In the past, the Fed announced their clear intention to use quantitative easing to stimulate the economy. They even named QE2, operation twist. This time, it has been much more stealth in nature. While the Fed has signaled its intention to pause on interest rate cuts, they have reversed course in shrinking their balance sheet and may instead drive it to new highs in 2020. This is clearly a short-term positive for risk assets and has sent the stock market to record highs.
The stock market has rallied nicely to start 2019 but we think there is a big problem. The major central banks, the Fed, ECB and BoJ, have pumped up asset prices since 2008 with a massive liquidity injection of $11 trillion. They kept interest rates at ridiculously low levels on the short and long end of the curve and investors were forced into risk assets. This grand experiment is known as quantitative easing. Now is the more difficult part called quantitative tightening, the central bankers are trying to normalize policy.
October has been a rough month for the stock market with the recent downdraft wiping out index gains for the entire year. The deterioration has been rapid despite a strong earnings season and overall S&P earnings increasing by nearly 30 percent. It is highly unusual for earnings and stock prices to diverge to this extent. Something is obviously deeply troubling investors, and we wonder if the Fed is triggering the start to the next bear market?
President Trump made a safe pick for the next Fed Chair in Jerome Powell. This isn't the typical Trumpian move as he didn't make a non-traditional pick to replace Janet Yellen. We recently wrote about the possibility of John Taylor and viewed it as unlikely because Taylor would likely want to raise rates faster than the current Fed.
President Trump is said to be considering tapping Stanford economist John Taylor as the next Fed Chairman. If Taylor gets the nod, it is possible that the Fed adopts the Taylor rule to set the Fed funds rates. The so-called Taylor rule is a formula that he proposed in 1993 for setting the federal funds rate -- the overnight bank lending rate used by the Fed to fight inflation or stimulate the economy. It challenges the Fed’s traditional reliance on the Federal Open Market Committee’s ad hoc judgment.
Last Friday on CNBC, former Fed Chairman Alan Greenspan said that it's fair to characterize the current bond bubble as an "irrational exuberance" type of forecast. He did hedge the statement by saying that he has "no time frame on the forecast." Also note that he started making this bond bubble call in 2015.
The Wall Street Journal is reporting that President Trump is considering renominating Janet Yellen as Fed Chair but also views his economic adviser Gary Cohn as a top candidate. The president has changed his tune since the election season when he criticized Yellen repeatedly. Now he says that he thinks she is doing a good job and has "a lot of respect for her." Cohn would represent a dramatic shift away from an academic led Fed to a savvy business leader in Cohn who had a 26 year career at Goldman Sachs.
I usually reserve Friday blog posts for lighter topics but with the FOMC meeting this week, I think it is important to touch on the Fed's plan to shrink its $4.5 trillion balance sheet. While the announcement was widely expected, it spelled out in greater detail plans to slowly unwind the Fed's sizable bond holdings. We believe that this step is very positive alongside interest rate hikes. The economy is doing well enough that the Fed can step back from its emergency measures, thus saving ammo for the next recession. We do not believe that this will cause a spike in long term rates but will monitor the situation closely.
Since the Great Recession, market participants have had to hang on to every word coming out of the Fed and its governors. Central bankers became the driving force behind the bull market. It is no surprise that we have written far too many blog posts on Central Banks and their influence. Thankfully since May 2016, we haven't written anything on the Fed because they were essentially on hold. Furthermore, the economy has been gaining momentum and fundamentals are now the driving force behind the stock market hitting new highs.
In the financial markets, we have always had two important components: investors and regulators. Today, we are seeing governments as significant market participants that impact global markets. Sovereign wealth funds and public pension funds around the world are now among the largest owners of publicly traded stocks and bonds. China and Japan alone represent $5 trillion in public funds out of an estimated total $30 trillion of investments owned by 160 countries. No doubt these are investors of great size that can crowd out individual and institutional investors.
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