This page has been archived and commenting is disabled.
The Fed's "Mutant, Broken Market"
From Guy Haselmann of ScotiaBank
Undermining the Integrity of Financial Markets
Introduction
Financial markets are broken. Fundamental analysis and Modern Portfolio Theory are relics of the past. Investors used to care about maximizing a portfolio’s expected return for a given amount of targeted risk. The goal used to be that prudent diversification through the analysis of security correlations could move the Efficient Frontier Line ‘up and to the left’. In other words, improve returns per unit of risk.
Today, Fed policies have commandeered investor thinking and altered investor behavior. The powerful driver of moral hazard has fueled greed, and imbued more fear of underperforming peers and benchmarks, than fear of downside risks. Some investors are buying the riskiest assets simply because prices have been rising. Some investors say they are buying equities instead of Treasuries because ‘equities have upside, while bonds yields are puny and their prices are capped at par’.
Fed policies have led to (investor) herd behavior that has plunged market volatilities and manipulated asset prices and correlations to lofty levels. The rallying cry has simply become “don’t fight the Fed”. Relative return - without regard for risk - is all that matters. As a result, future return expectations have fallen with ever-rising prices; correspondingly, risk levels have risen in parallel. The allure of the Fed’s magic spell has lapsed investors into a soporific state of cognitive dissonance, with them focusing more on trying to justify valuations, rather than on the Upside Downside Capture Ratio.
Markets have thus mutated into one of two possible combustible states. Either financial assets have all transcended into prodigious bubbles, or stocks and bonds are signifying two completely separate outcomes. Either possibility will have dangerous repercussions for the economy, and for portfolios and investors. At the moment, I believe that the Treasury market has it right, signifying concerns about disinflation and future growth.
Using Financial Asset Prices as a Policy Tool
Uber-accommodation and aggressive promises by the Fed have been successful at chasing money into equities and the lowest part of the capital structure - as was its intent - but the stellar performance of equities have been divorced from the underlying economy for the last few years. (Note: better earnings from improved margins are unsustainable without revenue growth.)
Fed policies have also laid the foundation for debt issuance to fund private sector share buybacks and mergers, creating the self-reinforcing illusion that all is well. Super-subsidizing the cost of debt destabilizes the basic tenets of investment. By creating an environment, whereby investor decisions are enticed into the junkiest credits and equities (the junkier the better), and whereby financial market manipulation is being used as a policy tool, the Fed is undermining the integrity and foundation of financial markets.
Investors have also been led to believe, that should pressures build on those risky securities, more subsidies will be offered. This dangerous feedback loop is unsustainable. At some point - probably in the very near future - investors will lose faith in the central banks’ ability to support the economy through higher financial asset prices.
It is far too early for history to judge the success (or lack thereof) of QE policy. The smug references of claiming victory by some FOMC members likely derives not from comprehensive faith in their success, but rather from attempts at maintaining confidence in the institution. After all, Fed policies are experimental, have had questionable success, and the unintended consequences of the actions have yet to be felt.
On balance, markets have too much faith in the FOMC, which is over-promising on what can reasonably be delivered with such limited powers. Bigger than the bubble in financial asset prices is probably the bubble in Fed-confidence.
Big Objectives, Limited Tools
As far as economic management is concerned, the Fed really only has one basic instrument: managing liquidity through managing the supply of money. How does it make sense that the Fed can achieve its dual mandate objectives of price stability and full employment with this one blunt tool? When all you have is a hammer, than everything looks like a nail. With this one tool in mind, it seems silly to think that heated debates arise after each new piece of economic data, on how much to tweak money supply. A $17 trillion economy cannot be micro-managed.
Debate even shifts between the focus on the price mandate and the employment mandate and whether there is a trade-off between them. It does not require much thought to realize that the ‘dual mandates’ of the Fed are bewildering and illusory and in need of a face-lift.
