Treacherous Market Conditions Ahead

Tyler Durden's picture

From Scotiabank's Guy Haselmann

Treacherous Market Conditions

Vanishing QE Matters

When the latest round of QE was announced in September of 2012, the economy was healing. Considerable progress had been made toward the Fed’s dual mandates and the FOMC was already providing extraordinary accommodation through two policy actions, ZIRP and forward guidance. At the time, I thought the action was overkill and bordered on recklessness.

I wrote that open-ended QE (dubbed ‘QE-infinity’) was dissimilar to the earlier QE programs for three reasons: 1) it began under much different economic and financial conditions; 2) its open-ended time frame hijacked the markets’ typical price discovery and discount mechanisms; and 3) it began after earlier actions had already changed investor behavior. At the time, moral hazard was already alive and well.

Financial assets are valued simply by aggregating the discounted value of future cash flows. The fact that the FOMC did not give QE (and thus ZIRP) an end-date meant that price discovery for financial assets were demolished. Investors increased their ‘melt-up’ mentality, because the discount rate used to value cash flows could be assumed to be zero in perpetuity. Dividing a number by zero equals the empty set. Investors were not willing to ‘fight the Fed’ and why should they; the Fed was showing determination to stay the course until it was satisfied with the pace of the recovery.

Yet, the US and global economies have only been able to muster sub-par growth despite massive (pre-2014) coordinated accommodation. Shouldn’t investors today worry more about how the global economies will perform now that QE is ending, China is reeling-in its credit bubble, Japan has initiated the first of a series of VAT hikes, and EM central banks have hiked rates?

Investors and portfolio managers constantly ask what the timing associated with, or what the catalyst will be, that derails the asset rally. Last year, I suggested it would be when the Fed began exiting from QE-infinity. Clearly, the catalyst is in the rear view mirror. Moreover, it is accompanied by the other factors mentioned in the preceding paragraph. The purpose of this note is to serve as a reminder that the time is now and the catalyst(s) have set the wheels in motion. Risk/reward is skewed to the downside. With these ‘policy pivots’, investors should demand a higher burden of proof that the economy and risk assets can stand on their own. Investors should forget trying to determine valuation. Weak growth mattered little to the surge in risk assets during the last few years. In addition, the ‘P’ and the ‘E’ are distorted by Fed policy and ZIRP-induced share buybacks; and thus should be de-emphasized. The bottom line could simply be that QE means ‘risk-on’, while ending QE means ‘risk-off’.


Expecting Too Much of the FOMC

Markets afford the FOMC too much reverence. I am confident that the Fed is overpromising and over-reaching on what it can actually deliver. It has always been quite a leap of faith to believe that ever-rising asset prices would create a wealth effect adequate enough to boost consumption, so as to make progress on the Fed’s dual mandates without causing adverse financial markets conditions.

An apt analogy to the Fed’s visible efforts might be the World Cup referee who early in the game tries to maintain order by calling a tight game, but continues blowing the whistle so frequently that the referee becomes the show. After a while, the fans begin gauging the validity of every disruptive whistle, rather than spectating on the beauty of the game. A good referee is typically one who went unnoticed during the game or one who was quickly forgotten once it ended.

It is confounding to me why markets have so much confidence in the Fed’s ability to fix the complicated ailments of the economy, especially given its limited tools. One FOMC member told me two years ago that “my colleagues want to be looked at, as if, they are doing something {to achieve their dual mandates}; even though they know that the benefits are quite small”. Such credence, however, fails to adequately consider the negative aspects of the policy action.

I believe the FOMC has chronically miscalculated the relationship between the short-term economic benefits and the longer-term financial market costs of its policies. How much are Fed policies sacrificing future consumption at the expense of benefits today? To what extend are Fed policies fueling generational and social-class inequalities?

