The China stock market has plunged into a tailspin. After rising an extraordinary +150% over the past year, the Shanghai Stock Exchange Composite Index has fallen by nearly just as notable -30% in the past three weeks. Despite the fact that China stocks are still +80% higher than they were just one short year ago, the recent sharp plunge has compelled Chinese policy makers to fire all of their stimulus and liquidity guns in a frantic attempt to stem the decline. How the recent market chaos in China ultimately plays out remains to be seen, but the response by Chinese policy makers in recent weeks raises and worthwhile question. What would U.S. Federal Reserve Chair Janet Yellen do if the S&P 500 Index was falling by -30% in similarly short order?
The knee jerk response would be that the Fed would simply launch into a QE4 stimulus program. After all, given that the Fed is quickly seeing their long sought after objective to raise interest rates by the end of the year headed down the drain along with Greece’s Euro Zone membership and China’s stock prices, they would be without the ability to first cut interest rates in an attempt to stabilize the market.
But how eager would the Fed be to enter into yet another asset purchase program amid a -30% market decline? After all, it is not as though the last two rounds of quantitative easing programs succeeded in doing much in the way of creating sustainable growth for the economy other than artificially inflating asset prices including stocks, encouraging the latest round of unhealthy speculative lending activity and exacerbating an already wide income inequality gap. And to this latter point, the fact that Janet Yellen has been outspoken in her concern and frustration about a income gap that has blown out dramatically over the past three decades that completely coincided with the “Fed put” era suggests that she may be inclined toward policy alternatives other than those that have been implemented in the recent past. Lastly, the fact that the Fed has just completed a five-bagger on its balance sheet to $4.5 trillion over the past six years, they may either lack the willingness or even the ability to expand it much further without risking greater systemic risks than they already have to the global financial system in the future.
So what then might she and her policy committee consider? Given that China has been so aggressive recently, let us explore what they have implemented to see if anything viable translates to the U.S. market place.
As mentioned above, they cannot cut interest rates since the Fed funds rate is already at 0%. After all, interest rates cannot go negative, right? Oh yeah, I forgot that we are now living in a bizarro world with negative interest rates well out the yield curve in other parts of the world including across Europe. But as we have seen outside of the U.S., even if you as a lender have to go so far as to pay a government for the right to borrow money from you (interesting arrangement indeed), it does not mean that economic prosperity and sustained market gains are the natural next steps due to any inclination to reallocate capital elsewhere.
What about easing the rules on margin financing? This has been set at 50% since before the movie Jaws hit movie theaters for the first time. And the Fed’s own internal research has concluded that this is not an effective policy tool anyway.
How about the many other options we are seeing in China that reside outside of the Fed’s direct jurisdiction? Maybe they can’t do many of these things directly, but they could certainly actively work to encourage such ideas.
The Fed could help compel prominent investment professionals to take to the airwaves to proclaim their bullishness on U.S. stocks. Sure, but how would that be any different than the daily diet we currently get in the financial media today. We already have too much of this one sided pontificating in the U.S., so encouraging even more of it certainly won’t move the needle here.
Lower stock trading fees? We’ve also got this more than covered here in the U.S. And unlike some global governments that need to get paid for borrowing money from lenders, traders cannot get paid by brokers for making trades. The HFTs would bankrupt the brokers in a nanosecond.
Compel major financial institutions to enter the U.S. stock market to buy shares? Perhaps, but isn’t this the very activity that we have spent the last six years since the financial crisis working to get banks and financial institutions out of doing?
How about suspending new IPO activity? In a market that is already falling by -30%, that would pretty much take care of itself with companies releasing the old “citing market conditions” press release to explain why they are delaying their IPO.
Instituting selling bans and trading limits? If anything, the loss of liquidity would likely only serve to increase the sense of panic and inclination to sell, not discourage it.
In short, if we witnessed a similar sudden -30% decline in U.S. markets, the tools readily available to the Fed are fairly limited at this point. Sure they could always go back to the QE4 well including instituting another round of daily U.S. Treasury purchases or, who knows, maybe even S&P 500 futures. But these are guns that are exhausted at this point, and after spending nearly a year from December 2013 to October 2014 working to slowly extracting themselves from QE3, this would likely be a last resort.
All of this brings us to two key points about monetary policy as we move forward.
First, the recent experience in China has demonstrated the fact that hard limits exist in the ability of policy makers to endlessly inflate asset markets. Investors have exclaimed the “don’t fight the Fed mantra” for years as the reason to steadily file into stocks. But the past three weeks in China has taught us once again that policy makers can only do so much to prevent a major market decline. I say once again because this is a lesson that investors should have already learned during the last two major U.S. bear markets since the start of the millennium as well as the experience in Japan dating back to the last day of the 1980s.
Second, how much should monetary policy makers work to defend the closing price on their major stock indices anyway? Is the China economy so much better off with the Shanghai Composite at 3700 today than it was with it at around 2000 last summer? After all, the rate of growth in the economy has slowed over this time period, so maybe not. And the same could be said for the U.S. Is our economy so much better off with the S&P 500 Index over 2000 than it was at 1350 three years ago? One could even go so far as to contend that it is worse today over 2000 because the advance over this time period has not been sufficiently supported by underlying earnings and has created a potentially destabilizing valuation premium as a result. This, of course, is exactly part of what we are seeing play out in China today.
Before closing, a final point on policy balance. China has been compelled to take so many aggressive policy steps to stem the recent stock market decline. But why then did these same policy makers not seek to more assertively raise interest rates, adequately tighten margin requirements, send financial professionals out more effectively to talk down stock market optimism, effectively increase trading fees and implement sufficient buying curbs among many other potential policy prescriptions when the Shanghai Composite was skyrocketing from 2000 to over 5000 in order to help head this problem off in advance? Borrowing a reference from former Fed Governor Kevin Warsh, sometimes a market would be left better off had it received a steady diet of spinach to help control its stratospheric rise instead of getting nothing more than an endless supply of candy. For once the sugar high finally wears off, the subsequent downside can be nasty.
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