It’s starting to get a little weird. Here we are, more than five years into an economic recovery, with an improving employment picture, strong stock market, OK housing market, strong auto demand . . . and the Fed is still easing via QE while keeping short rates at zero. That’s a monetary policy for a financial crisis, not the middle of a recovery. In her July 2 IMF speech, Chair Yellen admitted this is starting to cause excessive speculation, but she nevertheless intends to pursue an easy policy for a quite a while longer. That is music to speculators’ ears.
Two Remedies for Excessive Speculation
Yellen recognizes there are “pockets of increased risk-taking across the financial system” (such as shrinking spreads in the junk bond market). That will not, however, be addressed with higher interest rates, which could kill the patient as well as the disease. Instead Yellen will resort to “Macroprudential Policies” of two kinds—“building resilience” and “leaning against the wind.” “Building resilience” basically refers to the measures Dodd Frank and Basel III are taking to make banks and other institutions more resistant to panics – less leverage, more liquidity, less risk taking, a resolution regime if they get into trouble. Significantly, she had far less to say about “leaning against the wind” (one substantive paragraph versus four). Here she notes that Basle III and the bank stress tests pay due regard to “loss absorbing capacity.” She notes margin requirements could be boosted to rein in speculation.
Here’s the problem. The bond market is already overheated. Another full year of zero Fed Funds, followed by many months of minimal rates (0.25%-1%) will make the situation worse. Meanwhile excess capacity in the U.S. economy is shrinking and inflationary pressures are slowly building. Supply side blunders such as Obamacare, absence of corporate tax reform, the War on Coal, the XL Pipeline freeze, and wrapping community banks in Dodd-Frank red tape, are impeding productivity growth and making the economy more inflation-prone. When the bond market finally cracks, the rise in rates could be dramatic and wrenching, very likely causing a stock market sell-off.
The Tech Bubble
We have been here before, twice actually. We are in the third consecutive “jobless recovery” where the Fed was “looser for longer” than anyone expected, creating asset bubbles in the process – tech stocks in the 1990s, housing in the 2000s. It’s useful to consider what the Fed should have done differently to prevent these bubbles, and why it did not.
In December 1996, two years into the big stock market rally, Fed Chairman Greenspan made his “irrational exuberance” speech. Stocks stumbled but recovered fairly quickly. By 1997 Greenspan had bought into the “New Economy” hype; for example, a breathless Business Week article quotes a colleague saying ”He is very open to the possibility that we have entered a new economic age.” Greenspan was not wrong that improving productivity justified a looser for longer Fed policy in the late 1990s. (The Asian financial crisis also necessitated a rate cut in 1998.) Where Greenspan erred was in confusing the economy and the stock market. Accelerating productivity did not justify an absurd and obvious mania in TMT (Tech, Media, Telecom) stocks. He should have ended the mania by:
- first, giving another “irrational exuberance” speech where he explicitly threatened to raise margin requirements
and, later, when that did not work,
- actually raising margin requirements dramatically, causing a stock market panic as leveraged speculators—day traders on Main Street as well as prop traders on Wall Street—dumped shares.
Clearly, this would have been politically difficult; a TMT crash would have cost influential voters huge losses. However, it would have been far better to have a brief panic in 1997 than a huge liquidation of absurdly over-valued stocks three years later.
The Housing Bubble
In 2005 or 2006 the Fed, OTS, OCC, FDIC and other regulators should have simply prohibited sub-prime mortgages and their close cousins, Alt-A mortgages. As described in my May 21 2014 post “Fed Freakout” (a fake 2006 WSJ article describing the likely fallout from such a ban) it would have caused financial and economic turmoil, not to mention a political backlash. But far better to burst the bubble early; the quality of sub-prime mortgages deteriorated dramatically in 2006 and 2007 as real estate prices became ever more inflated.
Yellen’s Bond Bubble
Yellen should take similar action now—something that surprises traders and prevents the worst junk bond issues from coming to market. A sell-off in crappy bonds and heightened market volatility would scare traders and keep them cautious. She would be castigated by the usual Keynesian suspects who see unlimited slack in the labor market, and also by central bankers in emerging markets enjoying low rates (such as India).
Unfortunately, there is no reason to believe Yellen will do it. On the contrary—and this is a key point—it appears that Yellen is relying on the aforementioned “building resistance” reforms such as Dodd Frank to prevent a bond sell-off from causing financial damage. But that’s a mistake. Financial speculation, like a hurricane’s flood tide, is hard to channel and contain. When the bond bubble bursts it will probably hit areas not now well regulated by the Fed and covered by Dodd Frank, such as ETF’s and bond mutual funds.
Macroprudential Policy Needs to be Unpopular to Work Well
Everyone likes a party, and no one likes the jerk next door who calls the cops when it gets too loud. To end a mania, regulators must take dramatic action that destroys fortunes, roils financial markets, and curtails economic growth. All of which elicit a political backlash that is difficult for regulators to counter because it is impossible to prove “what would have happened” if the mania had continued. Arguably, however, the searing experience of the 2008 crash makes it easier now than in the past for the Fed to step in and pop the bond bubble.
What Equity Investors Should Do
For now, keep riding the bull market higher. But don’t get too comfortable. At some point the combination of higher inflation, the end of QE, rising Fed Funds, lack of liquidity on Wall Street trading desks, and some unforeseeable event (a default, a war, a macro shock) will cause a severe bond market sell-off that scares investors and could slash stock prices 10-30%. It will be good to have some cash ahead of the panic.
As to timing, that’s tough to figure. Bull markets often last longer than you expect. Risks are rising but high valuation per se will probably not cause stocks to decline so long as interest rates are low and profits are rising. On the latter topic, bears are mistaken to argue that profit growth is merely driven by non-operational factors such as share buy-backs, restructuring, low interest rates, etc. As Q2 profits are reported over the next few weeks it will become apparent that profit and revenue growth are improving, in turn sustaining strong dividend growth in 2014 and very likely 2015. Using today’s price for the S&P 500 and estimated 2015 dividends, the index is yielding a juicy 2.4%. That’s still quite attractive in Janet Yellen’s zero Fed funds world.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
