Submitted by Joseph Calhoun via Alhambra Partners,
The Wizard: I AM OZ…the Great and Powerful! Who are you?
The Wizard: Pay no attention to that man behind the curtain! The Great Oz has spoken!
Dorothy: How can you talk if you haven’t got a brain?
Scarecrow: I don’t know. But some people without brains do an awful lot of talking, don’t they?
All lines from Frank Baum’s The Wizard of Oz
The last few years the underlying theme of the markets is one of central bank omnipotence. Don’t worry about X, the Fed or the ECB or the BOJ has your back and will do whatever it takes to make sure nothing bad happens. The acceptance of this meme by market players has pushed all manner of assets to prices that in more normal times would make no sense whatsoever. It has been a wholesale rejection of safety and prudence in favor of the risk taking the central banks believe is necessary for the global or local economy to improve. The BOJ has convinced not only themselves but the world that currency devaluation and inflation will cure what has ailed Japan’s economy for over two decades. The ECB has somehow convinced the world that Greece is a worthy borrower for 5 years at less than 5% per annum. And the Fed has convinced themselves and the entire world that a rising stock market is evidence that their policies are working in the real economy. No matter that the economic data doesn’t support that conclusion and that it gets the causation backward.
Of course, it hasn’t just been empty headed scarecrow talk that has produced this effect. The BOJ and the Fed (and maybe soon the ECB) have been buying assets in the open market to back up their talk and create the illusion of activity, the equivalent of the Wizard of Oz’s smoke and mirrors. In the case of the Fed, it is almost all illusion as the cash produced by QE has largely ended up back at the Fed in the form of excess reserves. The BOJ has been more aggressive, buying not just JGBs but also stocks and REITs on the stock exchange, something the Fed is prevented from doing (sarcasm alert) only by their strict adherence to the statutes that govern their behavior. For the ECB the threat of intervention has so far allowed them to avoid having to do much but recent emanations from the Draghi hint at a Yen to join the party. Leave it to the Europeans to be fashionably late and arrive just as the lampshades have become party hats.
The ability to talk markets into doing what he wanted without saying much that was comprehensible was a talent that Alan Greenspan had in spades and earned him the nickname of The Shy Wizard of Money. Ben Bernanke, even though he looks more like a garden gnome than a wizard, spent years building up something resembling credibility that he used to extend Greenspan’s powers of persuasion even through a financial crisis largely of his own making. Bernanke got the party going and like a lot of men, left the mess for a woman to clean up. So far, it seems Janet Yellen’s words don’t carry quite the same weight as her wizard predecessors and the market Toto has a firm grip on the curtain hiding the levers of monetary policy.
When language and illusion become so important to market outcomes it doesn’t take much to upset the market applecart and Yellen started her tenure with what at the time seemed a minor faux pas. Until her first press conference the accepted scenario for monetary policy was that QE would wind down and at some point in the far future, the Fed would start to normalize interest rates (whatever normal is in this economy). Her faux pas was to provide unusual clarity for a Fed chair about what the phrase “considerable period” actually means. It turns out that for Yellen that unspecified epoch of Fed tightening could be as little as six months, something the market obviously wasn’t expecting. Except for a head fake breakout in the S&P 500, it has been downhill for stocks – especially the high beta, NASDAQ momentum darlings – ever since.
Yellen has spent the intervening time trying her best to convince the market that she didn’t actually say what she so obviously did. At a Chicago event on unemployment she said the Fed’s “extraordinary commitment” to “improving the labor market is still needed and will be for some time and I believe that this view is widely held by my fellow policymakers at the Fed.” Unfortunately for Yellen, the market, at least for now, isn’t buying it and once the momentum shifts in a market driven exclusively by that ephemeral emotion it is hard to reverse. For the traders who have moved this market for years now – HFT or actual human – momentum is momentum whether it is up or down and once they get something moving in one direction they’ll push it that way as hard as they can. For the last few weeks that direction has been down and so far Yellen hasn’t been able to change that. Or maybe she doesn’t really want to – yet. After all, there has been some angst on the FOMC recently about “financial stability” or what everyone else calls bubble behavior.
As the Fed continues to wind down QE to its inevitable conclusion, the markets will be left with the reality of our current circumstances. That reality is one that is very hard to read right now with the economic data still mixed after the winter weather distortions. The problem for Yellen and the Fed is that the only thing that will be kind to the stock market is data that is not too good but also not too bad. Data that is too strong will be seen as hastening the day of reckoning while data that is too weak will raise the fears of recession and a Fed with no policy levers left to pull. Only data that continues to show an economy growing slowly but below potential keeps the Fed in the game and the stock market going higher. And that is assuming the market continues to believe Fed policy is actually effective.
Right now, I see some indications that could push the Fed to tighten even sooner than now expected and also some indications that the economy is slipping into recession. Recent data on credit indicates that banks are finally ramping up lending. Commercial and Industrial loans are rising at a double digit annual rate of change although it is unclear whether this is an indication of business optimism or stress. After all, we did see a big jump in these loans leading into the last recession. Total bank credit has also accelerated, the annualized pace roughly doubling since the beginning of the year. Again, though it is hard to say why credit is rising other than that there is obvious demand and banks are meeting it with supply.
On the flip side, the bond market and the US dollar index seem to be flashing some warning signs about future growth. I wrote a post yesterday that covers this in more detail, but the gist is that it seems highly unlikely that the long end of the bond market would be rallying so furiously if the market was expecting a burst of growth. Similarly, if the nation’s currency is a reflection of growth expectations – and I think that is certainly one thing it reflects – then the fall in the dollar index indicates that expectations for growth are, at a minimum, better outside the US than in.
So the outlook for the economy is decidedly uncertain right now and I think so is the confidence in Janet Yellen. I think the more dire outcome for stocks would be if Toto fully pulled back the curtain on monetary policy and revealed it to be nothing more than a bunch clueless economists sitting in a conference room with no ability to control the economy or the markets. If US growth disappoints after all the Fed has done, how could anyone continue to view the Fed wizards as omnipotent? That would send the stock market back over the rainbow to the reality of an economy with big structural problems that can only be solved through political negotiation, something that has been notable only by its absence over – at least – the last 6 years. Are we headed back to Kansas?
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