Investors expected that the Fed would not only end its bond buying program, but many believed it would also raise interest rates. While the Fed did agree to taper its bond buying, essentially decreasing its $150 billion monthly bond buying program by $15 billion per month, ending the program in 2022. However, the Fed kept interest rates the same and clearly signaled that it would not raise interest rates anytime soon, and almost definitely not until the taper of its bond buying was completed – in other words, not for at least one more year.
Investors who had been betting on the Fed raising interest rates wagered on the yield curve flattening for Treasuries. Therefore, they invested in short-term Treasuries believing those would outperform longer-term Treasuries, as well as 10-year and 30-year bonds. Instead, we are seeing the opposite happen. Short-term bonds are dropping in price and yields are approaching their highest levels since March 2020. Meanwhile, prices for long-term bonds have climbed. This same phenomenon is happening for government bonds that only in the United States, but also in the UK, Canada, and elsewhere.
There are warning signs that the stock market is transitioning from some form of reality to misguided euphoria. The S&P 500 is up almost 10% in the last 30 days. However, this broad optimism doesn’t seem to be matched by many forms of fundamental reality.
Earnings are barely moving, and profit margins are under pressure from higher wages and rising product costs. However transitory one imagines supply chain constraints and lack of available workers, the situation has certainly extended much further than most predicted.
Central bank independence and fiscal responsibility matter, even though the Western world is acting as if these rules no longer apply. Well, perhaps. But the world has given us three examples where the consequences are extreme when these basic foundations of economic policy are ignored or violated. Ultimately, if markets lose confidence in a central bank’s independence and thoughtfulness (yes, thinking really matters), or a sovereign government’s fiscal responsibility (where thoughtfulness is never taken for granted), inflation expectations will undermine an economy and make recovery almost hopeless.
Technology is facing policy changes with global resonance, such as China’s new crackdown, the rising resistance to social media, and government’s desire to manage and control technological development. “I’ll build a wall and we will be fine...
Separating signal versus noise is challenging these days because today’s signal is more muddled than ever. One of the more unusual circumstances, which I covered in more detail in the article “Important and Unknowable” is that the immediate past is telling us extraordinarily little about the near future. That is unusual because we can typically estimate the near-term by connecting the dots with reasonable depth and data from the recent past.
One of the reasons why people have inflation fears, currency tremors, market jitters, and emotional vacillation between joy and terror is that all these outcomes seem equally likely that any sense to realistically gauge the directions of these key metrics. We can usually rely upon near-term data to predict the near-term future, and that usually gives us a reasonable sense of comfort about the markets, and how to plan, prepare, predict, and withstand anticipated market moves. But that does not seem to be the case now.
Economic predictions have always been highly variable and uncertain, and, for some reason, relied upon as if the future were a magical algorithm. Essentially, economists would make one fundamental mistake. They thought they were practicing a science. Data could be collected, inputted, and a predictive algorithm could be generated. Even Nobel Prize winners like Paul Samuelson believed that with enough data we could come to understand the economy and how it functioned.
This is nonsense. As Daniel Kahneman and Amos Tversky have shown us, human behavior and irrationality, combined with unpredictability and randomness (thank you Naseem Taleb) make this even a questionable social science. Using existing analysis and algorithms to reliably forecast is a fool’s errand, essential for someone’s tenure, and maybe even a Nobel Prize, but doesn’t add much that is useful. Some of the more laughable Nobel Prizes have been given to people who determined that markets were efficient. They are not. Economies can be predicted with useful data input. They cannot. A couple of inputs about inflation and the unemployment rate, and we know how to manage an economy. We can’t. That last one is the Philip’s Curve – true for a limited time and then it goes spectacularly wrong – a lot like most risk and market prediction models.
One thing we can add is that most predictions seem too good to be true, and almost always are. The economy is not a perpetual motion machine, nor is it a credit card with no limit and no requirement to pay the balance. The current notion that “deficits don’t matter” seems patently silly and naïve to think that we can simply print money without any economic discipline to generate sustainable profitable businesses with the efficient use of capital.
“Money goes where it’s needed, but it stays where it is treated well.”
Walter Wriston (former CEO of Citicorp)
That means it has to generate a return and not be co-opted by governments and public policy, nor be flooded by capital with no economic discipline.
Deficits may be a reasonable way to jumpstart a sluggish economy, but they are not sustainable. Current thinking is that fiscal discipline, debt repayment, and the idea of a balanced budget are anachronistic and useless. It is dangerous to stress test this idea because the downside is potentially cataclysmic. Capital likes a free market, but we hardly have a free market with money today. Constant stimulus does not create economic discipline.
The world economy is struggling to escape the Covid-19 economic shock. During the worst of this pandemic, the world’s developed economies provided an enormous fiscal stimulus on a scale not seen since the second world war.
Now, however, the US is proposing to more than double its already generous fiscal stimulus. Is this a good idea or excessively risky?
