IceCap: Every Fed Chair Has A Plan, Until...

Authored by Keith Dicker, President, CIO IceCap Asset Management,

It's Easy

In the world of knitting, stitching and crocheting; threading the needle is easy. Line-up your thread, needle and a good cup of tea and you’re all set.

In most other worlds – it can be tricky.

If executed perfectly – threading the needle can be rewarding, exhilarating and thrilling all at the same time.

If executed imperfectly – it can end in disaster.

In American football, 49ers quarterback Nick Mullens expertly threaded the football between 4 different Raiders players, landing it perfectly in the hands of his teammate George Kittle, who then galloped 60 yards for a touch down.

That was thrilling.

Sporting a human-wingsuit, Jeff Corlis dove off a 12,000 foot mountain and expertly threaded the needle known as “The Crack” in the Swiss Alps.

That was exhilarating.

Unknown to many, threading the needle is also being attempted in the high stakes game of global finance.

Leaders at the world’s central banks are all trying to steer their domestic economies through a small opening while avoiding the pitfalls created by a lifetime of excessive borrowing and ill-fated policy responses.

In the minds of these financial maestros, they have the tools, the doctorate degrees and the blessings of governments to thread the financial needle.

In an effort to resolve any financial crisis, the world’s central banks have always tried to thread the needle by changing interest rates and/or changing the amount of money in the system.

The central banks and their supporters all claim that only through their actions, was a serious crisis resolved allowing everyone to live happily thereafter.

What the central banks and their supporters do not tell you, is that the actions to save one crisis, have always sowed the seeds for the next crisis.

In the minds of investors with common sense and objectivity – we expect the exact same outcomes that have occurred every other time central banks tried to thread the needle.

After all, expecting anything else would be the classic definition of insanity.

The needle is a sharp tool. Yet, if the user is not careful – a simple prick can cause an awful lot of damage.

Send In The Clowns

Unfortunately for most investors, the majority of the investment industry either refuse, are unable or simply not allowed to share with investors how all financial events are linked together. And what is even more alarming, the industry is once again shepherding investors into the very markets that are about to experience the after-effects of central banks once again trying to thread the needle.

The Needle

The foundation necessary to truly understand the movements of global capital markets is knowing the USD is the world’s reserve currency. And by default, financial actions by the US Federal Reserve affect the entire world.

This of course is quite different from every other central bank in the world. The actions of central banks in every other country primarily affect their local, domestic economy only.

Actions by the Bank of England are never talked about by the Japanese.

Whenever the Reserve Bank of Australia makes a significant change, it won’t even cause a yawn in Brazil.

The Bank of Canada is an unknown entity to the Americans.

Meanwhile, it is true that the European Central Bank (ECB) is more widely known around the world. Yet, it is also true this fame has been achieved due to clownish-type behavior from the supposedly sharpest financial minds in Europe – not due to their actions causing ripples in international economies.

The US Federal Reserve however is a different story. And despite anyone's subjective feelings towards America’s current debt, fiscal, political, or social states; understanding and respecting the power of the Federal Reserve and the USD is paramount to your financial success and security.

To better appreciate how and why the US Federal Reserve is the Financial Needle of the world, one needs to simply observe the actions and reactions in the recent past.

Let’s first start in 1996 Asia, and what was sold as the Asian Miracle.

The economic hitman

In the mid-90s, investors everywhere were screaming for opportunities to invest in the roaring tigers.

I started my career during this time, and I was instantly attracted to the Asian Growth Mutual Fund which just finished the year up +86%.

Asking my mentor at the time whether clients should still invest in this fund, the fella responded “even if the fund does ¼ of what it did last year, clients will still make 20%+.”

Three years later, this happened:

This was my first real lick of a financial crisis and it didn’t taste good.

It turns out, the Asian Miracle was no miracle at all. Instead it was simply the powerful concoction of exponential domestic borrowing, combined with a flood of foreign investment.

This combination can only cause markets to go in one direction – and that’s up.

Of course, when capital starts to leave, the opposite is also true. And this is where the US Federal Reserve came into play.

In early 1997, the US Federal Reserve increased overnight interest rates by 0.25%. Now on the surface, this tiny increase may not seem like the tiger killer – but it was.

In fact, it was just enough to frighten stock markets. And just enough to get the first wave of foreign investors to begin withdrawing their capital from the by now – very debt heavy Asian region. And just enough for them to reallocate their capital to America.

It was this first outflow of foreign capital that really loosened up the olives in the jar. And as you know, once that first olive moves, the rest tumble out very quickly.

At the time, the US Federal Reserve was trying to somewhat reduce the extreme level of exuberance in US stock markets.

What it actually managed to reduce was the entire Asian currency and bond markets.


Of course, not only did the Fed manage to deflate an entire continent; the turmoil from Asia spread to Russia, and then ignited the collapse of not only the Russian Ruble, but also the New York based hedge fund, Long Term Capital Management (LTCM).

Unknown to most of the world, LTCM was levered to the hilt and completely riding the coat tail of continued prosperity in Russia.

