The following is an excellent excerpt from the book “THE ONLY GAME IN TOWN: Central Banks, Instability, and Avoiding the Next Collapse” by Mohamed A. El-Erian from Part III: “From the What to the So What” from Chapter 17: “Bridging the Gap Between Markets and Fundamentals” on page 120 and I quote:
“Financial booms sprinkle the fairy dust of illusionary riches.” –BIS
“Issue 9: Yet none of these uncertainties and fluidities seemed to disturb financial markets that, operating with unusually low volatility, went from one record to another. As such, the contrasting gap between financial risk taking (high) and economic risk taking (low) has never been so wide.
You would expect higher financial market volatility in the face of the long list of economic, financial, institutional, geopolitical, political, and social uncertainties we’ve covered thus far. Yet this hasn’t happened much in 2011-15, judging by the most common measures of volatility (at least as yet). Instead, volatility has been unusually low, with the very occasional spikes that have occurred proving temporary and reversible.
This post-crisis volatility regime has been reminiscent of the descriptors that the Hildon company in the United Kingdom offers its mineral water drinkers–“delightfully still” or “gently sparkling.” It is an operating environment that has sucked in many market participants, reminding us of John Maynard Keynes’s observations about how herd behaviors can take over markets. After all, “wordly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” And the longer the herd behavior continues and builds on itself, the greater the validity of a hypothesis put forward by Hyman Minsky–that is, the risk that the resulting “stability” proves temporary as, behind the scenes, it is breeding instability.
The explanation for this unusual “vol” behavior lies in a combination of factors–from growth having been stuck in a low-level equilibrium to investors seeking “carry” income and other investment gains as a means of meeting ambitious return targets that are resistant to any meaningful downward revisions regardless of how much asset prices have already risen. The result is to live in the moment, downplaying its artificial nature and the subsequent risk of major dislocations.
This special moment has been underpinned by two huge injectors of cash into the marketplace: central banks and the deployment of unusually large cash balances held by large companies.
The determined efforts of central banks and their unquestionable influence on financial assets have translated to markets operating under the mantra that “bad economic news is good for markets.” Rather than lead to a downward revision in investor’s assessment of fundamentals and, therefore, what constitutes fair financial value, disappointing economic news has been interpreted as implying that central banks will be even more engaged in repressing volatility, pushing asset prices to higher artificial levels and, by making people “feel richer,” getting them to spend more (also inducing companies to invest in expanding production capacity). To the extent that there are hiccups along the way, and there inevitably will be, markets have been conditioned to expect central banks to deal successfully with them.
Corporate cash has played a similar, albeit small, role.
Having been shocked and shaken by the ferocity of the global financial crisis, including a virtual shutdown in their access to credit and working capital, companies subsequently accumulated significant cash holdings for prudential reasons. Initially they were hesitant to deploy this cash. Yet the longer it sat on their balance sheets, and especially given that it earned very little interest income, the greater the pressure on corporate management and boards to release it to shareholders via share buybacks and higher dividends; part of it also ended up in defensive merger and acquisition (M&A) deals. All of which has served to push up financial asset prices.
As we noted earlier, the impact of such factors has been so pervasive as to also override historical correlations between asset classes. Rather than follow long-established historical patterns warranted by the fundamental attributes of securities within individual asset classes–be they bonds, commodities, equities, or foreign exchange–these inherently different instruments have tended to move together in strikingly anomalous fashion. Indeed, you need only look at what happened in 2014 for a recent illustration.
For the year as a whole, investors in U.S. equities earned a handsome return of 14 percent (as measured by the Standard & Poor’s index) at a time when they also made quite a bit of money on their holdings of ultrasafe government bonds (whose prices went up as the yield on ten-year Treasuries fell by some eighty points and on thirty-year long bonds by about one hundred basis points). From an historical and analytical perspective, this is quite an unusual correlation: Riskless government bonds are not supposed to go up in price at the same time as risky equities; and both rose substantially.
To amplify this phenomenon of unusual covariances, the rise in stocks was accompanied by a fall rather than rise in commodities, and quite a sharp fall at that. Commodity prices fell by 18 percent during the year (as measured by the Thomson Reuters Core Commodity CRB Index), with the internals going well beyond energy, which (as will be detailed later) was impacted by a change in the supply paradigm. Again, that is not supposed to happen. Conventional wisdom is that many commodities tend to do well when equities surge.
Remember, these are highly liquid markets that are heavily trafficked by sophisticated investors. Yet one (equities) was suggesting good economic news while the other two (bonds and commodities) appeared to flash a yellow (if not red) light about what lay ahead for the economy and for financial risk takers.
Such breakdowns in correlations naturally undermined the more refined market differentiations that sophisticated investors pursue, thereby further distorting market signals and accentuating the threat of meaningful and ultimately unsustainable and damaging resource misallocations. Once again, generalized risk taking has run ahead of what would be warranted by fundamentals, thereby resurrecting the catch-22 situation that government and central banks had hoped to decisively put behind them after the global financial crisis: tolerate excessive risk taking, which invites the potential return of widespread financial disorder down the road, which in turn will contaminate the real economy, or stand ready to deploy expensive bailouts to again rescue offenders in the financial sector.
I suspect that none of this would come as surprising news to central banks. It is, after all, one of the unintended consequences of them being the only policy game in town that they have to use blunt instruments that are poorly suited to the tasks at hand. I also suspect that some central bankers would argue that it’s a bet worth taking–and would do so in the hope that artificially high prices would end up promoting economic activity and allow economies to pivot from artificially high prices would end up promoting economic activity and allow economies to pivot from artificially induced growth to genuine expansion. Under their hoped-for scenario, economic risk taking would catch up and validate financial risk taking, and central banks could collectively embark on that elusive “normalization” of monetary policy.
