A Week of Talk, Not Action

Good Evening: After wobbling a bit last week in the wake of the FOMC meeting, U.S. stocks sharply rallied today. Wednesday’s FOMC communiqué was light on the exit strategy hints some market participants had feared prior to the meeting, so investors decided to bid share prices higher almost as soon as the Fed’s statement hit the wires last week. However, once the S&P 500 reached 1080 and had investors dreaming about an “11 handle” on the widely watched benchmark index, stocks reversed course and went lower into Friday. One source of last week’s desire to take profits was an opinion piece in the Wall Street Journal by Fed governor, Kevin Warsh (see below). Mr. Warsh used soaring prose to present the Federal Reserve as an institution brimming with responsible central bankers, ones who might just be able to leap tall buildings in a single bound to save our economy.. Capitalism in a democratic republic is just slightly more complicated than the “we won the battle; now let’s win the peace” situation portrayed by Mr. Warsh. In the final analysis, the Fed has too much in common with the G-20 and the ECB’s Jean-Claude Trichet to be credible on stimulus removal. They are all trying to talk tough, but their actions belie their words.

After the downbeat finish last week on Wall Street, stocks overnight in Asia were weak. Japan’s Nikkei, Hong Kong’s Hang Seng, and China’s CSI 300 all declined by 2% or more on Monday. U.S. stock index futures poked into red territory for a spell early this morning, but rallied when Europe held firm and the week’s first M&A deals hit the wires. With large companies like Abbott Labs, Xerox, and Johnson & Johnson on the prowl as acquirers, the Monday morning blahs were soon dispatched. There were no economic releases this morning, so investors were free to wonder just how quickly share prices might rise if strategic acquisitions once again became de rigueur. Stocks ramped higher as soon as the opening bell rang, and the major averages were up between 1% and 2% within the first hour of trading.

Rather than forging a disciplined blueprint for global financial regulation, this weekend’s G-20 meeting produced the usual bombast without the corresponding policy bombshells (see below). Thus encouraged, investors kept right on seeking equities, especially those of the technology variety. The indexes then stayed within a whisker of their highs for most of the rest of the session. The major averages finished with gains ranging from 1.25% (Dow & Dow Transports) to 2.4% (Russell 2000). Treasurys rallied modestly, and yields fell between 2 and 7 bps against the backdrop of a flatter curve. The only threat to risk appetites came in the form of ECB president Trichet’s plea for a “strong dollar” (see below). Since it was issued by a central banker not from these shores, investors saw fit to levitate the greenback against only the European currencies. The yen and commodity currencies (e.g. Canada, Australia) remained aloft, though gold did lose some of its early luster to finish flat. But led by a 1.5% rise in crude oil prices, the CRB index rose 0.6% on Monday.

In a fairy tale told to me once upon a time, a wolf dons a sheepskin in order to look harmless as he sneaks up on an unsuspecting herd. Fooling both the sheep and their guardian Shepards, the wolf ends up enjoying a lamb dinner. These long ago Shepards have been succeeded (at least in modern finance) by regulators and central bankers. With inflation low during the 1990’s and early 2000’s, interest rates also stayed low, or were held low by central banks. Coddled as they were by the bargain cost of capital, borrowers also enjoyed an increase in the supply of capital when regulators decided to look the other way at ever more shoddy lending practices. When even complex and leveraged contraptions like CDOs and CPDOs flourished in this protected setting, the wolves of a credit crisis gathered under these disguises. Looking for threats from without, the Shepards of our financial system didn’t closely scrutinize the lupine predators that posed as sheep within their midst. In the ensuing financial slaughter of 2007 to 2009, many innocents came to grief and the survivors were asked to make do with mutton as the Shepards spent vast sums reconstituting the flock.

I bring this old tale to life with a modern setting not just because it rings true to me, but also because it still applies one year after the great tumult — this time with a twist. Politicians and central bankers have thrown every dollar, euro, yen, and sterling not nailed down at the financial crisis; when more were called for, they were simply called forth by governments via deficit spending and by central bankers via money printing. Voluntarily blind and deaf during the great boom that preceded the Great Recession, the regulators have seemingly been struck mute as well. They await instructions from their policy masters in government, and, as the G-20 proved only too well this weekend, the only agreement these large nations could find was in the definite promise to keep trying to find policies to agree upon.

The central bankers have yet to face such divisiveness within their ranks. They all agree that the best policy is to keep the pedal to the floor. Near zero short rates and quantitative purchases of fixed income securities are the official policy lines from Tokyo, to Brussels, and from London to Washington. But this unanimity has come with a price. Note, please, that these policies undermine those who wish to save and/or stay safe, while rewarding those who wish to borrow and/or speculate. If these policies seem familiar to you, it is because they’ve been tried before — though with lesser vigor than in 2009. When the stock market bubble aided by low interest rates burst in 2000, the Maestro lowered rates, opened the monetary gas valve, and inflated a housing bubble. Now that both bubbles have burst, the central bankers have turned to the same solution. This time they’ve upped the pressure and upped the ante in the hope of once again inflating asset prices in order to save us from — you guessed it — falling asset prices.

If the problems we face and the so-called solutions being applied are starting to sound circular to you, you’re not alone. The central bankers know it, too. They are asking us to just have faith and trust in them to do the right thing. Fed governor Warsh’s WSJ piece was more about confidence building and instilling trust than it was about policy prescriptions. He wants us all — including our foreign creditors — to know that the Fed “gets it”. He wants the world to have faith that his teammates on the FOMC have the right amount of “clairvoyance” (his word, not mine) to determine just the right moment to remove all the overly simulative policies in force today. Just not yet. Reading from almost the same script, even the supposedly more disciplined ECB said the same thing today. As for the Far East, the BOJ has for almost two decades not seen an interest rate that couldn’t be just a fraction lower. I’m sure they, too, will relent at just the right moment. Just not yet.

We can curse the politicians all we want, and we can blame the central bankers, too, but at least we can’t complain that history isn’t repeating itself. The Bank for International Settlements (the BIS – the central bank to the world’s central banks) warned of this possibility back in June (see below). Like me and many others, the BIS feels the biggest risk to the current quantitatively easy policies is exiting too slowly. Three months (and likely one quarter of positive GDP) later, not one of the G-3 central banks has moved closer to the door marked “exit”. These days, it is the BIS and not the FOMC that is looking clairvoyant. The simple truth is that it now requires tough talk, pretense of the desire to tighten policy, and other forms of play acting by our central bankers just to hold inflation expectations in check — thus preventing either the bond market or the dollar from collapsing. As the chosen asset class of make believe, stocks love it when central bankers talk tough and act easy. Equity investors seem to intuitively know that the central bankers are simply donning costumes to prevent the flock from bolting. Kevin Warsh included, they are themselves sheep — but in wolves’ clothing.

— Jack McHugh

G-20 Plans to End ‘Financial Balance of Terror’ After Summit
Trichet Says Strong Dollar Is ‘Extremely Important’
The Fed’s Job Is Only Half Over
BIS Sees Risk Central Banks Will Raise Interest Rates Too Late
Traders Juggle Krone, Krona, Kiwi in Central Bank Bet

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