Quantitative Deflation

As the euphoria generated by the election of Donald Trump subsides, ebbing away like a strange and fantastic dream, the financial markets are coming to realize that the promises of tax cuts, spending hikes and deregulation are empty.  One very tall central banker we know, for example, is no longer worried about his eponymous rule prohibiting bank principal trading being repealed.  Thus we all mentally reset the quantum monetary clock back to the week prior to the November ’16 election and ask: what next?

The embrace of the election of Donald John Trump as POTUS was part of a larger collective delusion, a desperate hope that we could put aside low economic growth and trillions of dollars in unpayable debt, and time warp back three decades to the heady days of Ronald Reagan.  But now, after eight years of aggressive market manipulation by the Federal Open Market Committee, the proverbial bill has come due.  

The unwind that now faces the US financial markets represents not merely giving back the gains seen since last November, but a more general reset of risk pricing that could see bond yields soar and equity market valuations revert back to the dark days of 2010.  After years of aggressive open market operations (aka “quantitative easing”) by the FOMC, the economists at the central bank actually believe that we can go back to business as usual without a proportionate period of readjustment that approximates the duration of extraordinary policy action.  

Think of the past eight years as a steroid induced coma care of the FOMC, when ultra low interests rates and trillions of dollars in QE bond purchases were employed to make Americans think that everything is alright without requiring any adjustment.  During this period of national stasis, asset prices for real estate, commodities and of course financial assets soared as though it were 1980 all over again.  But with population growth below 0.5% annually and productivity flat to down, most economically literate observers understand that 2% GDP growth is about as good as it gets.

The externality in the equation was and is Mr. Trump, the human embodiment of BREXIT who fell into the political vacuum of the 2016 presidential race and walked away with the prize.  Nobody was more surprised than he by this remarkable turn of events, but the subsequent rush of euphoria inspired by his Reaganesque talk of making America “great again” took the valuations for US stocks up well above any level deserved by the underlying rate of corporate earnings and economic growth.  Ponder the widening credit wreckage in the auto loan sector as a general commentary on credit quality across the US, from bank C&I loans to commercial real estate in Manhattan.  

The Sell Side chorus and financial media all managed to rationalize the spectacular jump in stock valuations for nearly six months, but now it seems that we all have come back down to earth.  Think of the Trump Bump as a collective, reflexive reprise of the residential mortgage bubble of the 2000s, albeit one that is shorter in duration and more intense in terms of magnitude.  Now comes the reckoning, as investors confront the fact that over the past eight years prices for many assets have run 10 or even 20 times the underlying rate of economic income growth.  

Financials bellwether JPMorgan (NYSE:JPM) was below $70 before the election of Donald Trump this past November but closed at $87 last night, down from a near-term peak in the 90s.  As stocks reprice downward to approximate some sort of rational relationship to the underlying fundamentals, look for interest rates to also fall.  Benchmarks like the 10-year Treasury bond likely will plummet under the irresistible weight of the flight to quality.  Smart money was headed out of stocks as the New Year began, but now the outbound crush of once upon a time bulls is going to literally squeeze the life and then some out of the great Trump stock market rally.  

Look for the key spread relationship of 2s vs.10s in the Treasury market to head toward 1% and below as the T-bond surges down to 2% and lower, this under the weight of investors fleeing stocks to supposed “risk-free” assets.  The end of the post-election stock market rally may indeed spell big political trouble for Mr. Trump, but may also breathe some life back into a US residential housing finance sector that has been swooning since October ’16.  

There may indeed be reasons to be concerned about growing evidence of inflation in the US, but the near-term rebound from the Trump Bump may instead see lower interest rates and stock prices as the Yellen deflation takes hold.  Signs of rationality may even begin to appear in Washington as the wreckage of the Trump legislative program expands.  In the event, look for Steve Bannon to return to private life and the political prospects of Gary Cohn and the gang from Goldman Sachs to ascend, at least for now.  As the inexorable logic of base-ten arithmetic asserts itself once again, the rats will clamber onto the pieces of floating wreckage with the best view.

Cannot wait for Q1 earnings from financials...