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Scotiabank Warns The Fed "Put" Is Now Much Further Out-Of-The-Money
Via Scotiabank's Guy Haselmann,
The brilliant Mel Brooks 1974 parody Young Frankenstein ranks No. 28 on Total Film magazine’s list of all-time funniest movies. When QE-infinity was first announced, I drew analogous similarities between the monstrous experiments of Dr. Frankenstein (Dr. F) and the Fed.
In the movie, it was only after the monster went berserk that Dr. F (Gene Wilder) learned that Igor had snatched the “Abby Normal” brain. Clearly, even the most well-intentioned experiments can have unintended consequences. In this vein, the Fed created a financial market monster via six years of ‘pedal to the metal’ Fed stimulus designed to encourage risk-taking and speculation, and like Dr. F, the Fed was confident it had the tools to control it. Unfortunately, history will likely view QE- infinity as the “Abby-Normal” brain that sent its grand experiment awry. The full argument follows.
There are two important and distinct reasons why QE-infinity was materially different and more hazardous to financial markets than QE1 and QE2:
1) it originated subsequent to earlier action that had already changed investor behavior; and
2) its open-ended time frame hijacked the market’s typical price discovery mechanisms.
At first, misallocation of resources resulted when money became (basically) free after the Fed lowered its interest rate to zero. Next, the market’s normal functioning was altered, and price discovery distorted, when the Fed decided to embark on QE1 and QE2. Finally, when QE-infinity was introduced, price discovery was completely demolished. It even triggered talk of an equity market ‘melt-up’.
QE1 and QE2 changed investor behavior because the Fed was implicitly providing a market “put” by suggesting that any dissatisfaction with the pace of the recovery would always be met with more action. In general, investor behavior moved away from determining whether adequate compensation was being received for risks, and towards fear of missing out on the upside of easy Fed-driven market profits. This was particularly true for asset managers who were now even more incentivized to seek out-sized risks to ensure they beat peers and benchmarks. They were convinced because the Fed appeared resolute in its determination, and investors had been overwhelmingly programmed over the years not to ‘fight the Fed’.
QE-infinity turbo-charged the equity markets myopic focus on its upside potential. Basic finance teaches that asset valuation entails discounting all future cash flows to today’s present value. Yet, when the last QE program was (initially) not given an end date, the market had to accept zero rates (ZIRP) as extending infinitely into the future. In other words, the discounted rate used to value those cash flows was assumed to be zero in perpetuity. Dividing a number by zero equals the empty-set; thus, triggering talk of an equity market “melt-up”.
Furthermore, by forcing interest rates to such artificially low levels, the Fed flipped the foundations of the Capital Asset Pricing Model upside-down. Equities became the preferred asset class simply because they provided uncapped upside, while bonds technically were capped at par. Asset managers even moved into dividend paying stocks as a substituted for their fixed income exposures. This shift in perception had a material impact on asset allocation models and increased systemic risk.
With QE terminated and expectations of a near-term rate hike looming, the Fed “put” is now much further out-of-the-money. More importantly, the discounting function for future cash flows is moving away from zero. In addition, as the Fed’s policy pivot is tightening the spigot of easy money, share buyback programs that have enhanced the illusion of the power of the equity market will wane.
Going forward, prices will have to be supported by fundamental values rather than easy money and speculation. The upside vs. downside distribution now looks skewed to the ‘left-tail’. The Junk bond market started declining last June. A move that was not solely due to the decline in oil, since WTI did not fall below $90 until October. The divergence with the equity market is large and worrisome.
The bottom line is that I expect a large equity price adjustment (down) to occur imminently. Portfolios need to adjust from blindly accepting the Fed’s ‘sugar high’ toward realistically assessing valuations based on fundamentals. After six years of fuel, there is quite a bit of speculation to work off. Risk-assets will not like a hike in rates, while a pause would probably be attributable to bad news that is not good for risk assets.