In such (admittedly ideal) circumstances, the initial volatility associated with the policy regime change would quickly give way to underlying stability in the context of a firmer foundation for risk assets. There would be no need for a really messy correction in financial asset prices down the road.
The scarier alternative speaks to higher volatility as a result of increasing policy ineffectiveness. With genuine growth not returning financial risk taking would not be validated by fundamentals. Even if they were still willing to do so, central banks would be less able to counter the cumulative headwinds arising from economic, financial, geopolitical, institutional, political, and social factors discussed earlier. In such a world, they would face the risk of being criticized (and worse) for having irresponsibly manipulated asset prices and contributed to major resource misallocations over a number of years.
Answering questions in May 2014 after a speech to the Joint Economic Committee, Fed Chair Yellen acknowledged that she and her FOMC colleagues “probably do have an impact on the stock market.” But she reacted sharply to the notion that they were “goosing” the stock market, stating that “I would hardly endorse the term goosing the stock market.” Other central bankers have been more open about what monetary policy seeks to intentionally do to asset prices.
In the beginning of 2015, Charles Plosser noted that “one of the things I’ve tried to argue to look, if we believe that monetary policy is doing what we say it’s doing and depressing real interest rates and goosing the economy and we’re in some sense distorting what might be the normal market outcomes at some point, we’re going to have to stop doing it.” Linking this to the risk of financial instability down the road, he went on to argue that “at some point the pressure is going to be too great. The market forces are going to overwhelm us. We’re not going to be able to hold the line anymore. And then you get that rapid snapback in premiums as the market realizes that central banks can’t do this forever. And that’s going to cause volatility and disruption.”
Whether you label it “goosing ” or “stimulating” markets with the hope of enhancing economic growth, this is what central banks have been doing for a number of years. It reflects the few instruments they have at their disposal and the fact that they have essentially been acting on their own. And it is a path that is difficult to alter without the risk of ending up being the cause of disruptions and dislocations, if not worse.
In speeches in the run-up to the December 2014 FOMC policy meeting, Fed officials had prepared the markets for an adjustment in the language governing the central bank’s forward policy guidance–specifically the clean removal of the phrase “considerable period” (which applied to the timing of the next interest rate hike). Indeed, many seasoned market participants believed that, with such preparation, there was only a small probability of a “language tantrum” similar in consequences to the “taper tantrum” some fifteen months earlier.
Yet for reasons best known to the FOMC–and, judging from the relatively large (three) number of dissenters, this was not a straight-forward decision–officials opted for yet another language formulation that introduced the notion of a “patient” Fed, linking it to the notion of “considerable period” of ultralow interest rates for a specific number of policy meetings. This maneuver was reminiscent of how the Fed reacted back in September 2013, when, after preparing the markets for a taper of its QE3, it refrained from doing so.
Both episodes were perplexing for a central bank that has gone out of its way not to unnecessarily surprise markets. And it was particularly so at a time when the Fed was in the business of seeking to repress all risk factors. Yet something–whether internal or external–made central bankers hesitate to err too far from the prior path. It highlighted a repeated dilemma for central bankers around the world as they venture deeper in experimental policy terrain, where both the status quo and changed circumstances render policymakers uncomfortable.
Needless to say, the reactions of the markets–seeing central bankers again confirm that, whenever there is some doubt, they will opt for being more dovish–during both episodes were similar: They took off in a big way.”
(THE FOLLOWING IS PRAISE FROM WALTER ISAACSON AND AN EXCERPT FROM THE INSIDE FRONT BOOK JACKET AND I QUOTE:
“Today’s global economy is beset by low growth and rising inequality. By looking at the tools now being used by the world’s major central banks, Mohamed El-Erian shows how we can instead promote inclusive economic growth. This is a must-read from one of the most astute financial analysts of our time.” –WALTER ISAACSON, author of Steve Jobs
JACKET COVER: “In The Only Game in Town, El-Erian casts his gaze toward the future of the global economy and markets, outlining the choices we face both individually and collectively in an era of economic uncertainty and financial insecurity. Beginning with their response to the 2008 global crisis, El-Erian explains how and why our central banks became the critical policy actors–and, most important, why they cannot continue in this role alone. They saved the financial system from collapse in 2008 and a multiyear economic depression, but lack the tools to enable a return to high inclusive growth and durable financial stability. The time has come for a policy handoff, from a prolonged period of monetary policy experimentation to a strategy that better targets what ails economies and distorts the financial sector–before we stumble into another crisis.”
MY COMMENTS: I HOPE HILLARY CLINTON GIVES BERNIE SANDERS A CABINET POSITION BECAUSE HE IS A VERY SMART MAN, PARTICULARLY ABOUT THE FIVE BIG INVESTMENT BANKS, WHO RECEIVED HUGE SALARIES AND GAVE US BAD INFORMATION CONCERNING THE TOXIC, UNREGULATED DERIVATIVES, WHICH THE SEC SHOULD HAVE LOOKED INTO YEARS AGO BEFORE THE 2008 FINANCIAL CRASH WHICH HAPPENED DURING THE BUSH-CHENEY ADMINISTRATION AND LED TO THE $700 BILLION TARP BANK BAILOUT BY THE TAXPAYERS.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran