The Truman Show Markets

Tyler Durden's picture

Via Global Macro Monitor,

We have finally made the time to more closely review the release of last week’s Fed minutes from the July 25-26 meeting.   We kind of like what we see.

Debate Breaking Out Among FOMC Members?

A debate appears to breaking out between members and staff of the Federal Reserve’s FOMC about the impact of QE on long-term interest rates and their impact on asset markets.

On the one side are what we call the Bubblistas,  who believe and are concened the repressed low long-term U.S. interest rates are leading to excess asset speculation.

 

On the other, the academic “Efficient Marketistas,” — who, by the way, we believe were partly responsible for the 1990’s equity bubble and the 2003-07 credit bubble — think the markets are pricing all information and fundamentals correctly.

How do you think they explain Italian junk yields trading through U.S. Treasuries?   Covered interest rate parity?  That is expectations of continued appreciation of the euro/dollar?  Such absurdity.

What Is The Bond Market Telling Us?

We also always chuckle when we hear market commentators talk about, “what is the bond market telling us?”    We completely agree, and have been expressing the same view for years,  of what Mark Dow wrote last month on the Behavioral Macro blog,

“The bond market—in both shape and level—has been telling us very little about US economic prospects/activity. However, short-term changes do inform us as to the prevailing narrative.”  – Mark Dow

FOMC Minutes

Have a look at our annotated version of a few key paragraphs of of the Fed minutes released last week and what we believe telegraphed the subject of Chariman Yellen’s Jacksole Hole speech later this week on financial stability.

Minutes of the Federal Open Market Committee

July 25-26, 2017

 

..Asset purchases by foreign central banks and the Federal Reserve’s securities holdings [see our Table below] were also likely contributing to currently low term premiums [QE/ZIRP distortions – Bubblistas], although the exact size of these contributions was uncertain. A number of participants pointed to potential concerns about low longer-term interest rates, including the possibility that inflation expectations were too low [Efficient Marketistas] , that yields could rise abruptly [see our “beach ball effect” on repressed interest rates], or that low yields were inducing investors to take on excessive risk in a search for higher returns [fear of yield chasers and financial destabilization – Bubblistas].

 

Several participants noted that the further increases in equity prices, together with continued low longer-term interest rates, had led to an easing of financial conditions [see our post, Market Liquidity Conditions Still Loose As A Goose]

 

However, different assessments were expressed about the implications of this development for the outlook for aggregate demand [uncertain over wealth effect of rising asset prices] and, consequently, appropriate monetary policy. According to one view, the easing of financial conditions meant that the economic effects of the Committee’s actions in gradually removing policy accommodation had been largely offset by other factors influencing financial markets [concerns of losing control to the markets], and that a tighter monetary policy than otherwise was warranted [Bubblisitas]. According to another view, recent rises in equity prices might be part of a broad-based adjustment of asset prices to changes in longer-term financial conditions [Efficient Marketistas], importantly including a lower neutral real interest rate, and, therefore, the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services.-  FOMC Minutes from July 25-26 Meeting – Released August 16, 2017

We produced this table in March and do not believe the data have changed much, though with more Treasury issuance the percentage of the U.S. Treasuries held by the Fed and foreign central banks is certainly lower.

Fed_Foregin Central Bank Holdings

Nevertheless,  at the time,  65 percent of all long-term Treasuries,  with maturities longer than one year, were held by the Fed and foreign central banks.  That is by non-price sensitive holders.    Add to that foreign private holders, forced into the U.S. bond market by negative interest rates in Europe and Japan,  and not much of the cash market is available for domestic investors.

Stunningly,  more than 80 percent of Treasury securities longer than one year are held by the Fed and foreigners,  making short selling or straying from your benchmark a very dangerous proposition.

From The Great Moderation To The Great Distortion

The supply of bonds and notes taken out of the market by the Fed and foreign central banks,  coupled with foreign private bond flows (due to foreign QE and NIRP), has resulted in a massive distortion of long-term risk-free interest rates.   Since, most risk assets are priced off of these rates,  then, by simple logic,  risk in all asset market is  mispriced.