Even more problematic is the prospect that FOMC analysis could be faulty. In 2012, I wrote that “the Fed should not confuse good deflation with bad deflation in that good deflation is a drop in prices caused by technology-enhanced declines in the costs of production. Trying to fight such imagined deflation would lead to asset bubbles and problems elsewhere”. Bad deflation is when the consumers stop spending because they believe prices will be lower in the future. Globalization and technological advancements result in the ‘good type’ of deflation. Zero interest rate policy expedites the process, rather than reversing or easing price pressures.
Dubious Economic Ideology
The group-think FOMC has perpetuated this state of being, because Fed leadership believes in the same outdated economic theories popularized over a half-century ago. Bernanke and Yellen, among others, were influenced by a few Noble Laureates during their studies in the 1970’s; those such as, James Tobin, Paul Samuelson, and Bob Solow. Samuelson was credited with creating ‘Neoclassical Synthesis’, which all policymakers use as their basic approach (they also use faulty neoclassical fullemployment optimization models).
The Samuelson ‘synthesis’ basically says that with skillful monetary and fiscal policy, the economy can be kept close to full employment and will behave as the models of long-run growth suggest it will. However, every now and then (like the present), the emphasis will have to be on the short run. Few would argue that the Fed has taken this path, and in doing so, has created a ‘time-inconsistency’ problem whereby it is trying to bring demand forward at the expense of the future.
In past speeches, Yellen has blamed the Fed’s extraordinary measures on the underutilization of labor resources (slack). It was interesting, however, that when Yellen presented at Jackson Hole in front of the foremost academic experts on labor markets, she did not reveal any biases regarding the amount of labor slack. Had she regurgitate any of her earlier assumptions (that were used to justify current policy), she would have likely opened herself up to criticism; especially given the complex relationship between employment, wages, inflation, and growth.
By showing more ambivalence and lacking the confidence to share those assumptions with this group of academic ‘experts’, she exposed the dubious and experimental nature of FOMC policies. It can therefore be argued that the FOMC is basing the greatest experiment in Fed history on low-confidence assumptions about labor market slack and Phillips Curve trade-offs.
Solow, Samuelson and Tobin explicitly acknowledged the non-static nature of the Phillips Curve due to shifts in expectations and to hysteresis. Yellen seemingly ignored this aspect of their work, because it did not jive with the Fed’s policy actions.
(For review and emphasis) ‘Hysteresis’, according to Investopedia, is: “the delayed effects of unemployment. As unemployment increases, more people adjust to a lower standard of living. As they become accustomed to the lower standard of living, people may not be as determined to achieve the previously desired higher living standard. In addition, as more people become unemployed, it becomes more socially acceptable to be or remain unemployed. After the labor market returns to normal, some unemployed people may be disinterested in returning to the work force.”
Counter-productive Policy
The Fed cannot do anything about hysteresis and has had little, if any, help from the fiscal tools that could help. Using monetary tools where a fiscal solution is required has consequences, and further enables fiscal stalemate. Furthermore, it could be argued that holding interest rates at zero for a prolonged period of time is actually counter-productive.
As mentioned earlier, corporations have been incentivized to issue cheap debt, but those who are not buying back shares or increasing dividends are using the proceeds to modernize plant and equipment. Improved productivity has resulted, but those gains have not spilled into wage improvement; hence, feeding the Fed’s argument of ‘slack’.
As a matter of fact, gains in productivity through modernization have exposed production redundancies, allowing firms to lay-off workers and cut prices. Certainly capitalist societies always strive for advancement in this manner, but Fed policy has turbo-charged the process. Without new and modernized job training, old jobs become outdated, unemployment swells, and hysteresis results.
Conclusion
The FOMC has backed itself into a predicament where there is no easy escape. Its policies might be counter-productive for the economy and harmful to financial markets, which will likely to lead to tarnished credibility in the near future.
If the economy muddles along or stalls, the effectiveness of QE will be questioned. In the unlikely possibility that the economy grows satisfactorily, the Fed will be accused of being behind the curve.
Investors betting on Fed promises, and its hopes of navigating economic ‘lift-off’, will likely have a difficult path going forward. Investors smart enough to have believed in the implicit information embedded in (unloved) long dated Treasuries (+25% YTD) should continue to reap the best reward per unit of risk.