During the (volatile) adjustment process, the Fed will likely vacillate between over-confidence and fear. Investors should not be fooled, but rather, should stay focused solely on re-calibrating exposures based on the new market risk vs. reward distribution under a paradigm of declining accommodation. With compromised market liquidity, first movers will have the advantage, especially since market liquidity is dreadful. Risk paring is currently unfolding. Capital will flow to Treasuries. I remain a bond bull.
“Maybe you had too much too fast, or just over played your part. Nothin’ shakin’ on shakedown street”. – Grateful Dead
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Perhaps the dead cat (or Fed cat) bounce will morph into a Schrödinger's cat plunge, as the FOMC can’t seem to avoid closely observing the markets.
It;s what I said here earlier!!
http://www.zerohedge.com/news/2015-01-08/2015-everything-can-be-fixed-pr...
And fuck you disabledvet!
Scoot-ya bank.
Scoot ya out the door after you've been fleeced.
"With QE terminated and expectations of a near-term rate hike looming, "
Hugh? When did the world end?
...Bank of Obama...
Oh look its me..
realistically assessing valuations based on fundamentals
Huh? What does he mean by that?
I would think it was clear what he meant by that; he meant the S&P is going to crash.
Crash? What's a crash? Another word I used to know a lot time ago, but not any more. Why is everyone talking in Old English this morning?
Got QEIV?
Janet will be going out to the corner store soon to "pick things up"
Crash? I don't think that word means what you think it means.
AAANNNNDDD we're up 305
I think the word disintegrate will likely to be closer to reality.....
Not sure. Could somebody look up the word "funamentals", please? I feel like I used to know what it meant, but that was so long ago, it's just gone now.
Fundamentals.... hmmmm...
I'm going to give it a shot with an example (from Google Finance): "Chipotle Mexican Grill restaurants serve a menu of burritos, tacos, burrito bowls (a burrito without the tortilla) and salads. As of December 31, 2012, the Company operated 1,410 restaurants, including Chipotle restaurants throughout the United States, as well as five in Canada, five in London, England, and one in Paris, France, and also one ShopHouse Southeast Asian Kitchen, a restaurant in Washington, D.C. Chipotle categorizes its restaurants as either end-caps (at the end of a line of retail outlets), in-lines (in a line of retail outlets), free-standing or other. As of December 31, 2012, of its restaurants in operation, the Company had 258 free-standing units, 861 end-cap locations, 233 in-line locations and 58 other. The average restaurant size is about 2,535 square feet and seats about 56 people. Most of its restaurants also feature outdoor patio space".
So how much can such a restaurant business possibly be worth? What would a fair market capitalization be?
How about 22 BILLION DOLLARS? After all, they sell really great mexican food and they have a lot of restaurants with 56 seats on average.
What would a fair P/E be?
How about 56? After all, they are a company with huge growth potential, no?
Are these the "fundamentals" he was talking about? Or do I need to dig deeper?
I think I just got the runs....
I got the bank runs a while ago and it doen't go away....
Its got 'fun' in it so it means a free trip to the Casino -De-La-Rigged....
https://www.youtube.com/watch?v=LZctouMPIjk
I agree completely. The Stawks are going down. Also, Scottia Bank is pretty cool.
+100
it does feel that way,
Just need a little rally, while whats left in of the smart money exits.
Federal Reserve is able to contribute significantly to the expansion of crisis since the US government appears to be increasingly dependent on Fed's quantitative easing policies.
you got me on the shakedown quote. thirty years upon my head to have you call me child.
this ship of fools is sinking
but theres a party going on. come in...enjoy!
10 things the media won’t be talking about after the Paris terror attack
Do NOT click on the above link!
WTFRLY= Wasting Time For Really Low Yield.
QE4 is coming...
Plus some "new mortgage products" for the 40% already in collections.
I agree.
I do not see how losing a thousand pts S&P is politically acceptable.
Can anyone give reason to think that we will not have another 6 years of driving the stock market up?
I agree.
I do not see how losing a thousand pts S&P is politically acceptable.
