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The global economy is
healing, so we are told. Yet, the moment the Federal Reserve (Fed) indicates
just that – and thus implying no additional stimulus may be warranted
– the markets appear to throw a tantrum. In the process, the U.S.
dollar has enjoyed what may be a temporary lift. To make sense of the recent
turmoil, let’s look at the drivers of this “recovery” and
potential implications for the U.S. dollar, gold, bonds and the stock market.
In our assessment, what we see unfolding is the
latest chapter in the tug of war between inflationary and deflationary
forces. During the “goldilocks” economy of the last decade,
investors levered themselves up. Homeowners treated their homes as if they
were ATMs; banks set up off-balance sheet Special Investment Vehicles (SIVs);
governments engaging in arrangements to get cheap loans that may cost future
generations dearly. Cumulatively, it was an amazing money generation process;
yet, central banks remained on the sidelines, as inflation – according
to the metrics focused on - appeared contained. Indeed, we have argued in the
past that central banks lost control of the money creation process, as they
could not keep up with the plethora of “financial innovation”
that justified greater leverage. It was only a matter of time before the
world no longer appeared quite so risk-free. Rational investors thus reduced
their exposure: de-levered. When de-leveraging spreads, however, massive
deflationary forces may be put in motion. The financial system itself was at
risk, as institutions did not hold sufficiently liquid assets to de-lever in
an orderly way. Without intervention, deflationary forces might have thrown
the global economy into a depression.
The trouble occurs when the money creation process
takes on a life of its own, because the money destruction process is rather
difficult to stop. However, it hasn’t stopped policy makers from
trying: in an effort to fight what may have been a disorderly collapse of the
financial system, unprecedented monetary and fiscal initiatives were
undertaken to stem against market forces. Trillion dollar deficits, trillions
in securities purchased by the Fed with money created out of thin air (when
the Fed buys securities, it merely credits the account of the bank with an
accounting entry – while no physical dollar bills are printed, many
– including us – refer to this process as the printing of money).
Will it work? The Fed thinks it might. But nobody
really knows. We do know that a depression works in removing the excesses of
a bubble. However, the cost of a depression may be severe, both in social and
monetary terms. Critics of the “let ‘em
fail” argument say that businesses and jobs beyond those that have
engaged in bad decisions will be caught by contagion effects and may
ultimately be bound to fail too. Fed Chair Bernanke, a student of the Great
Depression, frequently warns against repeating the policy mistakes of that
era. So does the reflationary argument work, i.e. does printing and spending
money help bring an economy back from the brink of disaster? We cannot find
an example in history where it has. As Bernanke points out, policy makers
have learned a great deal by studying crises of the past. Our reservation
comes from the following observation: central bankers at any time have always
been considered amongst the smartest of their era, yet – with hindsight
– they may have engaged in terrible mistakes. While we certainly wish
that Bernanke is right, we nonetheless maintain a degree of skepticism and
believe it is any investor’s duty to take the risk that the world does
not evolve the way he envisions into account. Our policy makers also might be
well served to be more humble, as they are putting the world’s savings
at risk.
Yet, the reason central bankers are bold, not
humble, is because they fear hesitation will lead to deflationary forces
taking the upper hand yet again. Bernanke’s contention, that one of the
biggest mistakes during the Great Depression was to tighten monetary policy
too early, stems from that fear. In its recently released minutes, the Federal Reserve Open Market Committee (FOMC)
placed that fear in today’s context: “While recent employment
data had been encouraging, a number of members perceived a non negligible risk that improvements in employment could
diminish as the year progressed, as had occurred in 2010 and 2011, and saw
this risk as reinforcing the case for leaving the forward guidance unchanged
at this meeting."
In our view, the reason why the Fed is committed to
keeping rates low until the end of 2014 is precisely because the Fed does not
want to be perceived as tightening too early. Why the end of 2014? Well,
because it’s not today or tomorrow. We believe nobody – not even
at the Fed – knows whether the end of 2014 is the right date. The
problem with that policy will be when the market no longer buys it. The
market just needs to see one member of the FOMC turn more hawkish, as a
result of improving economic data, to interpret that we may be starting down
the road of monetary tightening. Yet, if the market thinks the Fed may
tighten, deflationary forces take over, possibly unraveling all the
“hard work” the Fed has done.