Since February, I have predicted that 30-year Treasury yields would drop below 3% before the end of year. The yield reached 3.05% today; earlier than anticipated. I expect 30-year yields to outperform for a while longer, and continue the march to lower yields. Those expecting much higher (back end) yields will likely be waiting quite a long time; possibly even a year or more. Waiting for inflation in recent years has been like waiting for Godot (he never shows up).
- 7164 reads
- Printer-friendly version
- Send to friend
- advertisements -


Wow that pic of those hideous creatures sure reminds me of Alan Greenspan
Don't forget his wife, snooty Andrea Mitchell
Few mutant prawns on the barbie for the long weekend! Delicious.
Brundle Fly!!!
http://www.youtube.com/watch?v=NH-8L1iZq20
It is not a mutant market now, it is virtually no market outside of the Fed's QE helicopter cash drops to the .01%. 20 years ago, the term for the government helping the economy was called "pump priming." Now, the pump is broken all to economic hell. The latest sign of an economy in disaster mode: "This week's 3.97-million album sales tally is the smallest weekly sum for album sales since Nielsen SoundScan began tracking data in 1991. It's also the first time weekly sales have fallen below four million in that time span." The middle class buyers who used to buy music albums are AWOL. Maybe streaming audio and iTunes has cut into album sales but this drop in sales of a reliably selling product, CDs, shows the USA is way past the point of no economic return. One of the last jobs where many employees have some sort of job security is a tenured public grade school teacher. Everyone from Bill Gates to soon to be gone rightwinger Diane Sawyer is battling to privatize public eduacation with charter schools run by their friends, to eliminate tenure and, incidentally, middle class union paychecks. The .01% thieving mutants are in charge now, so expect the destruction of the middle class to continue.
...fucking really? charters are not being set up to destroy union jobs. they are being set up because the union employment centers (schools) are FAILING to educate kids. incidentally, i have recently taken my kids out of a charter (one of the best "public" schools in our state) because it is impossible to deliver a quality outcome--even at a well ranked charter. the only funding we could get was earmarked to pour into the heads of kids with mush for brains (can't have any money for bright kids, so don't even ask). and, any structural issues we tried to push for to make the best of a broken system were inevitably blocked by--you can guess this one--the teachers union.
Translation there will be war
As long as the top 10% keep doing well, the Fed will keep doing their job (which is to keep the top 1% doing well).
It's against my nature to be agreeable, but I'll have to say you have hit upon a truth. Just looking at the classic definition of inflation, it's apparent that the first recipients of the largesse are the biggest beneficiaries, those being the 1%. Or, in this case the .05%, the upper of the upper crust. The looting is in progress and the Fed only hopes that they can keep the various plates spinning until the process is complete. The rest of us will have moldy scraps, and we'll pay dearly for those. Some famous person or other said that we get the government we deserve.
FED has stooped to making brokers send ads on how to short, and how shorting can benefit your portfolio. Got 4 of them.
Why not just tell us to jump out the window???
NFLX nearing $500, Chipotle almost $700, the list goes on and on
Elsewhere:
Bizarre ISIS - police T-shirts appear in Ferguson
http://tinyurl.com/l6vebnw
Look! The SEC! Thank God...our reputations are saved!
Sadly, the assumptions that second moments exist in the price or the return of stocks is totally wrong. They don't. Build more castles on sand.
Hear that giant sucking sound? Wait ... do you hear it now? Yeah that one. That's the sound of all the money in the world going down the drain into the bottomless well of devouring entropy. Good friend of mine, entropy. And from where I sit I can tell you, you and your money are not getting off so easily. #B2CAD7
Inflation is everywhere except in the official measure. But yes, yields will continue to fall.
I give up. I'm opening a MyRA.
I just responded to an enail inquiry from a Nigerian prince.
I just got a job working part time from home, making $9500 a week. Sounds like we're both set for life. The only question is where to "invest" our coming fortunes. That's where the MyRA comes in.
