was a top rated bank analyst who understood the credit risks on the banks’ balance sheets better than most.
My Dad often reminds me how for his parent’s generation who had experienced the despair of the Great Depression of the 1930s, they were forever fearful of buying too much real estate with debt. They had seen first hand the anchor that was leashed around the necks of those who had over leveraged themselves. The scar was so deep that generation never embraced using debt to buy assets. It was until their kids (the BabyBoomers) came of age that debt exploded higher.
Maybe it will take a whole new generation of FOMC committee members to raise rates. The fear of the last crisis is too fresh in the current board’s mind. In hindsight I should have ignored the tough talk from the handful of FOMC hawks. I have always believed the Fed would be behind the curve the whole way up. But their posturing tricked me into thinking we would get one rate increase just to remove the emergency zero rate.
The fear from the last crisis has left the Fed with a mindset that it is easier to stop inflation than it is to reverse deflation. Therefore they are willing to risk being easier for longer.
Fellow Canadian, WSJ reporter Greg Ip wrote a terrific piece titled Memo to Fed: Let the Economy Overheat.* I don’t think he needs to suggest anything of the like to the Fed as they are already on the same page, but the article does a good job at understanding what they are thinking.
From the article:
The Federal Reserve signaled Wednesday, with some trepidation, that it remains on track to raise interest rates later this year.
Ordinarily, with unemployment now approaching levels associated with an economy at full strength, the case for raising rates would be open and shut: the Fed would not want unemployment to drop so far that the economy overheats and inflation takes off.
But these are not ordinary times. An overheating economy right now would be welcome: It would help nudge inflation back to more normal levels, restore some of the long-term growth potential lost since the financial crisis, and boost ordinary workers' wages more effectively than remedies such as big increase in the minimum wage, which can reduce employment for the low-skilled. While low rates may be fueling speculation in financial markets, that threat doesn't yet outweigh the many benefits.
However, millions of Americans who are working part time but want full-time work, and others who aren't looking for work but want a job, aren't counted as unemployed. Additionally, structural shifts seem to have weakened workers' ability to win big wage gains. This suggests it may require unemployment below 5% for an extended period to generate significant wage gains and to eventually get inflation higher.
The economy's supply side has weakened, so there is little "slack" to tamp down price pressure. Both the labor force and productivity are growing at well below prerecession rates, which means that much of the disappointing pace of economic growth is due to a weaker supply-side to the economy. If so, then capacity constraints and cost pressures could emerge more quickly when growth picks up.
The hawks will argue that leaving rates at zero will do nothing more than fuel more financial asset gains. Yet Greg counters:
Easy monetary policy worsens inequality. Low interest rates work in part by boosting the prices of assets such as stocks and property. And since such assets are owned mostly by the rich, this widens the nation's wealth gap.
But this is a short-sighted objection. Higher asset prices won't make workers poorer; but higher unemployment will. If the economy overheats and unemployment drops below 5%, this will do more for the average worker, with fewer negative side effects, than interventions such as a higher minimum wage. That's the lesson of the 1996 to 2000 boom when the Fed let unemployment fall below 4%. Wages grew strongly.
I think Janet & Co. will mouth words about being concerned about the excesses in the financial markets, but they are ready to accept the trade offs. They are just too scared about the consequences of raising rates too early. They are too many Ray Dalio’s warning about making a 1937 type mistake. The memories of the last deflationary collapse of 2008 are still too fresh.
If you leave rates too low for too long you risk overshooting on the other side. The worries about an overheating economy six months to a year down the road are real. That is why the yield curve is steepening.
Yellen most likely welcomes this development. If you are worried about slipping into a deflationary morass, then steepening the yield curve is one of the most reliable signals that monetary policy is accommodative.
Risk assets that benefit from an easy monetary policy are exploding higher. The small cap equity ETF has broken out to new highs:
The small caps are more sensitive to a weaker US dollar and easy monetary policy – both of which Yellen is encouraging.
The dark side of this policy is the speculative bubble is growing. Have a look at a few decade long Nasdaq composite chart:
We have seen this movie before… My worry is that it will get worse before it gets better.
The risks of this whole financial experiment lighting up like a huge forest fire are way higher than most market participants are discounting.
The Fed is convinced they will be able to handle inflation, and that deflation is the real worry. I will leave you with this thought – when was the last time the Fed got something like this correct? What do you think you should be hedging against?
In the Magnum episode his friends all “sense” that something is wrong at the same moment, and rush to save Magnum before he drowns. It makes perfect sense that Magnum’s friend Rick who is partying on the King Kamehameha II with some young ladies, all of a sudden stops it all, to rescue Magnum. Who hasn’t had this sort of vision in the midst of an all night boat party off of Honolulu?
This is how it works on TV, but I don’t think the Fed will be quite as fortunate. There will be no hero saviour at the end of this story. Just make sure you remember this next crisis will look nothing like the last one. Don’t hedge with the idea it will be a repeat of 2008. It will look nothing like 2008…
Hell has no fury like…
It feels like Saving Private Ryan out there with all the tape bombs being dropped from the Greek negotiations. It is tough trading this sort of noise as there are so many conflicting signals.
I am not sure of much, but I do know one thing; the Greeks consistently play this game better than the Europeans. Have a look at this great headline:
Who would want to bet against this man? The fury of IMF’s Christine Lagarde, or the wrath of his wife? Seems like a pretty easy choice to me. Greece is going to the wall.
I don’t know how this is going to play out. But my one prediction is that no matter what, Greece isn’t the one that blinks…
Thanks for reading and have a great week-end,