There is a cost to Fed Policy!
The Federal Reserve has pursued the unprecedented monetary policy of lowering rates to zero and increasing their portfolio from 500 billion to over 4 trillion. These are policies aiming to achieve maximum employment and low inflation. By many measures, they were successful. Growth of around 2% is at the long term US average and recent core inflation measures are coming in around 2%. But as the Fed reminds us, there is a cost to their policies. However, they do not lay out explicitly what those costs are, nor how expensive they can be. They just try to reassure the public by saying they are monitoring them.
I recently had conversations with novice market participants who were stunned by the size and rapid growth of a number of hedge funds and financial firms. Some firms that recently had capital in the low billions are now in the hundreds of billions with assets in the trillions. This made these novices nervous, and rightfully so. Though most have no idea what “there are costs to Fed policy” means, these people have identified the biggest costs to Fed policy without realizing it.
You have to take a step back and understand trading psychology to see how financial risks build. Current Fed policy has never been matched by size or duration in US history and has successfully made asset prices rise on a constant upward trajectory. Financial managers who were waiting for a market pull back to invest have instead ended up chasing the market higher. You see this in a slow grind of prices higher with limited pullbacks. This sense of being left out and missing lower prices encourages unsustainable asset inflation. However, as prices start to drop, managers do not want to lose money slowly every day. Managers instead cut risk at the same time, overwhelming the system leading to large quick losses. Markets will trade with this asymmetric skew at times, especially today. The longer markets go straight up, the more severe the sell off on the way down.
This leads to the greatest costs to Fed policy: the reversal of the unprecedented inflation caused by Fed policy.
OK, I understand this is the point where I lose half of my readers. Anyone talking about high inflation must have their heads stuck in the 1970s clouds. But I’m not talking about the Feds preferred inflation metrics that we hear and read about daily. These focus on the cost of living and giving the public a sense of contained inflation, helping to control wage inflation. No, I’m talking about inflation in financial assets not included in any of these inflation metrics. When not held in check, financial asset inflation leads to imbalances, often with disastrous results.
There has been a tremendous amount of inflation in many financial markets. Lifting low real-estate and equity prices after the 2008 financial crisis has been beneficial and necessary asset inflation. However, the most liquid securities, both in the US and globally have also been lifted to lofty levels as herd mentality and perceived liquidity benefits overwhelm decisions based on value. Assets such as bonds are at much richer levels than when we had the great depression and right before the 2008 financial crisis. This is undeniably a statement of lofty prices. And investment managers whose assets under management have soared continue to get bigger and more concentrated as the medium to small managers diminish.
Now that the Fed is in a rate increase cycle and will reduce their portfolio through runoff or outright sales, you should expect financial deflation. The Fed knows this and it makes them nervous, as well as it should. Previous cycles of reversing excessively accommodative Fed policies that inflated financial assets resulted in financial asset deflation with increased market volatility and diminished market liquidity. This created issues not just for less liquid assets, but, more importantly, for the most liquid and over-invested securities. This was seen during the hedge fund Long Term Capital Management’s liquidity issues in 1998 and the financial crisis of 2008. Financial asset deflation will not hit all asset classes, just the most overvalued.
The Fed is in a tightening cycle because the economy is and should continue to do well. However, financial firms who only had to worry about investing the billions flowing in to them like a tsunami, will now be tested on how to avoid being left high and dry with the receding tide. Some managers will go out of business and some will gate their investors. Globally, investors should expect more difficult conditions and less liquidity. And as history shows, the first investors to position accordingly are able to navigate these outward flowing tides while the rest get grounded. One leading indicator of future illiquidity and volatility is when hedge fund managers, underperforming from the onset of financial deflation, try to retain clients headed for the door with lower fees. Hedge funds are just now beginning to experience what should be a turbulent phase.
Though it is impossible to calculate the cost to Fed policy, I hope you now have a clearer understanding of the largest cost and are able to position accordingly before everyone else understands too. The veil to the Feds costs have been lifted and the blinders are off. Saying I did not know there were costs with the rest of the masses is no longer excusable.
By Michael Carino
Michael Carino is the CEO of Greenwich Endeavors, a financial service firm, and has been a fixed income fund manager and owner for more than 20 years.