We have been bombarded by Central Bank speakers in recent days. What does it all mean; if anything at all? Do we need to change our thinking on markets? These are serious questions for investors as we close out the first half of 2017. However, before we dive in, we want to step back and consider some previous things that central bankers have said at interesting economic and financial junctures in the past. The point of this is not simply to have a giggle at someone else’s expense. We are simply trying to illustrate that central bankers can and do get things wrong.
Is it because they are human after all? Or are they being duplicitous? Frankly, we suspect they are simply clueless to the bubble blowing effect that their policies have had in the last 20 years or so, and that the negative impact on both markets and the real economy can be devastating when these bubbles pop. Let’s start with some quotes from Ben Bernanke around the time of the housing peak in 2005/2006.
“We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” Ben Bernanke quote July 2005.
“Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.“ Ben Bernanke quote 15th February 2006.
As it turns out, Dr Bernanke was wrong. House prices did not continue to rise, or even stabilise. Shortly after his utterances, Nationwide house prices started to fall, and would only begin to stabilise after a 25% decline over 5 years.
Chart 1 – US S&P CoreLogic Case-Shiller National House Price Index
By 2007, it had dawned on Dr Bernanke that house prices were indeed falling. However, he either truly believed that any problems were peculiar to the subprime market, and would likely be contained. Or, he had to try and hoodwink us and make us believe that everything would be ok, even though he was starting to get truly worried.
“Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low.” Ben Bernanke quote 15th February 2007.
“All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” Ben Bernanke quote 17th May 2017.
“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.” Ben Bernanke quote 28th March 2007.
During the Summer of 2007, markets began to smell a rat. Two Bear Sterns hedge funds (investing in risky credit products and employing significant leverage) collapsed almost overnight. Equity markets took fright, resulting in a 10% decline in the S&P 500 into mid August. We have to suspect that Dr Bernanke was definitely getting more than a little worried by this time. His worst case scenario could have been playing out right before him and trouble in subprime lending was infecting the broader credit markets which could have proved contagious and spread to the equity markets.
Chart 2 – The US Equity market in 2007 along with the Fed Funds interest rate
Being the great student of the Great Depression, with a belief that the Fed should have done much more during that time, Bernanke knew what to do. He had to start cutting interest rates just in case he was wrong, and at the same time continue to give the public impression that everything was ok; finances and the economy were sound and he had everything under control. And so it was that he cut the Fed Funds rate three times before the end of 2007 (for a total of 100 basis points) as the equity market major topping pattern was being formed.
According to the National Bureau of Economic Research (NBER) who are tasked with dating recessions, the US economy entered a recession in November 2007. These guys have the benefit of hindsight and are using data that will have been revised from the initial publication, sometimes quite dramatically. However, there were some who were forecasting a recession in 2007, and there were some reliable signals that the probability of a recession was way above zero; the shape of the yield curve for one. However, Dr Bernanke was in damage limitation mode. With the economy stuttering, he had to give out the battle cry; “Keep calm and carry on!”
“The Federal Reserve is not currently forecasting a recession.“ Ben Bernanke quote 10th January 2008.
“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Ben Bernanke quote 9th June 2008
Chart 3 – US GDP Growth Y/Y % and the yield curve advanced by 12 months
The rest, as they say, is history. The US went on to suffer a financial crisis and the worst economic recession since the great depression, despite interest rates being cut to the zero boundary, $100s of billions of fiscal stimulus and trillions of fresh money injected into the financial system.
Now perhaps we are being a little unkind to Dr Bernanke. So, it was with a little amusement that we came across a quote this week from his predecessor, Alan Greenspan. Firstly, Alan Greenspan was perhaps the luckiest Fed Chairman ever, in that he was in charge during a period of economic expansion and stability unprecedented since the Second World War. We would suggest that this is down to structural forces such as demographics, globalisation and financialisation rather than his skills. And even though he would become known as “The Maestro”, his skill in forecasting was poor prior to taking the job in the 1980’s. For example, in early 1973, he said;
“It is very rare that you can be unqualifiedly bullish as you can be now” Alan Greenspan quote 7th January 1973.
As can be seen in chart 4 below, he nailed the high within four days before the market fell by nearly 50%.
Chart 4 – the S&P 500 October 1972 to December 1974
Although it is more than a little fun to wallow in a bit of central banker bashing, there is a serious point to this. When central bankers speak, they are mainly speaking to financial market participants and academic economists. As such, they choose their words very carefully, and they are either trying to communicate upcoming policy (forward guidance) or tell us how good things are even when this may not actually be the case. From time to time, they also warn on this and that, and when they do, you know it must be bad as central bankers tend to be cheerleaders, not prophets of doom.