To refresh - the collapse of Asia caused the collapse of Russia which caused the collapse of LTCM. Which nearly caused the collapse of the Wall Street titans including Morgan Stanley, JP Morgan and Goldman Sachs.

This was all ignited by the Federal Reserve believing a 0.25% rate hike would only affect the local US economy and financial markets.

To clean up this financial mess the Federal Reserve sprang into action and did their thing - it would once again try to thread the financial needle to save the day and right the ship.

In 1998, the Fed began to reverse its previous rate increase and proceeded to cut rates from 5.50% all the way down to 4.50%.

It turns out, the Federal Reserve didn’t thread the financial needle at all. And in fact, the only thing it did was to provide the foundation to once again encourage excessive borrowing and investment.

But this time, instead of foreign capital moving out of America, it stayed right in America and found a home in the technology sector.

At this point, we don’t know what is more frightening – the fact that we (and many others) can vividly recall the days of the infamous Tech Bubble splattering against the wall, or the fact that nearly 50% of today’s investment industry is too young to remember or too young to have experienced this financial moment in time.

Monetary cocktail

For those who want to reminisce, the days of, JDS Uniphase and Nortel were certainly a scene.

But what is lost upon those who lived (and then lost) the dream – was the fact that to save the world from the collapse of the Tech Bubble, the Federal Reserve once again tried to thread the financial needle.

This time, Alan Greenspan and his soothsayers at the Federal Reserve knew things were not only wrong – but very wrong.

And when things are very wrong, the Federal Reserve did something they had never done before – they reduced interest rates all the way from 6.50% down to 1.00%.

And to put the financial cherry on top – it stayed that way for nearly 5 years.

Put another way, the global financial system received such a jolt from the breaking of the Tech Bubble – the Federal Reserve had to provide more stimulus than what was ever provided in financial history.

Of course, this record would be shattered again in less than 4 years.

Notice how each financial crisis, required increasingly more financial stimulus to bailout the losses and help the world get back on track.

Also notice the pattern – every single time a crisis occurred, it was put in motion by central banks and their reaction to the previous crisis.

Understanding this – it should be incredibly clear to everyone that the seeds for the next crisis have already been planted, the crisis has already started to grow, and nothing is standing in its way.

To complete our stroll down financial memory lane; understand that the 2008-09 Great Financial Crisis was completely enabled by the US Federal Reserve.

The Fed’s reaction to the Tech bubble by keeping interest rates at 1.00% for 5 years was the breeding ground for all of those low-cost mortgages, and ultra-excessive product creations by the Wall Street machine.

And the losses, shocks and paralysis from the 2008-09 crisis was so severe, the Federal Reserve and other major central banks responded in a way never before seen in our lifetime.

First they bailed out entire banking sectors.

Next, they lowered interest rates to 0%.

Then they proceeded to print over $14 Trillion dollars.

Finally some central banks (Japan, Eurozone, Switzerland, Denmark, and Sweden) cut interest rates below 0% - or put another way, they created NEGATIVE interest rates.

Collectively, this monetary cocktail has been brewing for 10 years.

History rhymes

For many, 10 years can be a blink of the eye.

For others, 10 years can seem like a long time.

For the US Federal Reserve, 10 years of 0% interest rates combined with money printing is a lifetime.

Put another way, the Federal Reserve knew they painted themselves into a corner and they had to get out.

The first step with getting out of the corner involved putting an end to money printing. The second step focused on attempting to raise interest rates up towards normal levels. And the third step was beginning to unwind (or bringing back in) all the money it printed.

Chart below shows all 3 steps.

Notice how it took a full 3 years for the Federal Reserve to transition from ending the money printing program (QE) to actually beginning to unwind the money printing program (QE).

Also notice, it took the Federal Reserve 1 full year between raising rates in December 2015 to again in December 2016.

Everyone has a plan, until...

The reason it took so long to begin going down this slippery slope was due to the reaction of markets outside of the US.

Time and time again, whether it was Chinese markets, or emerging markets as a whole - the mere mention of the Federal Reserve ending QE, raising interest rates and unwinding its balance sheet caused tremors across these markets.

Note the similarities with the Asian Crisis in 1996.

For investors, these actions by the Federal Reserve signalled a removal of stimulus – and equity investors and the talking heads gobbled excessively about the risk of stock markets crashing.

Yet, while most were preoccupied with the stock market story, something else of even more importance was happening. The Fed Reserve’s actions of reducing its balance sheet and raising interest rates was slowly but surely causing foreign capital to move back into US Dollars.

And a world with less USD in circulation is a world that creates market stress, fragile currencies and deteriorating government fiscal positions.

While we have no sympathy for the Federal Reserve - we do have empathy for the Federal Reserve.

To be clear - they were damned if they stopped printing money and raised interest rates, and they were damned if they didn’t stop printing money and raised interest rates.

But that’s why they get paid the big bucks (from book deals after they leave the Fed).

Okay, enough of the history lesson

Let’s now turn to what will happen in the future - and when it does happen, it will be historic.

Read on...