At this time last year, markets were in turmoil amidst mounting fears of trade war escalation and slowing economic output. The specter of recession loomed large for a while, but the dark shadows were soon dispelled. In the end, 2019 proved to be a bumper year for markets, thanks in no small part to the Federal Reserve’s timely return to loose monetary policy.
As 2020 kicks off, few seem to think the good times are nearing their end. Indeed, fears of recession have dissipated markedly in recent months. The Fed’s decision to adopt a dovish course have propped up markets, and will likely continue to do so for a while yet. Unfortunately, such policies can only delay – not prevent – the inevitable correction. Moreover, the longer the financial reckoning is delayed, the worse the ultimate recession will be – and the less capable the central bank will be of combating it.
The Fed keeps the good times rolling
On Dec. 30, Lawrence McDonald, the former head of macro strategy at Societe Generale, opined that the Fed’s actions in recent months to loosen monetary policy have provided stability in the face of growing turmoil:
“Since 2016, the strong dollar has been the global economy’s weak link. The Fed knows this and has chosen to contain the beast in an effort to sustain the recovery. The fastest balance sheet expansion since Lehman has finally weakened the greenback - breaking key technical levels...We must give the Fed credit. Staying ultra dovish, juicing the balance sheet from $3.7T on September 10th to $4.1T today, they've weakened the USD and stabilized the global economy.”
As the U.S. economy sputtered in late 2018, the Fed made the fateful choice to switch from a somewhat hawkish stance on interest rates to a superlatively dovish one. This new injection of monetary easing had the intended effect, reinvigorating confidence among investors, businesses and consumers. It has also led to a weakening dollar, further spurring the appearance of domestic economic strength.
The Fed’s dovish stance, reinforced by loosening monetary policy by central banks around the world, probably kept the U.S. from tipping into recession. However, as Mohamed A. El-Erian, chief economic advisor to Allianz, discussed on Jan. 5, this stabilization has come at a price:
“Rate actions by [central banks] around the world [are] a reminder of the huge extent of monetary policy loosening in 2019 – both overall and in terms of the delta relative to 2018. And it’s an issue that is intensified by the enormous expansion in balance sheets.”
The Fed had been working toward an economic “soft landing” since 2018, gradually raising interest rates and tightening monetary policy. The market’s subsequent temper tantrum was quickly exacerbated by President Donald Trump, who demanded that the central bank reverse course and continue to juice up the long-running economic expansion. The Fed obliged, resulting in the current continued expansion, but also setting the stage for more dangerous times ahead.
Still relying on emergency tools
If the economy is doing as well as some claim, one might expect the central bank to behave as if the economy is behaving normally. Yet, the Fed is still using monetary policy tools usually thought suited only to emergencies, as Lawrence McDonald pointed out last week:
“We must ask a key question. Why are central banks still using emergency tools designed for financial crisis conditions with an economy at full employment, stocks at all time highs? If markets can’t function on their own now, when will they?”
As the stock market increasingly becomes a proxy for economic health, political incentives increase to support its continued upward movement.
Fed Chair Jerome Powell bent the knee to political pressure in early 2019. As Ben Hunt of Epsilon Theory opined in March, this marked a major turning point for capital markets. Specifically, it marked, in Hunt’s view, the transformation of independent capital markets into a political utility:
“When I say that capital markets have been transformed into a political utility since 2009, what I’m saying in geek terms is that the normal distribution of variation in portfolio returns no longer exists. Everyone thinks it does. Everyone thinks that a normal distribution of some sort still describes the role of chance in market outcomes, that of course there’s a policy impact on skew or heteroskedasticity or the mean or volatility or whatever, but over the long term (or my favorite, 'over a credit cycle') there’s by and large a normal distribution of variance in portfolio outcomes around some mean expected return. I’m saying this is wrong. I’m saying that the distribution of variation in portfolio returns in a regulated utility like capital markets is whatever the State ALLOWS the distribution to be.”
In other words, markets are behaving as if everything is fine, yet the central bank is behaving as if the economy is in crisis. Meanwhile, the differentiation between political and apolitical forces in government appears to have been eroded substantively. This is a fundamental problem for capital markets.
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