Consider this post as being as much for me as it is for you, faithful reader. I want to verbalize what I think is going on in the markets, and what is qualitatively different now. Much of it will be influenced by what I’ve read on Bill Fleckenstein’s site, as well as from James Gruber and Turd Ferguson.
The longstanding narrative has been that the Fed (and other central bankers) is able to use aggressive monetary policy (i.e., money-printing) to fix the economy. Fleck calls it the “Goldilocks” syndrome – an inherent confidence in the Fed’s competence at managing markets and all problems that come. By contrast, my view has been that these stimulus measures only serve to inflate the price of financial assets, without providing any organic or sustainable growth in the real economy. A wealth effect which does not translate to more and better jobs. However, for a long time now, the Goldilocks view has prevailed.
But, something changed in the past week, and had been building up in the months before that. The suggestion of a taper in QE gained a lot of traction, with the idea being that the Fed had seen enough improvement in the economy to begin slowing down the drugs that were being dealt. So, in the lead up to last week’s FOMC statement (and subsequent press conference by the Bernank), rates started to creep up. And guys like Krugman were arguing that it was all about improvement in the economy, and not some evil force like bond vigilantes.
Then, last Wednesday. Bernanke doesn’t take a particularly hawkish stance, but merely hints at the possibility of tapering should conditions improve enough and other metrics are hit. And the market is roiled. Treasuries spike up, and have been continuing to do so ever since. Equities are hit hard, and that has been the trend in the last week. And, of course, given that it’s scared of its own shadow these days, gold is taken out to the woodshed yet again also.
I think there are a few implications to draw from all of it. First of all, throw out the garbage that the economy can go without stimulus. If ever we needed confirmation that the wealth effect was an artificial construct, just look at what non-action and merely dovish words can do. There is no seamless exit here. The Fed is in a trap of its own design, and now will be forced to backtrack on something it had no imminent plans to implement.
But, there is another part to it. What if this change is not about the taper, but the beginning of a recognition that the Fed has done too much and has far less control than everyone previously thought? What if this moment symbolizes the shift from total confidence in the Fed to seeds of doubt? If that were the reality of these markets, wouldn’t it suggest that whether they taper or not, or even expand the size of the program, the results might not meet the same reaction as in the past. It would suggest desperation and people might wonder why so much has been done, but so little has been achieved. We’ve seen something like that in Japan. Maybe that was the spark that is now spreading.
Anyway, I think all of it means greater volatility in what comes next. And that the market is going to assert itself a bit more from now on. The Fed is not bigger than the market. It never was. It wants to keeps rate low, but that’s not where rates want to be. And if the Fed tries to monetize every bond in an effort to control rates, it will lose the currency, and then still lose bonds again. The upshot from my seat is the Dollar losing its reserve currency status. And with no powerful growth on the horizon, we are likely to see stagflation.
That’s the roadmap in my opinion.
