Apparently this is not a very well understood concept among the financial elite. Or perhaps they understand it all too well and are milking every incentive and easing measure for all of the salary, stock options and bonuses they can provide.
Not much has truly changed
Other than transferring an enormous amount of risk from the financial system in to the hands of central banks and governments, the underlying fragility of the financial system remains. Further, because the lenders of last resort are now burdened and their arsenal of financial ammunition near empty, there are not many options for the next economic hiccup.
With both US equities and bonds expensive by most measures, the logical alternative for most value conscious investors is to search for value in other asset classes: emerging markets, commodities, foreign exchange and real estate in distressed markets. But these options don’t come without risks of their own as their fates are tied to that of the US dollar (read more below).
With a great rally comes a greater upset
The last 7.5 years have been very generous to equity and bond investors. Perhaps too generous if current valuations are of any indication. What many are not prepared for based on current sentiment readings is a sustained downturn. Yet at the same time expectations of interest rate hikes by the Federal Reserve continue to rise (as they have in fits and bursts since jaw boning about such tightening began in 2013).
When rates rise, lending conditions tighten. And as that happens margin levels shrink, leverage is reduced as the cost of holding positions rises. This means that most of the time a series of rate hikes, as is being priced in to Fed Funds Futures, is the beginning of the end for modern bull markets in equities.
Yet stocks don’t seem to have received the memo. And they usually are last. 10 year Treasury Bonds, however, have seen yields rise from a paltry 1.3% to nearly 1.75% over the last few months. This may be more than just smoke signals as there are many foreign sovereign investors lightening up on Treasury Bond positions over the course of 2016, including China.
King Dollar’s mighty move
The US dollar has been rallying as of late on interest rate expectations as well. This has knocked down many commodities, outside of the energy sector, and caused renewed pressure on foreign currencies. Dollar strength should be watched carefully. If the dollar continues to rally (the dollar index is now testing 97) then we may see a renewal of equity selling as rate hike fears begin to permeate the US stock market.
Fears of the Fed are foolish
They say don’t fight the Fed. But what if the Fed is all talk? Over the last three years, there’s been a lot of talk of higher rates, even normalization. But what we have after all that talk is one lonely rate hike that is almost a year old now. The market seems to key in on every word every Fed official says, almost as if their words were seen as valuable insights.
But if each speaker’s rate forecast, economic forecasting track record and previous speeches are carefully examined the inconsistencies and inaccuracies accumulate. My opinion is that many of these officials, while they probably mean well, don’t have the requisite tools to forecast something as complex and intricate as the US economy. Why? Because no one does. Such tools do not exist.
But one thing is certain…
With a track record as dismal as Fed officials seem to have, their forecasts and banter about tightening should be taken with nothing more than a grain of salt. They don’t have a magic ball and they can’t see in to the future much more than any other market participant, economist or statistician.
These are the same minds that brought us such failed monetary experiments as quantitative easing, which had the effect of redistributing middle class wealth to the already very wealthy, and bank bailouts which enabled more systemically reckless gambling.
As if flooding the system with credit would resolve the underlying structural solvency problems that our financial system and our government suffer from (hint: it made these issues worse by failing to address them in any meaningful way).
In conclusion, and I’m talking to you Mr. Market, let’s try not to take the hot air too seriously. After all, the people making it don’t seem to recognize the difference between liquidity and solvency.