I suspect that the Fed has been hoping that economic fundamentals would improve enough by the time QE was brought to an end to validate the artificially elevated asset prices that QE created. What if the FOMC is pulling back from its QE program, because members fear that its policies are building risks to financial stability at a faster pace than the economy is improving? If so, many investors are wrong-footed.


Measuring Moral Hazard

Investors have had a remarkable run during the last 4 years of risk-seeking, don’t-fight-the-Fed strategies. Yet, investors should not believe that the FOMC has a handle on the magnitude of the moral hazard and risk positions that have been built over this period. The Fed’s concern around the market’s reaction-function to QE is likely a major factor as to why the FOMC is tapering at a gradual pace. As such, the Fed probably wishes QE was already completed. It would certainly improve the FOMC’s flexibility.

Does the pace of tapering really matter? Will it have a material impact on valuations or the aggregate economy if the Fed is buying $65, $45 or $25 billion of assets in month X, Y, and Z respectively?

FOMC members want markets to believe that they are “data dependent”, but such verbiage could be a ‘slight-of-hand-trick’; espoused so that too much focus is not paid to the fact that the QE program is ending. This might be the reason that markets not reacted to the catalyst(s) to pare risk or why they have been slow to act. Despite Fed rhetoric, investors must realize that the hurdle to deviate from its $10 billion per meeting pace has always been enormous.

The market’s unremitting focus on every adjective and word uttered by the FOMC is inane, simply because the Fed is on a steady course for the next 6 months. This is a clear example that the FOMC has become too visible and too involved in financial markets. The ECB recognized that there are negative consequences to such market interference. Draghi stated that he could envision fewer ECB meetings, because he felt that their frequency leaves the market expecting action too often.


Self-Inflicted Quagmire

The Fed’s chronic desire for slack-less growth has stair-stepped official rates to zero over the last few decades, has made (unconventional) accommodative measures seem necessary, and has resulted in a depleted arsenal. Hence, the FOMC is at a critical juncture; and FOMC members have only themselves to blame for being in such a position.

The Fed’s ability to reverse any new ebb in economic activity in the future is now severely limited, increasing the importance that current Fed initiatives succeed. This is likely the justification for QE-infinity. Today, the Fed has little choice but to stay overly accommodative even if the economy heals satisfactorily. With this in mind, most expect the economy to heal and are preparing for the inflation battle. However, such an outcome is not assured and big problems will arise should the economy sputter.


Boom to Bust and Back Again

Prior to 2008 (under Greenspan), the Fed believed that the financial sector was mostly self-stabilizing and that bubbles were un-identifiable. The FOMC believed that, if necessary, they had the ability to ‘clean up’ after excesses (i.e., bubbles popped). Greenspan’s Fed believed that it had the adequate tools for ‘after-the-fact’ crisis management; which it believed was always more appealing than making the politically difficult decisions that would have been necessary to prevent financial crises or imbalances in the first place.

After the 2008 crisis, policymakers have tried to end this mindset by becoming more proactive in trying to prevent financial crises. Though well-intentioned, this new approach has arguably led to Fed policy itself becoming a source of systemic risk. In such, I believe the Fed’s atlas-complex and micromanagement are fermenting dangerous market conditions that have sown the seeds of the next market upheaval.


The Inverted-U Curve

If I had to graph the beneficial effects of (excessive) regulation and interventionist central banks and governments, I suspect it would have the shape of an inverted-U. Like most good things in life, a little is fine, but too much can kill you. There are often cumulative effects where short term benefits marginally decrease over time until eventually they turn into ever-mounting negative longer-term consequences.

The basic logic behind the inverted-U curve is that strategies that initially work well stop working past a certain point. Maybe a non-financial example would be useful. Criminologists often argue that punishment has inverted-U curve characteristics. Studies show that there are benefits to imprisonment, but lock up too many people for too long and the collateral damage starts to outweigh the benefits.

