They say that economic recoveries don’t simply die of old age. Typically, the Fed has been the actor that has tipped mature economic recoveries over the edge. There is a lot that could be said this week but we want to contain our enthusiasm into a digestible report. We are concerned about two parts of the Fed minutes released last week that could have serious implications for the global economy and financial markets, most likely later this year.
First, the Fed continues to discuss reducing their balance sheet and are hinting strongly that this may begin late this year. The risk here is that at the margin, the supply of Dollars into the global system is restricted, and the Dollar rallies hard. We have written before about the broad subject of how the world needs an ever increasing supply of Dollars to grow. Tracking the flow of liquidity around the world is hideously complex, but in simple terms either the US exports Dollars via the current account (by running an ever larger deficit) or when the Fed prints money and some leaks out into the global system.
The US current account deficit, having narrowed significantly during the financial crisis, never really widened again. Luckily, the Fed was printing gargantuan sums of Dollars post crisis which helped enable some global economic growth, and importantly supressed the value of the Dollar. However, as the Fed started to reduce QE in 2014 (finally ending QE late in the year), the Dollar rose rapidly as can be seen in chart 1 below.
Chart 1 – Central bank balance sheets and the US Dollar
Although the Dollar had been rising modestly between 2011 and 2014, the move went almost vertical after the Fed stopped printing money. Of course, this was aided by the extraordinary policies being employed by the BoJ and ECB (their combined balance sheets took off as the Fed stopped rising), but by mid-2015 the strong Dollar was being blamed on growing concerns about global economic growth. The culmination of these concerns were two short periods of angst over China which coincided with sharp declines in risk assets and even worries that the US economy could be headed for recession.
Of course, as the second China wobble hit a year ago, it was all hands to the pump as central banks collectively did whatever it took and China opened the credit taps to juice their economy. In particular, as the Fed backed away from tightening policy and ever lower yields encouraged more speculation, markets started to recover followed closely by economic improvement as Chinese demand improved on the back of massive support.
So, will the Dollar resume its long term uptrend if/when the Fed starts to reduce its balance sheet? Our simple view is yes it will. Speculating on what else may be happening later this year, we know that the Trump team will want to pass tax reform that will likely include something to encourage repatriation of corporate profits held overseas. This should also be bullish for the Dollar. Trump may also be looking at ways of reducing the current account deficit, such as border adjustment tax or even tariffs, which would also be bullish for the Dollar. If all three of these occur, we would expect a turbo charged Dollar bull run, which in the end will be bad for economic growth and financial markets.
Turning to the second concerning factor in the Fed minutes. Buried within the FOMC minutes was a short passage that says the Fed is now worried about asset prices being highly valued. This is quite an admission as Fed officials very rarely admit this in public.
The way we are looking at this is that the Fed, along with other major central banks, sponsored asset price inflation for years via QE and zero or negative rates. Their intention was to boost asset prices in the hope that the wealth effect would trickle down into the real economy, and every time markets wobbled, the central bankers would juice the system again just like they did in Q1 last year. Simply put, when asset prices have reached previous bubble level valuations after an 8 year bull market sponsored by central bankers, and led by the Fed, when that main sponsor starts to question market valuations, normal investors should be running for the hills.
With the global economy growing and financial markets performing well, the Fed are feeling comfortable in removing accommodation and are warning that asset prices are very expensive. We can see Fed policies combined with Trump’s policies leading to a very strong Dollar which could topple both the economy and financial markets, perhaps late this year. Is this bearish scenario baked in here?
Well, if Trump’s pro-growth policies kick in hard, then perhaps the US economy can handle a strong Dollar, but the global economy will likely still struggle. Will the Fed reverse course at the first sign of a financial market wobble? Quite possibly, as they have done several times in recent years.
Our message here is that we have a very mature business cycle and the Fed is not only increasing interest rates, but discussing a policy that could significantly boost the Dollar. Politicians are struggling to introduce pro-growth policies and may inadvertently introduce policies that could turbo change any Dollar rally. This, at a time when global debt has risen by $70 trillion since before the last crisis, which makes the system vulnerable to any shocks. One such shock could be a reversal of the bullish investor sentiment that central banks have cultivated as the Fed is now telling them that future returns will be modest at best.
Slowly but surely, the Fed seems to turning from market friend to foe, and economically may well be headed in the direction of policy error and killing the post 2009 recovery. There are many twists and turns that this plot could take in the months ahead, but we view Fed talk of balance sheet reduction and high asset prices as fair warning to investors.
Stewart Richardson
RMG Wealth Management
