Since the Fed began raising interest rates in December 2015, financial market liquidity conditions have loosened considerably. Recall our post, Orwellian Monetary Policy, which we wrote in May.
# “Tightening is Easing”;
Since U.S. monetary policy began tightening in December 2015, the Fed has added liquidity to the financial system through interest payments to banks on excess reserves and has reduced its surplus to the Treasury adding to the fiscal deficit. Thus the financial system has had an effective injection of central bank liquidity and a fiscal expansion during a period of monetary tighenting.
The current Fed policy effectively injects liquidity into the financial system through raising the IOER rate, printing money to make interest payments on reserves banks hold on deposit at the Fed. This compares to the traditional monetary where the Fed drains reserves from the financial system to drive the Fed Funds rate higher. We are years off to getting back to traditional monetary policy. Maybe not in our lifetime.
The Fed has once again lost control of a big part of monetary policy. Its ability to influence the risk taking incentives of the markets (see chart below)...
This is not the first time, but it has been exasperated by the structure of the new monetary policy, of which we spoke about earlier.
No judgement, whatsoever, on the policy makers. They saved the system and kept many of us from living under freeways and have a very difficult job. They now find themselves in a real dilemma, however, with another major global asset bubble on their hands.
We believe this is why the Fed has quickened its pace to start shrinking their balance sheet. Rather than being forced to overshoot interest rates, which could adversely affect the economy, the Fed will start draining reserves through balance sheet reduction hoping to introduce some risk aversion and sense back into the giddy global markets.
# Real Interest Rates;
Finally take a look at real interest rates. The current level of the 10-year real Treasury yield, calculated as the nominal yield less the 1-year lagged PCE deflator, is only at the 19th percentile on a monthly basis going back to the early 1960’s. Our sense is rates are going to have to move much higher (200-300 bps) and quantitative tightening is going to take some time to really break these markets and burst the global asset bubbles.
Asset bubbles don’t pop very easy, until they do...
The first derivative trade, that is selling when the direction of policy changes, is not going to cut it this time around. Global interest rates are just too low and the flood of central bank liquidity is too high.
The bears are much too loud and adamant and the buy the dipper Algos are in control. Until they aren’t.
Nevertheless, assets are exteremly expensive, monetary policy is moving in the wrong direction and the market is very vulnerable to a sharp selloff given a Black Swan event, which we increasingly think may be some sort of geopolitical shock or a humumgous populist backlash, for example, as the wealth gap continues to widen....