The Truman Show Markets

Fake news, fake economies (based on fake demand dependent on asset bubbles), fake markets (dependent on QE and low interest rates).  It’s the Truman Show, folks.

The 75 trillion dollar (size of global economy) question is when will Truman Burbank realize his world is fake?

We think when policy rates rise another 100-200 basis points and/or double digit percent reductions in the monetary bases of the G3,  maybe with the exception of Japan, which we may never see.  Whatever the case, it may take some time.

Stock Versus Flow Of Bank Reserves

The fear of overshooting interest rates and bursting asset bubbles may be one reason the Fed, alternatively,  wants to start shrinking its balance sheet.  We agree with the Fed that it is the stock (or level) of reserves in the financial system that matter and not the flows,  at least for now.  At some point, however,  the markets will worry the level of reserves are approaching drought level conditions and financial liquidity is becoming too tight.

Nevertheless, as long as interest rates remain repressed and low, the mispricing of asset markets  can last much longer than many think.  It already has, and, remember,  “the market can remain irrational longer than you can remain solvent.”

Investors, traders and ‘bots, for that matter, also have to make money in the market they are dealt.  Not the market that should be or the one they want it to be.

Furthermore,

It is hard to pop a bubble of financial exuberance, however, when the predominant investor sentiment appears to be grudging rationalisation of high prices, absent much enthusiasm. Dhaval Joshi, chief strategist for BCA Research, says: “At our client meetings, almost everybody disbelieves that current valuations allow developed market equities to generate attractive long-term returns. Yet many investors are willing to suspend this disbelief, at least for the time being.”  – FT

In other words, many market participants are acting as Truman Burbank, forcing themselves to believe the island of  Seahaven is real.  Fitting in world of virtual reality and 24/7 reality television.

There will come a day when Truman discovers or rediscovers reality and walks off the set, not like the financial collapse and Lehman moment of ’08, as there is too much liquidity in global financial system. More of a sustained period of secular stagnation before the central banks effectively become eemployment agencies and either directly, or indirectly, monetize wages.  Contrary to conventional wisdom, we believe inflation, rather than deflation will be the ultimate end game.   Though a period of deflation will sow the seeds and set the stage for the inflation.

After all,  major central banks are engaging in activities unthinkable 20 rears ago.

The Bank of Japan’s controversial march to the top of the shareholder rankings in the world’s third-largest equity market is picking up pace.

 

Already a top-five owner of 81 companies in the Nikkei 225 stock average, the BOJ is on course to become the No. 1 shareholder in 55 of those firms by the end of next year, according to estimates compiled by Bloomberg from the central bank’s exchange-traded fund holdings. – The Japan Times, August 15

The Monetary And Political Debates Begin

Nonetheless, we are encouraged the FOMC seems to now be debating such issues.  A debate that should have taken place before the 2007-08 credit bubble popped, which could have prevented much economic pain and indirectly and partially caused the political instability the U.S. is now experiencing.

Whether the central bankers can and/or have the courage to try and guide the global economy and markets to a safe landing and rid the distortions, which are both apparent and the ones we have no idea even exist,  from 10 years of zero interest rates and quantitative easing, is highly questionable.   It is clear from the minutes,  the FOMC members don’t even know themselves.

Nevertheless,  the debate we have long been looking for among the monetary policy makers appears to have finally begun.

Similarly, the legacy issues of slavery and the confederacy, which should have been dealt with 150 years ago,  but were circumvented by the presidental election of 1876,  have finally boiled to the surface in the U.S. and have added additional event risk to the markets.    We are,  at least, encouraged the issue is finally being discussed, debated, and hopefully will be addressed,  which should be good for the country in the longer term if it doesn’t permanently rupture the body politic, first.

Our Market View

You know our market view.  A volatile autumn, culminating in a sharp, quick sell off around or in October that should be bought.   It makes us nervous, however, many already believe and are beginning to arrive at the same view.

