We find it interesting that a lot of people are have finally been saying recently that the Federal Reserve is being ruled by the markets…and that the only reason they changed their tune recently was because of the big moves in the markets. Well, long time readers know this is something we have been saying (and proving) for many years now. As we have been describing it for a VERY, VERY long time, the Fed is much more “market dependent” than they admit to….and they’re at least as much “market dependent” as they are “data dependent”…..We’ve been thinking (and hoping) that had changed under Chairman Powell, but that hope has obviously faded in a major way.
This all started when the Fed had to implement QE2…soon after QE1 came to an end. The markets fell out of bed shortly after QE1 ended…and the Fed jumped back-in quickly with another QE program (QE2)…because the economy was still very fragile. The same thing happened after QE 2 ended…as the stock market fell hard IMMEDIATELY after that second QE plan came to an end. They then came up with QE3 (but this time they didn’t put an end-date on it.)
We saw it once again in September of 2013. This time it was the bond market that caused the Fed to change their plans. In May of 2013, they said they were going to “taper” back on their bond purchases in September of that year…as long as the economic data stayed on it was on during that spring. Well, the economy DID stay on that path over the summer…and yet the Fed had to delay the time table due to the “taper tantrum”. This tantrum involved a major decline in the bond market…which took the yield on the U.S. 10yr note from 1.63% to 2.95% in just four months!!! (The Fed tried to claim that the data had changed over that summer…and THAT’S why they delayed the “taper”, but the evidence showed that the economy did remain on the same path.)
It happened once again in the 4th quarter of 2014. The Fed was going to completely end its QE program…and it was assumed that the ECB would take-over the “QE baton” from the Fed. However, the ECB got some major push-back from Germany in the second half of that year…and it looked like there wasn’t going to be anybody to take over the “baton”. This led to a decline in the stock market (with a larger decline for the European and Japanese markets). The Fed tried to “jawbone” the markets higher that October…by saying they would either re-engage in their QE3 program…or start a new one (depending on which Fed member was doing the jawboning).
However, this did very little to stem the tide. Luckily, the BOJ was able to come-in and announce (and implement rather quickly) their own QE program….and the ECB finally came around in January of 2015……So in this example, instead of a new QE program from the Fed, the BOJ & ECB came to the rescue when the markets became dislocated.
We should note that the BOJ and ECB had no choice to come to the rescue…because the Fed could no longer engage in an ever increasing QE program at that time. The reason for this is that the Fed had bought so many Treasuries that the Treasury Borrowing Advisory Committee had to warn the Fed that a shortage of Treasuries was developing. Of course, a “shortage of Treasuries” meant a “shortage of collateral”…and the markets cannot function with a shortage of collateral.
As time went on, the system continued to heal itself and become less fragile. This led the Fed to think they could finally begin to tighten. This began with a well telegraphed increase in short-term rates in late 2015. However, the oil market began to crash…which absolutely killed the high yield market. Therefore, due (once again) to a disruption in the market place, the Fed had to step aside…and it stopped raising rates after just one hike.
Once things calmed down in the credit markets…and after things had stabilized, the Fed began raising rates once again…in the following December (2016). This did not disrupt the markets immediately like it had in the years immediately following the credit crisis…because the system had become more stable. (Some would say it was still not very stable, but it was certainly stable enough to keep the tightening from having an immediate negative impact).
Instead, the tightening did not impact the markets/economy for some 18-24 months (just like it usually did in the decades before the credit crisis). However, not only did the Fed continue to raise rates throughout 2017 and 2018, but in late 2017, it ALSO began to shrink its balance sheet at an ever increasing rate throughout 2018. Therefore, it was inevitable that it would have a negative impact on the markets and economic growth.
By the time the we got to the 4th quarter of 2018 got under way, the markets could no longer hold up under this tightening policy. Again, this should not have been a surprise…because EVERY tightening cycle since WWII has caused a significant decline in the markets. This time, it declined 20%.
The difference between what is going on now…and what took place every other time we’ve had a meaningful disruption in the markets over the past decade…is that the Fed has NOT re-engaged in a new QE program…and the ECB & BOJ have not done anything of substance either. Yes, the FED has stopped raising rates, but they ARE still tightening (via QT). Otherwise, the global central banks have only “jawboned” the markets. Not only is the Fed still tightening…but the ECB has still ended their QE program. Yes, the BOJ is still pumping, but the net liquidity flow from the 3 major central banks is NOT increasing yet…like it has after other market disruptions since 2009.
In other words, the markets are now back to doing what they did before the credit crisis. They’re at the mercy of the economic and earnings growth…at least until these central banks do something more than just “jawbone” about their plans…and actually turn the liquidity spigots back on (and allow multiples to expand again).
We believe this is something that is very healthy…even if it was painful back in the 4th quarter. Therefore, we hope that Chairman Powell has the guts to make us take our medicine (the way Volcker did several decades ago)…so that the markets can go back to moving based on a fundamental basis…instead of based on just liquidity flows. We’ll be much better off over the long-term if they do indeed have the courage to do it.
It probably seems to many that the Fed has indeed thrown in the towel once again…and has cow-towed to the markets. However, as we stated above, they have NOT started easing yet…they have only begun to tighten at a slightly slower pace. So maybe Mr. Powell is still the “next Volcker”…and he only wants to slow the rate of taking us off our addiction to liquidity…rather than giving us more of the drug………….Only time will tell.