In case you missed it, it’s ugly out there. US markets swooned as an unexpectedly weak manufacturing report, the ISM, was so bad it couldn’t be attributed solely to bad weather and deepened investor funk. The January Institute of Supply Management’s manufacturing index dropped from 56.5 in December to 51.3 in last month. Worse, it’s new orders sub index plunged from 61.4 to 51.2, the biggest decline since 1980. The S&P 500 fell 2.3%, the ten year Treasury rallied as yield fell to 2.58%, and the dollar dropped as investors anticipated the Fed putting the taper on hold.
The rout continued in Asia, with the Nikkei an impressive 4.2%:
Now admittedly Europe is a little less roiled as of this hour, and S&P futures are up half a percent, so Mr. Market’s latest tizzy may be burning itself out:
Update: Well, so much for allowing for the optimists braking the decline. This is Bloomberg as of 7:30 AM (admittedly with the usual retail user delay). S&P futures up only 6 points v. 8.5 on the earlier AM sighting:
Nevertheless, the distress in emerging markets continues apace. As we warned yesterday, even with the defensive increases in interest rates in Argentina, Mexico, Turkey, South Africa, and other emerging economies, investors who are now anticipating a return to the “old normal” are now looking at real returns relative to historical norms and deem them to be too low. So we can expect continuing pressure on emerging economies to raise rates further. That might halt the currency runs, but then you have the knock-on effect of the rate shock, which will kill growth. Most of these economies were already feeling a slowdown thanks to falling prices for commodities as demand from China cooled. A sudden downturn in these economies means more credit risk and lower prospective returns, leading to more capital outflows. It may take IMF intervention to break some of these vicious cycles.
If you have the luxury of being able to be detached, the market fireworks are perversely entertaining. At the beginning of January, the tone among US equity investors was close to being unanimously bullish as you ever get. The World Bank increased its global growth forecast on January 15. The IMF increased its global growth forecast on January 21. Last week’s FOMC statement ignored the emerging market perturbations, which was no surprise (the Fed has consistently refused to acknowledge the impact of its policies on emerging markets or commodities). And as Doug Noland points out, the central bank’s most vocal hawk, Dallas Fed president Dick Fisher, pronounced himself pleased that his colleagues were falling in line with his views. But even more disconcerting was the Fed’s increasingly optimistic reading on the economy.
Consider the contrast with today: Goldman forecasts a “more serious” global slowdown. Ford and GM revenues dropped sharply, with investors worried that the decline isn’t due solely to bad weather. And investor confidence about US corporate earnings growth is also waning.
The normal behavior at this point in the drama is for one or two regional Fed presidents to say reassuring things to the Market Gods. That might calm things down for a few days. But we have a new set of job reports due out on Friday. Before today, they were expected to show improvement from December’s weak 74,000 increase in nonfarm payrolls. The Bloomberg consensus was for a 181,000, increase, with forecasts ranging from 125,000 to 270,000. Presumably investors will shade their expectations lower based on the crappy ISM, but the open question is by how much.
But the bigger issue is how wretchedly wrong the Fed has been, and how consistently it has believed its own PR and been hostage to confirmation bias. In the runup to the crisis, it was Bernanke who coined the phrase “Great Moderation,” mistakenly seeing dampening of business cycles as a virtue, while ignoring the financialization of the economy, the dependence of growth on rising and unproductive consumer borrowing, and business net saving (as in disinvestment), previously unheard of in a period of growth. He professed to be worried about deflation in 2002 in his “Helicopter Ben” speech which gave cover to Greenspan to hold interest rates low for an unprecedented nine quarters after the dot com bust.
But what were Bernanke’s bulwarks against deflation? The first was a “buffer zone” of not letting inflation rates fall too far. But in driving short term rates below 1% (which alarmed me during the Fed’s crisis responses), the Fed anchored lower inflation expectations. His second bulwark was:
A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly.
The Fed failed and has continued to fail on that front. It sat pat as banks increased their leverage levels as the 2000s progressed and ignored the fact that they’d have to stand behind supposedly off-balance sheet vehicles like SIVs and credit card securitizations. While it has prodded banks to improve capital levels post crisis, most commentators deem the increases to be insufficient to eliminate the “too big to fail” problem. As for “well functioning capital markets,” the central bank has also ignored post crisis the rise of high-frequency trading, which has come to dominate the US equity markets and is making inroads into foreign exchange and commodities markets. HFT weakens market stability by providing the finance equivalent of junk calories: more liquidity when it’s not necessary or helpful (when markets are trading normally) and worse, a disruptive draining of liquidity when it’s most needed, when markets are roiled.
So despite professing concerns about deflation, Bernanke and his colleagues failed to take preventive measures and ignored the obvious signs of danger before the blowup, of extreme underpricing for risk across all credit markets. During the crisis, the central bank again failed to understand the severity of the problem, going into “mission accomplished” mode after each for the first three acute phases prior to the September-Octber 2008 meltdown.
We’ve chronicled at length how the authorities merely used duct tape and baling wire to patch up the financial system rather than engaging in badly needed fundamental reforms or focusing their rescue efforts on the real economy.