Finally, we leave you with some more money quotes from the FOMC minutes (via Bloomberg).   Looks like they are going to the pull the trigger on quantitative tightening (QT) in September,  unless markets become too volatile.

  • most market participants now anticipated that the FOMC would announce at its September meeting a date for implementation of a change in reinvestment policy, although a couple of survey respondents expressed the view that the timing could be affected by developments regarding the federal debt ceiling
  • The overall labor force participation rate edged up in June
  • new home sales in May partly reversed the previous month’s decline.
  • The most cited reason for the lackluster loan demand was subdued investment spending by nonfinancial businesses, but banks also reported that some borrowers had shifted to other sources of external financing or to internally generated funds.
  • This overall assessment incorporated the staff’s judgment that, since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets.
  • In this projection, the staff scaled back its assumptions regarding the magnitude and duration of fiscal policy expansion in the coming years. However, the effect of this change on the projection for real GDP over the next couple of years was largely offset by lower assumed paths for the exchange value of the dollar and for longer-term interest rates.
  • Participants noted that the fundamentals underpinning consumption growth, including increases in payrolls, remained solid.
  • uncertainty about the course of federal government policy, including in the areas of fiscal policy, trade, and health care, was tending to weigh down firms’ spending and hiring plans.
  • measured aggregate wage growth was being held down by compositional changes in employment associated with the hiring of less experienced workers at lower wages than those of established workers.
  • some likelihood that inflation might remain below 2 percent for longer than they currently expected
  • they differed in their assessments of whether inflation expectations were well anchored.
  • A number of participants noted that much of the analysis of inflation used in policymaking rested on a framework…A few participants cited evidence suggesting that this framework was not particularly useful in forecasting inflation. However, most participants thought that the framework remained valid
  • Participants agreed that it would not be desirable for the current regulatory framework to be changed in ways that allowed a reemergence of the types of risky practices that contributed to the crisis.
  • Most saw the outlook for economic activity and the labor market as little changed from their earlier projections and continued to anticipate that inflation would stabilize around the Committee’s 2 percent objective over the medium term. However, some participants expressed concern about the recent decline in inflation, which had occurred even as resource utilization had tightened, and noted their increased uncertainty about the outlook for inflation. They observed that the Committee could afford to be patient under current circumstances in deciding when to increase the federal funds rate further and argued against additional adjustments until incoming information confirmed that the recent low readings on inflation were not likely to persist and that inflation was more clearly on a path toward the Committee’s symmetric 2 percent objective over the medium term.
  • the extent of current downward pressure on longer-term yields arising from the Federal Reserve’s asset holdings and how this pressure would diminish over time as balance sheet normalization proceeded, the strength and degree of persistence of other domestic and global factors that had contributed to the easing of financial conditions and elevated asset prices, and whether and how much the neutral rate of interest would rise as the economy continued to expand.
  • in the Committee’s post meeting statement and its Addendum to the Policy Normalization Principles and Plans. Participants generally agreed that, in light of their current assessment of economic conditions and the outlook, it was appropriate to signal that implementation of the program likely would begin relatively soon, absent significant adverse developments in the economy or in financial markets.
  • several participants were prepared to announce a starting date for the program at the current meeting, most preferred to defer that decision until an upcoming meeting while accumulating additional information on the economic outlook and developments potentially affecting financial markets.
    FOMC Minutes from July 25-26 Meeting – Released August 16, 2017

 

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skbull44's picture

It's all fun and games until someone loses all their fiat...

BennyBoy's picture

 

That it's all fake was very apparent in 2007-2008.

Old news.

Thought Processor's picture

 

 

It's the "Human Show."  

 

Seriously, this must be quite entertaining for any aliens who are watching. 

 

 

seataka's picture

Bo wonder they dont want to reveal themslves, we are insane

 

medium giraffe's picture

OT: Munchkin dishes out more sanctions to Russia & China:

  • US will continue to target those who support N. Korea weapons programs and isolate them from US financial system
  • It is unacceptable for individuals and companies in China and Russia and elsewhere to enable N. Korea to generate income from weapons programs.

Lol.