There are direct and indirect effects to incarceration. The direct effect prison has on crime is that it puts a bad person behind bars, where he can’t victimize anyone else. However, longer sentences work only on young men, because studies suggest that once someone passes the crucial mid-twenties age, all longer sentences do is protect society from dangerous criminal at the point that they become less dangerous.

The indirect effect on crime has to deal with how a person’s imprisonment affects all the people with whom that criminal has a relationship. A high number of those incarcerated are fathers and it has a devastating effect on his children (even one-fourth of convicted juveniles have children). Earnings –both from crime and legal jobs – also no longer support families. Having a parent incarcerated increases a child’s chance of juvenile delinquency by 400% and the odds of a serious psychiatric disorder by 250%.

Negative second-order consequences are always harder to measure and identify. Nevertheless, I firmly believe the FOMC policy has far surpassed its period of net benefit. I believe it is the second-order negative unintended consequences that will soon appear as the Fed implements its exit from QE.


Market Complacency

Many investors are sitting on their hands unsure of what to do; unsure how to value financial securities; unsure what the true price of money is; and unsure just how far governments are willing to go before popular backlash arises. Gillian Tett recently wrote in the Financial Times, “Far from being a sign of sunny confidence in the future, ultra-low volatility may show that investors have lost faith that markets work”.

It seems only fitting that Paul McCully, the man who coined the phrase “Minsky Moment” in 1998, returned to Pimco last week after several years of semi-retirement. A “Minsky Moment” is a collapse of asset values which is part of the credit cycle or business cycle. Economist Hyman Minsky argued that such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money. There might never be a Minsky Moment as clear and obvious as the one the Fed has created at this very moment under its brazen current policy experiment. Time will tell.


Investor Action

As I mentioned, risk assets need to prove that they can maintain their lofty valuations without the assistance of the Fed’s QE. For the balance of the year, Fed policy will deviate very little if at all, from its current path and this is regardless of whether 2014 GDP growth ends up at 1.5% or 3.5%. In other words, in terms of the path of QE, the Fed is far less data dependent then they are willing to admit.

Markets are likely headed for a difficult period as the FOMC tries to gradually wean investors off of its liquidity addiction. It is too late for the FOMC to do much other than to try to limit the damage. Investors, however, should use this year’s decision to begin the ‘taper’ as the catalyst to pare risk. Investors should monetize gains ASAP; and move to cash and higher up the capital structure. Investors should place a premium on liquid securities and emphasize return of capital exposures. Yes, it really is this simple.

During the past 3 years, investors used the Fed’s QE policy to seek risk in order to beat competitors and to outperform benchmarks. Today, the hot air of forward (guidance) promises is not an adequate replacement for the substance of a $1 trillion per year asset purchase program.

Peer and benchmark outperformance between now and October (end of QE) means that portfolio managers will need to have the courage to leave the (ever-inflating) risk-asset party. The risk versus reward distribution is unfavorably skewed; offering inadequate compensation for riskier assets. Moreover, risk-seeking trades are crowded and poor market liquidity conspires against the FOMC’s ability to navigate the smooth landing that it desires.

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SheepDog-One's picture

Sure is a lot of financial working group bailed out bankster hand wringing going on lately, I'll believe any of it when I see it. I bet equities get Fed main lined Viagra in the morning, its Wonderland Wednesday after all and S&P + 15 by close.

seek's picture

It's ass covering. They know it's going to blow apart again soon so they're doing this to show they were trying to fix the problem, even though we all know it's too late to do so.

Zirpedge's picture

No ass covering here, It's all investors fault for trying to discover prices "Investors should forget trying to determine valuation."

Why don't you just buy stocks and stop all the madness of worrying about price discovery?

People worry too much and irresponsible sites like ZH generate ad revenue from the fear porn. You think any of these guys can generate alpha? Been trying to call the top for 5+ years now, likely from their momma's basements. 

BeetleBailey's picture

Look Mister 8 weeks and a day.

Fucking troll somewhere else.