Can anyone give reason to think that we will not have another 6 years of driving the stock market up?
Scotiabank soon to be Scotiabankrupted if Shale fails in Canada. I'm sure a stronger $ will do wonders for Canadian real estate too. One more thing rates will rise in 2012.
No Way. Canadian Banks are entirely different than American Banks; it's the strongest banking system in the world; look it up. Scottia refines precioius metals in their subsidiary; they're nobodys fool.
I think you mean 'they're not just anybody's fool'.
" One more thing rates will rise in 2012"
Wow. Your hindsight is, well, abysmal?
Going forward, prices will have to be supported by fundamental values
Like the employment number and earnings per share number and so on bitchez.
The FED must have a tremendous Schwanzstucker!
Yes, they're very popular.
Bullshit. It's closer than ever to mkt, but the real question is: does the put have the credibility after N+ years of promising QE exits and rate hikes?
. . . and Marty Feldman did not have to wear any make-up for the role.
The hugely unexpected is about to happen to treasuries. No one believes that yields can rise in the current economic environment and with the Fed ready to man the so-called printers. But yields are in the process of bottoming and the next rise in 10 YR yields especially, will send markets into chaos. Tens, if not hundreds, of trillions in derivatives are about to go up in smoke when 10 Yr yields cross into 4% territory.
Follow the blue route...
http://www.globaldeflationnews.com/10-year-u-s-treasury-index-yieldellio...
"Tens, if not hundreds, of trillions in derivatives are about to go up in smoke when 10 Yr yields cross into 4% territory."
Thank God the "Spending Bill" passed by our "elected legislators" so GOV would not shut down again included a bailout provision for the TBTF's derivative losses.
God will thank them all personally when they are directed to the down elevator (the one with the red door)
I wish I could believe that - that a return to real interest rates greater than zero - true price discovery could be allowed occur. The FED will never let rates go - EVER, in my opinion.
Socialism is everywhere now. Its in our education - our medicine - and now its in our money - like DNA. There is nothing left of the free market. We are just different shades of Venezuela. Russia is more free market than we are now (I can't beleive I just said that), and thats depressing. But perhaps the most depressing thing is the realization that in the absence of hurling my savings into the stock market, I shall never see a positive real rate of return on my savings ever again.
In other words, all the things I was taught growing up - that saving is good and that you can aim for better things if you squirrel away your earnings - that stewardship of one's wealth (forego consumption today for a better life tomorrow) - that hard work and diligence are hallmarks of productive individuals - of a productive society - all these principles, successfully destroyed by central banks.
And you don't realize how bad its gotten until you see opposition parties rally around the government saying, "we have to stand united during these difficult times (plummeting oil)", - that they themselves are completely oblivious to the capital destruction that has underlined economic activity since the evisceration of the only price mechanism thats really ever mattered. And worse still - the people have bought it, all of it, hook, line, and sinker.
Government balance sheets will bleed red, services will stop, the elderly will be abandoned (precursor to soylent green), employment and compensation will be increasingly eroded by burgeoning tax rates and higher prices to pay for somebody else's life style - FOREVER.
Lots of things to look forward to.
Good times.
Stupid Canuck banks.
Longest resignation letter ever written, trouble is he is assuming the Fed are going to raise interest rates - and that ain't just gonna happen. It will find a never ending list of reasons why it can't stating it will when x,y or z happen, but will then have a fresh set of excuses when x,y and z materialise.
Something massive is going to have to occur to blow this bubble apart,a massive external event, a war threatening oil supplies again, something along the lines of Japan going bust when the Yen collapses,they are basically doing what the Weimar government did, saying !we're doing it differently and this time it's going to work - trust us".
That is a long way away yet, what amazes me is how long these central banks can keep these obviously unsustainable bubbles and distortions going when to the average Joe they should collapse immediately.By that time the S&P will probably have a three handle on it.
Alot of throws at the dart board but no hits.
Let me try my underhand and up.
The Fed.