We all know that ever since the financial crisis, Central Banks have been taking unprecedented and unconventional actions to intervene in the financial market, employing everything from negative interest rates to various forms of quantitative easing. In all of these cases, the objective is to provide liquidity and prop up asset prices. Today’s investing advice will explore the shortcomings of these efforts.
No country has been more aggressive in their monetary approach than Japan, where the BOJ stepped directly into both the stock and bond market, and is now the largest holder of both. It has become so extreme that Bloomberg reported not a single Japanese 10-Year Bond on Tuesday.
The Bank of Japan has vacuumed up so much of the government bond market — in excess of 40 percent — that it’s left fewer securities for others to buy and sell. Some other buyers, such as pension funds and life insurers, also tend to follow buy-and-hold strategies.
On the other hand, in the US, the Federal Reserve is beginning the process of curtailing its actions, and in the process removing liquidity.
In his article Goldilocks and the Liquidity Bears, Jesse Felder explains why he thinks this could ultimately spell bad news for the bulls. The implications of this argument are grim, so understanding his investing advice is important in case he proves right about future inflation.
While most investors and pundits are currently focused on optimistic analyst earnings estimates for the coming year, there’s another far more important phenomenon underway that deserves more attention. Three years ago, Stan Druckenmiller gave a very important speech to a very exclusive group of listeners in which he disclosed the single greatest source of his tremendous success as an investor: central bank mistakes. Well, it looks as if some at the Fed are beginning to worry, like Stan, that they have now made the same mistakes they made in prior cycles all over again.
In that same speech several years ago, Druckenmiller also disclosed what he sees as the single most important factor behind major market moves:
“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”
And the Fed is not only removing liquidity now. According to Ms. George, they are clearly considering doing so at an even faster rate in the future. This has important implications for asset prices.
It’s important to note, too, that it’s not only Ms. George expressing more hawkish views today. As indicated by her colleague, Lael Brainard, hawishness at the central bank, it seems, is now the consensus. As Edward Harrison wrote this week:
“New Fed Chair Jerome Powell used his first public remarks before Congress to say so. His view: ‘While many factors shape the economic outlook, some of the headwinds the U.S. economy faced in previous years have turned into tailwinds.’ Don’t let the understated language fool you. This one sentence encapsulates a marked shift in tone. And now policy dove Lael Brainard is on-board too. The fact that she is giving the first major speech after Powell echoing the same theme is significant. It tells you that the messaging is coordinated. And it also tells you that there is a general consensus on that messaging.”
And if the Fed is now determined to remove the punch bowl, they have a lot of tightening yet to do. After today’s jobs numbers, the probability of 4 rate hikes this year climbed to roughly 30 percent. Even that would only take the Fed Funds rate to the 2.25-2.5% range, while the Taylor Rule suggests it should already be closer to 4%.
Certainly, it’s beginning to look as if the Fed is not only behind the curve today, but that they may soon be forced to take more drastic measures to tackle rising inflation. As my friend Eric Cinnamond has been explaining for some time now, the consensus among companies is that inflationary pressures are now as great as they have been in many years, if not decades.
For now, it seems the popular market narrative, reinforced by today’s jobs report, is that the economy finds itself in a “Goldilocks” scenario: not too hot so that the Fed feels the need to cool it off, but not too cool as to put a damper on the uber-bullish analyst estimates of company earnings for the coming year.
However, if the narrative continues to shift from the Goldilocks narrative, which appears to have peaked last year, into greater agreement with all of these companies pointing to inflation, then markets could be forced to rapidly reprice their current, rosy assumptions about fundamentals and Fed policy.
For these reasons, our investing advice is to focus more on what is going on with inflation at the individual company level and, more importantly, on the Fed’s reaction to those developments rather than on Wall Street’s current Goldilocks narrative. At the end of the day, as Druckenmiller says, “earnings don’t move the overall market,” and Wall Street’s not very good at predicting either anyway, especially at major turning points.