Oh stay.

I love retorting to asinine trolls like you.

Mister Lurker.....calling the top is not ZH's mission. It's to display the truth - with a side of sarcasm - and to make fun of the complete fucking asswipes the sheeple installed/the Bilderboogers picked/Diebold de-faulted on.

Hmmmm...5 years...but only a "member" for a couple of months.

Go back to you were a big thumbs up winner there.

philipat's picture

The Fed is trying to reduce QE? Unfortunately, "Belgium" didn't get the memo.

Zirpedge's picture

Oh Lord it's worse than I thought in here. It's Schizophrenic Bettle Bailey suffering the Stockholm Syndrome. I'm here to liberate you from your captors BB. You have started to identify with their radical ideology and you need to get out. Go on Huffpo or CNN for a dose of reality, I'll pray for you to escape the abusive cycle of fear porn purveyors. Damn you Tyler Durden!

BeetleBailey's picture

Blow yourself loser.....get out the sneezing powder and tweezers...find it...if it will come out..then go off into a dark your Mom's basement....unless she's kicked you out....

But there's always the truck stop rest room.....go on now....go....

Redneck Hippy's picture

Exactly. BTFATH, and shut up.

TheRideNeverEnds's picture

What if this time it really is different?

deKevelioc's picture

Will it have a material impact on valuations or the aggregate economy if the Fed is buying $65, $45 or $25 billion of assets in month X, Y, and Z respectively?


I stopped reading right there.  This jerk has never heard of Belgium.

Redneck Hippy's picture

It ain't just Belgium.  The BOJ's yen won't stay in Japan, Chinese yuan slipping as it gets converted to dollars, and shipped to the Cayman Islands, and Mr. Draghi is just getting warmed up.  

Seize Mars's picture

The FED isn't over promising. They're doing exactly as mandated by their shareholders: destroy the American republic.

It's on purpose.

Wake the fuck up.

SheepDog-One's picture

Operation- Kill the Golden Goose..... yea been saying that ever since TARP myself.

SharkBit's picture

Yeah, lot of bla, bla, bla diverting the educated into second guessing everything with the end result just buying more time until all the wealth has been transferred to the elite.  Wake the fuck up to the crime being committed in real time.

Zirpedge's picture

If the FED is all powerful, why don't you just buy shares in the FED? Problem solved.

Seize Mars's picture

Maybe you're unclear on the concept.

what's that smell's picture

try not to feed the troll....they bite the hand that spanks them.

Everybodys All American's picture

Does wake the fuck up include the president or is he "in on it"?

AccreditedEYE's picture

Is Scotiabank The Squid? No. BTFATH

Squid Viscous's picture

the smaller cousin - Cold water squids are renowned for their prowess at sucking up the shit that sinks down to the bottom,

Jack Sheet's picture

OK so what does this guy have for amateurs like me who got out of stawks tutto completo at the beginning of 2012?

shovelhead's picture


A ringside seat when the bodies start hitting the pavement isn't enough?

It's gonna be spectacular.

Right now you feel like the guy who sold out on Oct. 25th 1929 and feels like he made a mistake.

Squid Viscous's picture

collect your "low inflation" door prize of $3.89/gallon gasoline ... thanks for playing !

Da Yooper's picture

Time to flese the flock after all its been 85 years

The GDP dont have a clue

shovelhead's picture

So I guess the uptick in private jets, penthouse suites and luxury yachts isn't creating enough wealth effect to move the other 99.999% of the economy into the black?

RMolineaux's picture

Shovel makes an important point about the so-called wealth effect.  The Fed and the bankers give exaggerated importance to this idea because it is based on their own experience and perceptions.  Having six figure salaries it is believable that they will spend more when their stocks go up (especially if they are promoting buybacks).  But they seem to be blissfully unaware that the 90 percent pay little attention to stock prices when they make spending decisions.  For most, their only contact with stock prices is when they review (if they do) their year-end pension or mutual fund reports - long after the fact. 

buzzsaw99's picture

Financial assets are valued simply by aggregating the discounted value of future cash flows...


