Stanley Druckenmiller (Trades, Portfolio) is a living legend of the investing world. Having managed George Soros (Trades, Portfolio)’ Quantum Fund as well as his own hedge fund, Duquesne Capital, he has built an enviable reputation. Even after winding down Duquesne in 2010, Druckenmiller has remained in the public spotlight as a commentator on markets and the economy.
For the past several years, Druckenmiller has been focused on the Federal Reserve’s loose monetary policy. Throughout the Obama administration, he railed against the distorting effects of near-zero interest rates, repeatedly calling for rate hikes. Thus, it came as a surprise to many when he seemed to flip his position late last year.
A dovish turn
In a December op-ed published in The Wall Street Journal, Druckenmiller appeared to walk back his long-standing public advocacy for tightening monetary policy:
“This is a time for choosing. We believe the U.S. economy can sustain strong performance next year, but it can ill afford a major policy error, either from the Fed or the rest of the administration. Given recent economic and market developments, the Fed should cease—for now—its double-barreled blitz of higher interest rates and tighter liquidity.”
Fed Chairman Jerome Powell had broken with the long dovish policies of his two immediate predecessors, Ben Bernanke and Janet Yellen, and continued to push ahead with rate hikes into late 2018, even over the objections of President Donald Trump.
Druckenmiller’s comments might have come as a bit of a shock to the new Fed boss, since the hedge fund guru had been calling for more aggressive rate tightening throughout most of the first two years of the Trump administration.
What could have spooked Druckenmiller so much that he would shift his stance so abruptly?
Signs of weakness
According to Druckenmiller, the proximate cause of his dovish shift was mounting signs of weakness in the core economy. When an economy is faltering, tightening monetary policy is rarely a good idea, as Druckenmiller pointed out during an interview with the Economic Club of New York earlier this month.
“Since the founding of the Fed in 1913, they have never raised rates with the magnitude of decline we saw at the end of 2018,” he said.
In other words, the Fed has historically known better than to try raising interest rates when economic storm clouds are gathering. Yet, that is exactly what he perceived Powell to be doing both with the December hike and his pledge to continue his hawkish efforts into 2019.
For Druckenmiller, a return to a more normal interest rate level and monetary policy regime is the end goal. But that cannot be achieved through tightening policy at a time of economic stress. Drilling down into market signals, the guru saw signs of serious weakness, which had not dissipated by the time of his June interview. Retail and shipping indexes showed significant weakness, for example, leaving him with the conclusion that now is no longer a good time to be pursuing a hawkish monetary policy regime.
A missed opportunity
While it might be easy to label Druckenmiller a flip-flopper on interest rates, it would be far from fair. As he articulated in his December op-ed, there were many opportunities for the central bank to restore normalcy to monetary policy, which it failed to take:
“In a first-best world, the Fed would have stopped QE in 2010. It might then have mitigated asset-price inflation, a government-debt explosion, a boom in covenant-free corporate debt, and unearned-wealth inequality. It might also have avoided sowing the seeds of future financial distress. Booms and busts take the Fed furthest from its policy objectives of stable prices and maximum sustainable employment.”
“In a second-best world, on Mr. Powell’s arrival in February 2018, the Fed would have shrunk its balance sheet with speed and determination before raising rates. The economic expansion was still gaining traction at home and abroad. Tax and regulatory reforms were jolting the supply side of the economy from its slumber. Accelerated Fed QT, in the absence of rate rises, would have been much less disruptive to the real economy. Asset prices could then have found a more durable equilibrium and laid a stronger foundation for future growth.”
In Druckenmiller’s reading of the economic situation, the Fed had several opportunities to return monetary policy to its pre-Great Recession norm, but the central bank repeatedly refused to seize them.
Still a hawk at heart
In June, Druckenmiller lambasted Bernanke and Yellen for holding their fire:
“They should have been able to sneak a rate hike in when the opportunity presented itself.”
There is certainly some legitimacy to this point. Neither Bernanke nor Yellen seemed willing to support a return to stable, non-distortive interest rate levels for fear that it could disrupt the market, even after the economy had clearly regained its footing.
Bernanke only really made one attempt to move away from extraordinary policy measures early in the Obama administration. The market’s so-called “taper tantrum” spooked the Fed into walking back its efforts. After that, even a slow and steady normalization seemed to be off the table. By the time Powell took charge, his window of opportunity was very small indeed.
Verdict
After more than a decade of ultra-low interest rates, it is hard to say how the market would look if monetary policy was returned to its old normal. A generation of investors and economic actors has grown up under astonishingly loose monetary policy, and many have never experienced what that “old normal” was even like. As a result, one might call the monetary regime of today a “new normal” of sorts. But this is fundamentally not sustainable.
Druckenmiller may be right that now is a bad time to raise interest rates, given signs of a softening economy, as well as widespread uncertainty thanks to ongoing trade conflicts between the U.S., China and other major economic powers. However, he is also right that things will have to change ere long if the economy - and markets - are to be kept functional over the long run.
Disclosure: No positions.
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