Will tightening ever be bearable for the economy again? U.S. financial
institutions are in a stronger position than they were in 2008. Conversely,
governments around the world – not just the U.S. government – are
in far weaker positions, given the large amounts of debt they have incurred,
in an effort to manage the financial crisis. Many consumers have downsized
(read: lost their homes / filed for bankruptcy), but there continues to be
downward pressure on the housing market, as millions of homes remain in the
foreclosure process and are only slowly making it to the market. Bernanke may
have chosen the end of 2014 as the earliest time to raise rates because it
represents a date when the housing market may have freed itself from much of
the foreclosure pipeline. Indeed, Fed research suggests that residential
construction won’t fully recover until 2014. We don’t think that
is a coincidence. To Bernanke, a thriving home market appears to be key to a healthy consumer and thus a healthy and
sustainable recovery in consumer spending.
Tying monetary policy to the calendar has created
alarm with economic “hawks” – not just the Fed itself, with
the lone hawkish voting FOMC member, Richmond Fed President Jeff Lacker, openly dissenting. But if one follows
Bernanke’s line of thinking, what’s the alternative? The
alternative would be to firmly err on the side of inflation, as the Fed
thinks inflation is the one problem it knows how to fight. Except that a
central bank must never communicate that it wants to induce inflation, as it
may derail the markets. So the 2nd best option, from Bernanke’s point
of view, may be to commit to keeping rates low until the end of 2014; the
“risk” that the economy might perform better than expected (and
thus earlier tightening warranted) appears to be shoved aside. Just to make
sure the markets behave, the Fed also introduced an inflation target,
assuring the markets not to worry, all will be fine on the inflation front.
Unfortunately, we don’t think Bernanke’s
plan will work. The reason is that inflation may not be as easily fought as
Bernanke thinks. The extraordinary policies that have been pursued have not
only planted the seeds of inflation, but have re-introduced leverage into the
system. While Bernanke claims he can raise rates in 15 minutes, we believe
there is simply too much leverage in the economy to raise rates as much as
former Fed Chair Paul Volcker did in the early 1980s to convince the markets
the Fed is serious about inflation. Given the increased interest rate
sensitivity of the economy, much less tightening would likely be necessary.
We are not as optimistic as many current and former Fed officials that it
will be possible to engineer a sustainable economic growth while adhering to
the Fed’s inflation target. The Fed is ultimately responsible for
inflation; however, we have also learned that the modern Fed is unlikely to
risk severe economic hardship to achieve its price stability mandate.
What does it all mean for the markets? Deflationary
forces have favored the U.S. dollar and been a negative for gold. As
indicated, however, we don't think the Fed will sit by idly as the markets
price in tightening before the economy is “ready”. As such, a
flight into the dollar out of gold might be an opportunity to diversify out
of the dollar into a basket of hard currencies, including gold. With regard
to the bond market, we are rather concerned that the long end of the yield
curve has been extraordinarily well behaved until just a few weeks ago. The
reason for our concern is that periods of low volatility in any asset class
usually means that money has entered the space that might leave on short
notice: we call it fast money chasing yields. We don’t need a crisis
for investors to run for the hills in the bond market; we may just need a
return to more normal levels of volatility. As such, investors may want to
consider keeping interest risk low, i.e. staying on the short-end of the
yield curve, both in U.S. dollars and other currencies. With regard to the
stock market, it may do well should the Fed think of another round of easing,
but let’s keep in mind that the stock market has had a tremendous rally
in recent months.
If investors consider investing in the stock market
because of the Fed’s monetary policy, why not express that same view in
the currency market? After all, currencies – when no leverage is
employed – are historically less volatile than domestic (or
international) equities. Currencies may give investors the opportunity to
take advantage of the risks and opportunities provided by our policy makers
without taking on the equity risk.
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