There were certainly more fireworks on display across America on Tuesday that there were on Wall Street on Wednesday where both stock and bond markets crept back into action in a day of flat and uninspired price action and volumes. Not even the release of the minutes of the June FOMC meeting could change that.
The word that keeps surfacing now that we know what was discussed on June 13-14 is “discord”. Whereas minutes normally show a general sense of unanimity among the FOMC members, albeit with minor differences with respect to the interpretation of data, this time there seemed to have been quite a bit of disagreement as to what to do next.
The progression of the ongoing tightening cycle was not questioned but the doves and the hawks appear to have come to blows with respect to timing. One school believes that monetary policy should be geared to statistical evidence and that until inflation begins to tick up the Fed should be very cautious when moving towards the normalisation of policy. The other group is more sceptical about the validity of the data which, to be frank, is perfectly capable of speaking with forked tongue. Supporters of this view would be happier to stick with a policy of gradually but consistently withdrawing stimulus. Balance sheet reduction, though a separate subject, should be seen as nothing more than part of an ongoing process and markets should be wary of getting too excited about it. If, as and when the process begins, it will be with us not for years but for decades. There is no sense trying to trade short-term markets around it. In the unlikely event of its inception causing a “tantrum”, best trade the other way.
Feed the rich
One of the many unmentionables of the past 20 years is the simple truism that in any downturn the weakest in society get hit hardest. In trying to soften the blow for that group, the financial environment also improves for the not-so-weak and it is those people who benefit most from the accommodative rate policy. Thus, while the initial objective is to stop the many from going under, the outcome is asset price inflation, which in turn leads to the few getting richer and richer and the wealth gap widening.
Thus, quite inevitably, any tightening of monetary policy will take its toll and once again those who are most exposed who will be the ones who take it on the nose hardest. Whether the Fed doves believe that a slower normalisation of monetary policy can prevent the car crash or simply slow it down isn’t quite clear but the hawks would appear to have acknowledged that if a car crash were to happen, best get it over while the mood in the economy is still positive. The sooner the bitter pill is swallowed, the better.
One thing both sides apparently agree on is that unconventional measures cannot continue forever. On the surface the discord is over timing but there are clearly fears about what the suite of unintended consequences might be made up of. Fixed rate mortgages might protect America’s middle classes from most of the impact of higher interest rates but the rising defaults in the auto and student loan spaces, already at worrying levels, will barely improve.
My view remains that it is perfectly possible the monetary authorities can drive inflation higher rather than lower with higher interest rates and that after nearly a decade of experimental monetary policy there is no reason not to extend the experimental period and to try to pull rather than to push inflation through the interest rate structure.
Balacing act
I touched on a thought yesterday which wondered, if the strong bid in the bond market were a result not of people loving bonds but of them being necessities to buy them in order to maintain strategic asset allocation equilibrium, whether a downturn in stock prices would trigger a concomitant sell off of fixed income instruments. In consequence I have had a number of conversations, the key take away of which has been “Oops, that’s interesting, I’d never thought of it that way…”
Having long been perplexed as to why anybody would want to own Bunds at 16bp or 22bp or even 44bp of yield, the argument that they saw the ECB as the guarantor of the par value of the bonds simply didn’t satisfy. If, however, the straitjacket of strategic positioning, indexing, benchmarking and the obsession with tracking errors is brought into the argument, one is reminded that in the eyes of contemporary money management index neutral is the new flat. It might be risk free for the portfolio manager who only cares about his positioning relative to the index but it surely ain’t for the poor sod whose money he or she’s playing with and who is faced with years of negative total return on the bond portfolio once stimulative monetary policy is withdrawn.
When I was trained, which was when Adam was a boy, the paradigm was that when equities went up bonds went down and the other way around, reflecting the flow of money between the two key asset classes. Long before the coining of the rather stupid “risk on/risk off” phrase, one talked of “flight to quality”, which in times of uncertainty saw equity money run and hide in the bond market. If, however, bond holdings are governed by their relative portfolio weighting to equities, then the paradigm has shifted and stocks and bonds will curiously be condemned to march in step.
In the same context I have for some time been wondering how the Street would cope with a general, asset allocation-induced reduction of bond holdings in the event of equities taking a major and prolonged bath. The pretty uniform answer from those still at the coal face was “It can’t”. With minimum pieces for bond holding now commonly floored at 100,000 units, petty retail, for so long the buyer of last resort, has been frozen out of the markets. Macro hedge funds have also lost their mojo with super stars such as Alan Howard falling back to earth with a big thump and with heavy redemptions severely limiting their fire power.
Playing pool
Please don’t get me wrong. I’m not predicting the end of the world; markets have a way of swiftly adapting to altered states. What I do plead for, however, is not to prepare to fight the last war. At some point markets will turn and while everybody is trying to get out of the pool at the same time some will get flattened in the stampede. The safest thing to be doing will be to be trying to either be out of the pond before the others, which is nigh on impossible, or better still to try to climb out on the opposite side from the mob. My advice is to start mapping the pool and to pick one’s spot.
Yes, we all like the idea of non-correlated assets and all that malarkey but in our little world of financial instruments they don’t really exist. I do believe that cryptos might, come the revolution, find themselves fulfilling that role but until some transparent and regulated exchanges have been set up they will remain difficult for mere mortals to access. Once these exchanges do become available, expect the cryptos, bitcoin ahead of the many others, to get caught in the next updraft.
Finally, and on a very personal note, yesterday marked the second anniversary of the fire at my home which very nearly put paid to me. The sympathy and support I received from my friends in the markets in the aftermath was significant in accelerating my recovery although it was the lingering mental after-effects of that traumatic experience which made me decide to withdraw from the front line of markets in December 2015.
With the support of Sol Capital and International Financing Review I have been able to keep writing and with the benefit of physical distance from the City I have been able to see things I might not have otherwise seen while I was still up to my neck in it.
I should like to thank all who have helped my fight back and who, by comment and criticism, make getting up at oh-sparrow-hundred every morning worth its while.