Al Huxley's picture

LOL - now I can't possibly believe anything else he says.  I bet his name isn't even Guy Haselmann.

Squid Viscous's picture

reminiscent of '06/'07, LBO and M&A fever fueled by cheap money and ugly guys you won't see at midnight mass ...  how was Lloyd on Bloom-berg radio today I missed it? captivating I'm sure...

buzzsaw99's picture

Fed policy will deviate very little if at all, from its current path and this is regardless of whether 2014 GDP growth ends up at 1.5% or 3.5%. In other words, in terms of the path of QE, the Fed is far less data dependent then they are willing to admit...


GDP is a made up number that says whatever the fed wants it to say. The fed is data dependant in the extreme but the ONLY data they look at is the stock and bond markets. If rates are too high or the stock market too low they cite bullshit gdp or unemployment numbers as justification for market riggery. Do not be misled, GDP is a ruse. They jigger it higher and lower whenever they want.


also, it's sleight of hand, not slight of hand.

Tasty Sandwich's picture

The shadowstats guy has his own version.

Imagine if they didn't lie about inflation and actually used an accurate GDP deflator.

Even then though, GDP is a fairly useless indicator of the state of the economy.

buzzsaw99's picture

allow me to explain to haselmann what the fed is really thinking: The stock market is getting high with deteriorating macro fundamentals (that is to say, bubbly). The fed wishes that corporate borrowing was going into capex but instead much of it is going into stock buybacks, dividends, and m&a. they wouldn't mind that alone so much but trading volume is getting too lean to support their maggot buddies at the big banks. what they really want is volatility and volume to come back but with really low rates still in place because 1) they don't want to be blamed, and 2) the us gubbermint can't afford higher rates. in essence, the fed wants to have their cake and eat it too by jawboning the rubes into selling.

shovelhead's picture

Nailed it.

You work at NSA?

buzzsaw99's picture

the nsa archives my work but i don't get paid for it

BeetleBailey's picture

Look Mister 8 weeks and a day.

Fucking troll somewhere else.

Oh stay.

I love retorting to asinine trolls like you.

Mister Lurker.....calling the top is not ZH's mission. It's to display the truth - with a side of sarcasm - and to make fun of the complete fucking asswipes the sheeple installed/the Bilderboogers picked/Diebold de-faulted on.

Hmmmm...5 years...but only a "member" for a couple of months.

Go back to you were a big thumbs up winner there.



I Write Code's picture


Janet, Janet, you're the girl for me
Oh, you don't know me, but you make me so happy
I tried to call you before, but I lost my nerve
I tried my imagination, but I was disturbed

Janet, I got your number
I need to make you mine
Janet, don't change your number

I got it, (I got it), I got it
I got your number on the wall
I got it, (I got it), I got it
For a good time, for a good time call

mvsjcl's picture

I bet you write some mean code.

RMolineaux's picture

This item has many valuable insights about the box the Fed has put itself in, and what might happen when they try to climb out.  I would like to suggest two ideas that I believe do not receive enough attention in current economic evaluations:

The mal distribution of incomes has created a situation in the developed world where the wealthy are so saturated with ever new and ingenious toys that they are seriously suffering from boredom.  The less fortunate have ever decreasing discretionary income.  Combine both and you have a stagnant economy.

The culture of ever-increasing resource use (conventional growthmanship) is losing its persuason, both for the reasons cited above and because new resources are getting progressively more expensive and harder to find and extract.   We need to adjust our values and voluntarily accept "lower standards of living."  We might surprise ourselves and discover that we are happier that way.  Charles Hugh-Smith and Chris Hedges have written some interesting stuff along this line.  Europe seems to be more aware of it than the US, by promoting a shorter work week and longer vacations, among other things.