Unduly impressed with their “success” in largely restoring the status quo ante that got us into this mess, the Fed appeared to have persuaded itself that QE would help the real economy, as opposed to simply goose financial asset prices. Admittedly, there was some indirect stimulus as credit-worthy homeowners refinanced en masse and the top wealthy saw strong income growth. But the Fed has simply chosen to ignore inconvenient information: that per Willem Buiter, the wealth effect of housing works only when housing prices are in bubble territory (meaning the real economy stimulus of QE would be weak), that per Richard Koo, consumers and businesses in a balance sheet recession prioritize paying down debt over spending (so the Fed should have pushed for debt restructuring, particularly of mortgages, rather than giving banks and investors a free pass on reckless lending), that QE was not going to lead banks to loosen lending much to consumers or small businesses (and separately, even if banks were predisposed to be more generous, businesses don’t decide to run out and invest because money is on sale. Unless the cost of money is one of your major input costs, meaning you are a financial services industry participant, the cost of money is a secondary or tertiary consideration. It might constrain investment, but the big driver is whether the principals see a market opportunity. And in a generally crappy economy, opportunities are thin indeed).
From what we can tell at this remove, the Fed realized sometime last year that QE was not working and decided to get out. But even then, it seems to have failed to understand how it has painted itself in a corner. Nathan Tankus wrote how the Fed ignored what Keynes had written on this point:
Since Bernanke started talking about “tapering off” Quantitative Easing, the bond markets have freaked out. This is a very logical reaction….
Bernanke and other Federal Reserve economists appear bewildered by this phenomenon. The impression one gets from their follow-up comments is that they wished they could ask bond speculators “did you read the damn speech?” The answer, of course, is no and for good reason.
All investors need to know is the conditions under which QE (and for that matter, the Zero Interest Rate Policy) will be pursued has changed. Now the substantive change may actually be relatively minor, but that’s irrelevant to speculators. The reason is very simple: those holding assets with longer maturities will take huge capital losses with relatively small changes in interest rates (As a reminder: it is basic “bond math” that a change in interest rates send bond prices in the reverse direction. A rise in interest rates makes bond prices fall and a fall in interest rates make bond prices rise). It is better to exit now when those future changes are uncertain then take even more massive losses.
This is the logic behind the actual “liquidity trap” presented by Keynes in the general theory. Specifically, Chapter 15 entitled “The Psychological and Business Incentives To Liquidity.” Here he argues that every fall in the interest rate relative to what is commonly believed to be a “safe” rate increases the “risk of illiquidity”. The the “risk of illiquidity” is the risk of holding an asset not easily convertible into money at “book” value (this also means an asset is more or less “liquid” based on the relative easiness to convert into money “book” value). Further, rather then seeing interest as a return to “waiting”, Keynes argues that it is “a sort of insurance premium to offset the risk of loss on capital account”.
How can one evaluate the uncertainties relative to the “insurance”? By what has been subsequently known as “Keynes’s square rule”.
The square rule was defined by Keynes in this chapter as “an amount equal to the difference between the squares of the old rate of interest and the new” (mathematically represented as Δi = i2 ). If interest rates (at that maturity) are expected to rise faster then a squaring of itself, it means your capital losses (market price of the bond or investment) will fall faster then the increase in the rate of return (and vice versa).
Based on this understanding, a liquidity trap is not a short term rate of interest at zero but a uniform expectation that interest rates will rise to such an extent that the rate of return on a bond or equity won’t preserve your principal and thus a refusal by anyone but the central bank to buy bonds at such a high price (i.e., low interest rate).
So what happened was perverse: the Fed lost nerve temporarily and hedged its taper talk. Investors, who have strong incentives not to leave the party until it is almost too late, resumed investing in most risky trades (although Treasuries and MBS did not revert to their prior levels). Traders at big financial firms and many fund managers had every reason to keep asset prices aloft until December 31, since their bonuses keyed off full year profits. And many investors also seemed to take confidence in the notion that big financial crises happen only in the fall, so even if there might be some taper-related upheaval, anything in the first half would be a blip.
Now this investor confidence was also based on persistent sunny readings of decidedly mixed data. For instance, for the past three quarters, companies have increasingly beaten earnings expectations by lowering guidance. There have been far too many monthly improvements in official data that have resulted in part from downward revisions of the prior month’s results. The Fed and many investors have chosen to underweigh the severity of stress in the job market. But one of the biggest factors may well be the way income inequality plays into readings of the economy. The top wealthy simply don’t see it. The top 10% are for the most part not badly impacted. The Board of Governors is located in Washington, which is one of the strongest performing economies in the entire US. And who do they interact with, mainly? Bankers and CEOs, who are in the top income cohort.
The Fed has acted as if it can master the markets, and until late last year, that appeared to be correct. But consider what is happening in China, where observers have even more confidence in the authorities’ ability to control outcomes in a supposed command economy. The officialdom was afraid to let an entirely disposable mid-sized trust company default (instead there was an 11th hour rescue which smells of having been orchestrated). Most observers expected a default and assumed it would serve as a salutary warning to speculators. The fact that even the Chinese look to be fearful of crossing the Market Gods bodes ill for a soft landing there, and betides ill for the Fed navigating its way out of its cul de sac successfully.
As I often say, it would be better if I were proven wrong. But I find it hard to script a happy ending to this movie.