On Monday evening we brought you “Bank Of America Begins 66-Day Countdown Until The 'Ghost Of 1937'" Returns, [15]” in which we discussed why, if history is any guide, a rate hike cycle will be a disaster for equities. As a refresher, here’s the narrative:
Put simply, central bank's provision of liquidity for financial markets has been unprecedented. The extent of Wall Street addiction to liquidity is about to be revealed and the potential for unintended consequences is clearly high.
Which is not to say that attempts to "renormalize" rates are unheard of: previously both Israel and the RBNZ tried it and failed, with markets promptly forcing them to reverse tightening.
More notably, it was the ECB itself which in April of 2011 tried to halt Chinese inflation exports in their tracks, and pulled off one rate hike... before the wheels came off and Europe promptly entered a double dip recession.
But no episode is more notable than what happened in the US in 1937, smack in the middle of the Great Depression. This is the only time in US history which is analogous to what the Fed will attempt to do later this year, and not only because short rates collapsed to zero between 1929-36 but because the Fed’s balance sheet jumped from 5% to 20% of GDP to offset the Great Depression. Just like now. And then, briefly, the economy started to improve superficially, just like now, and as a result the Fed tightened in a series of three steps between Aug’36 & May’37, doubling reserve requirements from $3bn to $6bn, causing 3-month rates to jump from 0.1% in Dec’36 to 0.7% in April’37. As Bank of America notes, this didn’t end well: "The Fed exit strategy completely failed as the money supply immediately contracted; Fed tightening in H1’37 was followed in H2’37 by a severe recession and a 49% collapse in the Dow Jones."
So, now that Janet Yellen has the green light for liftoff courtesy of the BEA, Steve Liesman, and her friends at the San Francisco Fed, who have conspired to pass off [17] an epic perversion of statistical analysis as a legitimate attempt to do away with what they would like the public to believe is a statistical aberration called “residual seasonality”, we can now look nervously towards mid-2016 when, after rates have been hiked by a total of 50bps or so, the elusive correction will finally come, only instead of a “healthy” 10% move to the downside, it may well be a gut wrenching, QE4-inducing firesale.
But if the Fed does use a post-hike recessionary tailspin as an excuse to implement yet another round of bond buying (which should please the Boston Fed who, you'll recall, thinks QE should be [19] moved from the "unconventional" policy toolbox into the bin labeled "use as necessary to micromanage business cycle"), expect the diminishing returns which everyone has now become accustomed to associating with QE to be readily apparent. Here's BofAML on why "another round of QE [is] the biggest risk to global equities":
While most are focused on the risks around a withdrawal of liquidity, we believe the biggest hit to confidence could be the opposite: if another round of US QE is necessary to prop up the economy. While the market could have a knee-jerk rally on an indication of forthcoming stimulus, we think this would likely be short-lived and could end in the red. QE fatigue is already evident: each subsequent round of QE has seen diminishing risk rallies. Another round of QE would imply that $4.5tn was not enough. And it would also likely have a very negative read-through for QE programs currently underway in Europe and Japan.
In other words, the Fed is cornered.
Normalizing policy rates could well risk destabilizing financial markets and the economy, both of which are addicted to central bank liquidity and haven't seen a rate hike in nearly a decade. But because the Fed needs to at least be able to say it tried to pull off an exit, the FOMC will gingerly tighten until it sees evidence that the wheels are coming off.
At that point, the addict will fall off the wagon as the Fed delivers a fresh dose of monetary heroin. The addict, having developed a tolerance, will not respond as planned, necessitating still more QE as the Fed chases the dragon while the BoJ and ECB watch in horror as the future of PSPP and Abenomics suddenly becomes crystal clear.
As for what happens next, we'll reiterate our warning from Monday: "If the S&P is cut in half the Fed will launch not just QE4, but 5, 6 and so on, resulting in every other central bank doing the same as global currency war goes nuclear, and the race to the final currency collapse enters its final lap."