Go Big, But Where?
For its proponents, the idea of “going big” is designed to be a transformative political moment. But too much appears allocated inefficiently, and it may simply be irresponsible.
An easy money era produced only anemic growth. But the scale and direction of additional stimulus look more like irresponsible fiscal policy leading to significant overheating and the waste of resources. While there is a strong case for a more aggressive approach to fiscal policy, that policy still needs to be grounded in economic realities and reasonable priorities. These are not.
The pandemic, Fed interest rate policy and bond purchases, restrictive banking regulations, and banks’ swelling cash balances will have a lingering impact on liquidity and produce some mind-bending policies to deal with this uncharted territory. As the pandemic emerged in March 2020, strange things happened: Bond markets seized up and investors panicked. Bond yields spiked causing severe price declines. Credit default swap prices (debt protection derivatives) rose 100x in less than a month. The dollar rose and liquidity dropped for U.S. Treasuries, usually the world’s most liquid security. There was substantially lower demand at U.S. Treasury auctions. The Federal Reserve responded with an almost never-ending pile of cash, buying vast quantities of bonds with newly created cash. It has continued its purchases, at a pace of at least $120 billion a month. But this has not resulted in “happy days are here again.” This mountain of dollars is limiting liquidity and constraining markets. That’s right, read that again if you must – too much cash can constrain the economy.
The current low interest rate environment increases the discounted present value of future cash flows and reduces the return demanded for every investment. In other words, when the Fed funds rate is zero, 6% bonds become disproportionately attractive. Buyers have now bid bond prices up until yields are now significantly less. What does it mean if the prices of stocks and listed credit instruments are at levels not driven primarily by fundamentals reasons (i.e. current earnings and the outlook for future growth), but in large part because of the Fed’s buying, it’s injection of liquidity, and the resultant low cost of capital and the market’s lower demanded returns on financial instruments? My conclusions are limited by inadequate foresight and influenced by my optimistic and pessimistic biases. Experience teaches it is hard to get the answer right. Or, as Charlie Munger has said, “it’s not supposed to be easy. Anyone who finds it easy is stupid.” At the risk of being stupid, equity investments in companies, including the five largest, with the unique competitive positions and “closed-loop” business models will remain excellent investments. In addition, certain fixed income securities paying high yields with attractive long-term risk-adjusted safety are extremely attractive and are being ignored in this unique interest-rate environment. This combination will create substantial value. Unique macro forces created by the central banks, unprecedented and sustainably low interest rates combined with pandemic-tested sustainable business models have created truly unique opportunities.
We are rapidly approaching a zero-interest rate world. Interest rates are being driven to zero (or below zero in many cases) as a first-line tool for central banks to generate economic activity in the face of the dramatic negative impact of the pandemic, as well as existing and lingering economic fallout. This toolbox will be empty soon, and the only remaining weapon will be fiscal policy. Among other things, fiscal policy and domestic financial markets will have an overwhelming influence on global currencies. Capital flows will dramatically impact currency volatility as capital moves to more attractive countries with more liquid and robust asset markets.
Defining and the problem precisely is the only way to solve anything, and, undoubtedly, the single greatest challenge to achieving anything. Otherwise, it is a waste of time and resources (which describes most public policy). All too often decision-makers waste time, resources, and make matters worse because they simply do not understand the actual problem they’re trying to solve. Very few problems are well-defined, and few people take the time and effort to understand what it is they are trying to solve. Motivation, energy, and focus on an outcome are inefficient, misguided, and dysfunctional. Good intentions do not effectively define any problem, and typically lead to very bad outcomes. Wanting to solve a big problem is fine, but not defining it accurately is inefficient at best, and most likely disastrous. It will never lead to a solution.
Instead of “internet time” we now have “pandemic time.” The need for advanced systems to keep society functioning, manufacturing moving, and give consumers some sense of safety is immediate. Driving innovations – whether those innovations are in health care, technology or other areas of production and manufacturing – is essential to not only offset the impact of the global pandemic but stay competitive and sustainable long after the current health crisis has subsided. Technological advancements, especially machine learning and other powerful software tools, combined with developments in nanotechnology, monitoring, and global communication networks will accelerate a profound change that will permeate all aspects of business and manufacturing. Advanced technologies were set to indelibly affect all aspects of industry in about five years. The curve to successfully implement the best tools and make processes more efficient, informative, and effective has been accelerated by the pandemic. The need for automation and systematic tools to keep society functioning, keep manufacturing moving, and give consumers some sense of safety and confidence is immediate. More than anything, driving innovations – whether those innovations are in health care and life science, technology or other areas of production and manufacturing – is now seen as essential to not only offset the impact of the global pandemic but stay competitive and sustainable long after the current health crisis has subsided. Technological advancements, especially machine learning and other powerful software tools, combined with developments in nanotechnology, monitoring, and global communication networks will accelerate a profound change that will permeate all aspects of business and manufacturing.