DjangoCat's picture

N. Korea ramping up Bitcoin mining.  Russia doing the same.

USD fades to insignificance.  Sanctions meaningless.

taketheredpill's picture

"Nonetheless, we are encouraged the FOMC seems to now be debating such issues.  A debate that should have taken place before the 2007-08 credit bubble popped, which could have prevented much economic pain and indirectly and partially caused the political instability the U.S. is now experiencing"

 

Unfortunately if the correct decision (letting the banks fail / temporary nationalization, debt clearing recession etc.) was politically / socially unfeasible in 2008, then it's even worse now.

So if Quantitative Tightening causes risk markets to crack (deflation), expect the Fed to backtrack and hint at rate cuts and more QE.  And if that doesn't staunch the flow, look out, because the next step is when the Fed goes "all in".

Clowns on Acid's picture

"Finally, we leave you with some more money quotes from the FOMC minutes (via Bloomberg).   Looks like they are going to the pull the trigger on quantitative tightening (QT) in September,  unless markets become too volatile."

Well thats easy then isn't it.... as soon as Fed announces (or will they?) that reverse QE is on...markets get volatile and the Fed backs off. Of course the Fed coulds just be "retiring" a lot of USTs quietly....like they never existed.  Then show their Quarterly balancs sheet as - $350 Billioin USTs ...where did they go ? No one knows no one cares. Poof ! in 2 years QE is reversed. Buy buy buy buy Stawks....

hanekhw's picture

Does ANYONE know what's on the FEDs balance sheet.?What new miracles of modern accounting lie hidden there from scrutiny and public view I wonder? How elastic are the valuations and how scanty the reserves for loss? Perhaps nothing much as a tremendous amount of Goodwill. The US economy DOES resemble a giant blowfish. They should make it the FEDs emblem.

jaxville's picture

The one thing that is real is my gold.  Not like the stuff the Treasury claims to have.

  The media is so full of shit I now wonder about the veracity of sports scores.

DjangoCat's picture

Sports scores, good one.

Dg4884's picture

Precisely the reason why I prep.  Anyone caught holding this bag of shyte deserves to lose it.

Give Me Some Truth's picture

Great headline. This is "The Truman Show." I wish we could get a few names of the "show runners" and some more names of the people/organizations they have recruited to run the show.

A real audit of the fed might provide some of these answers. Which is of course why it won't happen. We can't "name names" and tell the entire world all the "tricks" they have used to produce their illusion.

Consuelo's picture

 

 

"You know our market view.  A volatile autumn, culminating in a sharp, quick sell off around or in October that should be bought."

 

Indeed...   Can't sit here and say that their prognostication is incorrect - hell, 'should be bought' has fairly well been the standard play since 2009, has it not?   No genius there.   

However...   It's another long-winded piece about how the global economic universe will continue to revolve around U.S. markets - essentially forever & ever, Amen.

Meanwhile, sanctions upon sanctions, geopolitical poking & prodding, provocative talk - and more sanctions.   What's that eventually (sooner than the author thinks) gonna buy the U.S.?

Grandad Grumps's picture

No, it is the Fed show and has been since 1913.

Give me control of a country's money supply and I care not who makes the laws.@therealsatan

ByTheCross's picture

And only the true man will get to the bottom of the rabbit hole.

The Truman Show did contain a big clue in the form of a falling light called Sirius. This is indeed a key.

 

seataka's picture

Bernie Madoff's last words to the camera as he was led off in chains:

"It's ALL a great big ponzi game"

 

sinbad2's picture

Always was, the reason Marx is so hated in the US, is that he exposed the ponzi scheme.

Rebelrebel7's picture

Thanks for the laughs! Comedic genius! 

sinbad2's picture

The problem with movies is they always end.

I don't know how long the US can keep the fantasy alive, but the US sold its gold reserves 50 years ago, and still the US pretends the gold is in Fort Knox, and most Americans believe that fantasy.

So maybe the US can fool the world that it isn't broke for another 50 years, but personally I think a year or 2 max, and then the credits will roll.

TrumanShow's picture

Hey thats my handle, get your own.