Communication breakdown, it’s always the same
Communication breakdown, it drives me insane

~ Led Zeppelin I

Are you confused about the Fed’s actions? Weren’t they supposed to hike rates in early 2015, then late 2015, now mid-2016 or maybe not at all? What is the logic behind this constant flip-flopping? What does it mean for your practice? Let’s attempt to answer those questions.

Call Me The Maestro
Do you remember Alan Greenspan, the Maestro? The man who so mastered the skill to speak for hours while appearing to earnestly answer questions, but who rarely gave away any substance. All that ambiguity was supposed to have been eliminated as the Fed planned to provide clear guidance for the markets—a new, open Fed of Ben Bernanke and Janet Yellen. But as of late, market participants are more and more confused about the Fed’s future actions and, more importantly, the logic behind them. Promised hikes never materialized and now there is talk of not hiking until mid-2016 or even later. Market participants are completely confused. Look at results of the RBS survey in the picture below. RBS asked its institutional clients two questions:

Question 1: Is volatility going to continue increasing?

Question 2: How do you account for the Fed’s actions when creating plans for your clients?



 
It is clear that most ‘smart money’ thinks the Fed is drifting rudderless and is possibly clueless. The chart above is extremely scary, and there are two reasons why.

Reason #1: Fed Is The (In)visible Hand
The Fed controls financial markets in a way that’s bigger than ever before. It owns a great deal of high quality collateral (Treasuries) that is needed to enable vast amounts of financial transactions. Zero interest rates drive corporate borrowing which in turn drives record issues of corporate debt and stock buybacks that move the markets higher. When buybacks stop, huge amount of money will disappear from the equity markets. The Fed practically owns the housing market through securitized debt instruments.

Reason #2: It Is A Confidence Game
Central banks depend on credibility. The Fed had such significant impact on the markets during the tenures of Greenspan, Bernanke and Yellen because of credibility that was established by Paul Volcker. Without that credibility, its rate-setting abilities would have been far less effective. When Volcker raised short-term rates to 17 percent to stamp out inflation in the early 1980s and stuck to his guns in the face of a recession, that persistence established a level of credibility that the Fed has enjoyed ever since. Now it appears that the credibility is gone.

 

Bullish Reflexivity
Famous speculator, George Soros, has coined the term “reflexivity” to describe financial markets. Reflexivity is what makes traditional financial and economic theories so inadequate for any predictions in the real world. Reflexivity is not complicated—it basically means that actions of investors impact the market which then impacts the investors’ actions again, resulting in a loop that can get out of control. The Fed has taken advantage of positive reflexive loops as it powered the markets through a phenomenal bull run. For example, the Fed lends free money to investors; corporations then borrow cheap debt and finance stock buybacks. Stock buybacks inflate stock prices and reduce the apparent leverage of the corporation, because equity is now worth more and debt-to-equity is lower. Lower debt-to-equity allows investors to borrow more funds and repeat the cycle again. There have been dozens of such bullish reflexive loops during the past five years.

Bearish Loops And Deflation
The Fed cannot hike rates because it will break the positive reflexive loops, while setting in motion a number of negative ones. The Fed’s stated goal is to get inflation above 2 percent. Recently the Fed suggested that the risk of a hard landing in emerging markets is also a consideration. Let’s try to imagine what would happen when the Fed hikes rates. The flow of funds to all kinds of positive feedback loops will be slowed or stopped. Investors will sell some risky assets. This will create significant deleveraging worldwide, because investors will value holding cash more than they do today. It is not surprising that China is begging the Fed to delay the rate hike; Chinese officials know what will happen to their markets. This deleveraging will create significant deflationary effects and CPI inflation will be even lower than it is now. To be fair, inflation is actually quite high for many items from rent to tuition and healthcare, but that’s another issue. For now let’s focus on the CPI as the definition of inflation, because that is what the Fed watches. The inflation will go closer to zero or even negative forcing the Fed to abandon its remaining credibility and quickly drop rates again. So, the Fed cannot hike or, if it does, will have to quickly backtrack because inflation will be even further from its goal and a Chinese hard landing will ensue. But the hike has been promised so often and the Fed can’t figure out how to undo all those promises.

Volatility Will Be On The Rise
This loss of credibility by the Fed is creating a uniquely risky environment where most market participants are lacking direction. This uncertainty means in a crisis event, liquidity may be nonexistent. As a result, I believe that many tactical managers used by advisors will not be able to get out of the way of risk, even if they did in 2008.

Your Response To The Fed’s Actions?
So, how should you think about the Fed’s actions in the context of managing and protecting your clients’ money? I put that question to Mark Hooker, who for many years led State Street’s Advanced Research Center with a team of 30 PhDs and now manages Infusion Global, an SMA money manager. Here is his reply:

I think the Greenspan put, which evolved into the Bernanke and now Yellen puts, is overrated—markets still fell roughly 50 percent after the tech bubble and again in the Global Financial Crisis, and about 15 percent peak to trough in 2011. Undoubtedly, the Fed’s support has made equity returns better than they would have been (largely through making yields on fixed income assets less attractive), but timing investments based on views of monetary policy action is a narrow and very difficult approach. Markets have been expecting rate hikes for years now but translating that into positive active returns has been challenging even for global macro managers who are experts.

And there you have it. You cannot ignore the Fed, but in making long-term decisions you should assume that market forces will prevail (and they certainly will).

With A Little Help From My Friends
No I get by with a little help from my friends
Mm I get high with a little help from my friends
Mm gonna try with a little help from my friends
—The Beatles, Sgt. Pepper’s Lonely Hearts Club Band

 

Just as this article was being finished, we got a one-two punch from China People’s Bank and the ECB. The Fed for now has painted itself into a corner with a series of dramatic reversals and a deluge of contradictory statements. Now the friends are here to help.

First, Mario Draghi suggested that ECB’s December will not only examine more stimulus measures, he actually suggested that Europe will employ new types of stimulus, hitherto not seen. Some analysts suggested that ECB will start buying stocks; others are talking about ‘people’s QE’ better known as ‘helicopter money’. Some journalists are demanding ECB act ‘unconventionally’ as if the global QE experiment to date could ever be called ‘conventional.’

And then shortly after Draghi’s comments People’s Bank of China cut interest rates by 25 basis points, the 6th decrease since November! PBC also reduced reserve requirements for banks. Chinese stocks jumped up and margin debt is higher again.

Will this Lonely Hearts’ Club Band effort work? The problem is that the Fed is the key central bank in the food chain. The credibility of ECB or PBC is never going to surpass that of the Fed and partially rests on it, simply because their impact on the global economy is much smaller. So, all they can do is give the Fed some breathing room, but they cannot really turn the tide of credibility in central banks’ favor.

Ultimately, we will likely see a QE4 and QE5 from the Fed regardless of what they will be called. But their effect will not be as large as previous rounds, due to the very same credibility problems (and other issues surrounding the shortage of high quality assets to monetize). That is setting the stage for ‘unconventional’ measures like purchasing stocks or corporate debt. If that does occur, we could see a phenomenal speculative rise in the value of those assets. But until we get to that point, it might be prudent to watch from the sidelines.


Daniel Satchkov is president of RiXtrema, a risk modeling and consulting firm, and creator of Advisor BioniX, the first risk-aware robo platform for advisors.