May You Live in Interesting Times

May You Live In Interesting Times

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Risk is higher. Markets are more unpredictable, and valuations more volatile. So, when anyone says “this time it’s different” it usually makes good sense to stop listening. However, these days the markets have given us more frequent and intense volatility. The NASDAQ is down almost 30% so far this year, and shocks from the pandemic, the Ukrainian war, massive central bank interest-rate maneuvers, and China’s zero-covid policy, are all ongoing inputs for turmoil that will continue for some time. Persistent uncertainty creates higher costs of capital and less affordability, weakening business investment, slowing GDP growth, and reducing investment returns. Hyperbolic “this time it’s different” statements are turning out to be true. This time days look darker, uncertainty greater, economic growth lower, vulnerability to additional shocks higher, and investors fear many more dark days to come. More frequent and intense volatility will not be calmed anytime soon. It really may be different this time.

Hope Over Experience

Hope Over Experience

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The Fed’s latest projection was for annual inflation to fall from over 5% at the end of 2022 to about 2.5% by the end of 2023. At this point, we’re not taking the Fed’s projections seriously, and for good reason. They were spectacularly wrong when a depth of understanding and insight into critical future events was essential. In other words, the understanding of how the economy works, the Fed’s ability to predict the effects of economic shocks, and its policy actions have gotten no better over the last 50 years. More specifically, price stability doesn’t seem to be coming anytime soon because people simply don’t think it will. If we look at the combination of rising wages and inflation expectations for both consumers and businesses, it is these expectations that drive inflationary pressures more than central bank policy. Inflation levels will be stickier than first theorized by the Fed, and the time to resolution is likely longer. Expect more “surprises” that will be no surprise.

Inflation

Folly and the Fed

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The average prices of food and fuel rose more than 16% in February from a year earlier and are expected to rise further by the war in Ukraine. Consumers are paying much more for meat, bread, milk, shelter, gas, and utilities. Only a small amount of food consumed in the U.S. is imported, and most of that is from Mexico and Canada. But Russia provides 15% of the world’s fertilizer and other agricultural chemicals that are now in short supply as planting season approaches. Wheat futures are up 29% since Feb. 25 and corn is up 15%. There is no shortage of wheat in the U.S., but global supply was the tightest in 14 years before the conflict, and dramatic shortages and price spikes are expected. What data is the Fed looking at, and how is it assessing inflationary risks? It’s hard to feel confident that the right hands are on the wheel because the combination of extraordinary factors, such as extremely tight labor markets and wage inflation (at over 6% annually and accelerating) showed inflation was already a significant risk. Yet interest rates were left unaltered. This is even before the crisis in Ukraine. The Fed should do whatever is necessary with interest rates to bring down inflation, including movements of more than a quarter-point, and a rapid reduction of its balance sheet. It also means recognizing that unemployment is likely to rise over the next couple of years. Paul Volcker would not have had to take extraordinary steps, driving the economy into a recession to crush runaway inflation, if his predecessors had not lost their focus on inflation. To avoid stagflation and the associated loss of public confidence in our economy today, the Fed has to do more than merely adjust its policy dials — it will have to head in a dramatically different direction.

Learning

Remembrance of Things Past – Liquidity, Stability, and Predictability

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Financial markets are imbalanced and lack liquidity in crucial sectors, even historically stable and predictable markets such as the global bond and currency markets. Investments are slanted in one direction more frequently and the markets are vulnerable to big price swings as a result. These large global markets are not immune to ever more lopsided trades creating extreme volatility. This occurs even when a small change occurs in positions, sentiment, or news. Even the world’s most liquid markets, US dollar currency trades and US Treasuries, are seeing skewed positioning resulting in surprisingly large shifts in prices and Treasury bond yields.

The market now leans too far one way or the other, and that imbalance will be forced to reverse more powerfully and unpredictably.

Think Differently

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Is It Really Different This Time? Well, sort of – and that makes all the difference. Interest rates are at zero, and worldwide markets assume that will change little for some time to come. Global coordinated monetary and fiscal policy are spiraling interest rates to this flattened level with little prospect of upward movement. The combination of monetary, fiscal, and interest-rate policy coordinated in this manner is unprecedented and is being pushed to its limits. A subliminal fear may be permeating the markets, generating extreme movements, causing both substantial profits and losses from massive capital flows magnifying price movements within compressed time frames. How do we explain this, and more importantly, how do we predict and profit from it? Bitcoin Explains Everything – Read That Twice If You Need To

Markets and Valuations

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The current low interest rate environment increases the discounted present value of future cash flows and reduces the return demanded for every investment. In other words, when the Fed funds rate is zero, 6% bonds become disproportionately attractive. Buyers have now bid bond prices up until yields are now significantly less.What does it mean if the prices of stocks and listed credit instruments are at levels not driven primarily by fundamentals reasons (i.e. current earnings and the outlook for future growth), but in large part because of the Fed’s buying, it’s injection of liquidity, and the resultant low cost of capital and the market’s lower demanded returns on financial instruments?

Currency Values in a Zero Interest Rate World

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We are rapidly approaching a zero-interest rate world. In the face of the dramatic negative impact of the pandemic, as well as existing and lingering economic fallout, central banks’ interest rate toolbox will be empty soon. The only remaining weapon will be fiscal policy. Among other things, fiscal policy and domestic financial markets will have an overwhelming influence on global currencies.