I'm going to parlay all of that Nigerian's inheritance into lottery tickets. I used non-GAPT (generally accepted probability theory) math and it's a sure thing.
I just applied for a job with the Squid
My Forever Stamp Fund is still open, for a limited time.
Send for an absolutely FREE Newsletter describing the benefit of investing in the risk free Forever Stamp Fund, TODAY!
>> I just got a job working part time from home,
I'm moonlighting looting while the cops are busy tear gassing peaceful protestors. The key to a lucrative looting career is to not stop and protest, keep keep looting and eveything is ok. I think as long as your looting the cops confuse you with a banker.
Just buy, you dumb goys,get your cash off the sidelines, everything's fine...stocks are cheap with these low interest rates...
Squid has the right idea... this Market Ain't NEVER Going Down! NEVER NEVER NEVER...
The only real conclusions from the assumtions stated above are:
There are no "market forces" at play. Price is completely controlled and manipulated. Either you put your money with the manipulators and win or you put your money against the manipulators and lose. This means that for all intents and purposes, the stock market is completely dead, killed by the banks, their computerized price control mechanisms and their parasitic, crony sycophants.
One might as well close all of the markets and just let the banks decide the price of everything, who works and in what industries and how much money we each should have. Another nail in the coffin of free will on earth.
Exactly. And if the time comes when they can't control it, they'll likely just turn it all off.
The ruling class has to be slaughtered, without mercy.
That's what they say about the rest of us.
You fight or die.
I agree Chuck. (And stop drinking so much. I loved you as a ball player)
You had me at "financial markets are broken."
Hey! Where have I seen that picture before?
Economy is in a Chinese Finger Trap of QE and ZIRP.
I always enjoy Guy Haselmann's commentary, but that's an awful lot of truthiness for one of the Fed's Primary Dealers. Do they allow that?
The Fed has absolutely sod all interest in unemployment or markets ...unless they're bwankers and bwankers trading positions
it has a (private) monopoly on money ..and has a mandate to support (ie. bailout) drunk stupid with financial gambling banker bums ..usually the same secret parasites that hold the Fed money monopoly
that's its only 2 interests ...mention of unemployment is merely a thin glossy veneer to hide the big stink of the corruption of its position
Fuck Janet Yellen, skip NIRP and goto raising interest rates. Watch the I'am rich QE bitchez run like all new money cock roaches do.
Old money sits back and laughs.
You can dress them up, they somehow manage to fuck up the evening.
"tarnished credibility"
Oh you had me laughing on that one.
Far too early to judge QE?
We've been judging it for years here on ZH and the civil verdict is "Liable"... as in liable for all the damage it has caused. The criminals have yet to be apprehended and prosecuted.
somebody say stackin...
There is no "Bad-type of Deflation" - it's ALL GOOD!
Both people and governments have lived beyond their means by taking on debt they cannot repay. Over the last several decades we have created entitlement societies built on the back of the industrial revolution, technological advantages, capital accumulated from the colonial era, and the domination of global finances. Promises were made on the assumption that the advantages we enjoyed would continue.
Ever greater prosperity and entitlements were to be sustained through debt financed consumption growth. In that eerie fantasy world, debt fueled consumption was to be the catalyst to bring about evermore growth. Now reality has begun to come into focus and it is becoming apparent that this is unsustainable. The entitlements and promises that have piled up have become overwhelming. More on why this system will fail in the article below.
http://brucewilds.blogspot.com/2014/08/modern-monetary-theory-is-wrong-d...
Rates will not significantly rise (if at all) in the near- and mid-term future, else the debt ponzi crumbles and collapses the system (default would trigger the drivatives financial bomb of mass destruction). But the paper gold ponzi will break at some point, and then all fiat currencies will collapse against real money. This eventuality is being fought really hard right now by TPTB, but the China put is in, and miners just coming out about even, puts a solid floor to the PM market. In a complete system collapse scenario, short-term (paper)-PM could still crater along with everything else... in that case, I do not intend to sell but add to the stack (phyzz only). good luck to all.