So what have central bankers been saying in the last week or so?. There has been a good dose of cheerleading, some forward guidance and some extraordinary hubris that only central bankers ever fall prey to. Let’s start with Mario Draghi who really sent a shockwave through markets when he said that “deflationary forces had been replaced by inflationary forces”. Although his speech can be characterised overall as balanced rather than hawkish, markets picked up on the hawkish sense of a new inflationary trend and assumed he was signalling a more urgent need to normalise policy. As a result, the Euro exploded higher, as did bond yields with equities falling quite sharply.
We said above that central bankers really only speak to financial market participants, and they seem to have created a nasty habit of watching how markets react to their forward guidance (and sometimes these comments can be seen as trial balloons), and if they don’t like the reaction, they say so. And so it was with Draghis’ comments, as literally 24 hours later, the ECB came out and said the market had “misjudged” Draghi’s speech. Immediately, equity markets rallied, but more intriguingly, FX and fixed income markets did not reverse their initial move.
Chart 5 – German 5 year bond yield
The chart above shows the German 5 year bond yield, and it looks to us as though a 1 year + bottom formation has now been completed with the break above minus 30 basis points. The market is clearly maintaining serious thoughts that the ECB is on its way to reducing QE further next year, perhaps even ending it. Furthermore, if the ECB hints that they want to raise the deposit rate from the current minus 40 basis points back to zero initially, then German bond yields could move smartly higher at some point.
In a sign that the extraordinary policies pursued by the ECB (and BoJ for that matter) in recent years have been impacting financial markets globally, bond yields rose everywhere. So, although higher German yields did support the Euro, we are a little nervous about buying it against the US Dollar, partly as the Euro looks a bit elevated versus interest rate differentials (Chart 6) but also because there is considerable overhead resistance just above current levels (Chart 7). To get really excited about the Euro, we think Draghi has to step up and tighten policy by more than expected at their September meeting.
Chart 6 – EUR/USD FX rate and 5 year bond differential
Chart 7 – EUR/USD longer term chart showing resistance around the 1.15 area
Although Draghi captured most of the headlines, it is notable that fully seven G10 central banks have been talking recently either hawkishly, or in a manner which indicates that the next major move is away from extraordinary policies. Leading the pack is the Fed who are furthest along the normalisation process, and where the market is very much underestimating the amount of tightening if the Fed follow through on what they are saying.
But what really caught our eye from the Fed last week were comments about how high asset values were and that “high asset values may lead to future stability risks” (Stanley Fischer). This is central bank speak for; we are now worried that our extraordinary policies have created significant asset bubbles, and a future bear market would hurt both financial markets and the real economy. Simply put, when central bankers are telling us that asset values are “somewhat rich” (Janet Yellen) and that they are worried about future stability, whilst at the same time raising interest rates and potentially reducing their balance sheet, we as market participants should be very worried. Our view remains that the Fed will continue to tighten policy until something breaks, either at home or abroad…we have pencilled in late 2017 for greater market troubles, with a topping process starting in the current timeframe.
Of course, even if the Fed are worried that they have created a massive bubble, they will be very careful in the way they manage markets, and they have to keep their cheerleading hat on at all times. And so we get to the hubristic central banking comment of the week, when Janet Yellen said that she doesn’t believe that there will be another financial crisis in our lifetimes. How can she be so sure? And frankly, we beg to differ. Every episode when asset markets have become this expensive and debt this high have been followed by a financial crisis.
The trigger for the crisis has always been falling asset values, and we now have a Fed that is acknowledging high asset values and yet are still tightening policy. We would humbly suggest that the chances of another crisis emerging from the next bear market in equities and credit are actually quite high, and perhaps the Fed are also worried about this privately, and are now trying to dig themselves out of a very deep hole with their policy tightening.
Which brings us to our last point, and the reason that many investors remain invested in risky assets despite the increasing warning signs. Many investors simply believe that during the next crisis, the Fed will be very quick to slash interest rates and print money – and why shouldn’t they? After all, Fed governors have told us that this is what they expect to do. Perhaps the only issue at hand is how far the Fed will be happy to see equity prices fall before they step in – the so called strike price of the Fed put option. Is it a 20% decline? A 30% decline? Only time will tell.
We will leave you this week with perhaps the most gratuitous Bernanke quote we found;
“It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.” Ben Bernanke quote 31st October 2007.
This came literally days after the start of the bear market, and Bernanke is trying to tell us that it is not appropriate for the Fed to support financial markets, thereby protecting lenders and investors from the consequences of the financial decisions. The months ahead saw him do everything to protect lenders by being party to the bailout of a number of big banks and in the years ahead, he decided to print trillions of Dollars to buy assets in the hope that asset markets (assets held predominantly by the richest in society) would rise in value and this new found wealth would trickle down to the real economy. Frankly, the evidence suggests that the new found wealth has remained in the hands of the wealthy, and some would argue that Fed policies have not helped the real economy at all.
So, during the next crisis, we suspect the Fed to do the appropriate thing, and force feed liquidity directly into the real economy, thereby bypassing financial markets and allowing investors to live with the consequences of their financial decisions.
Stewart Richardson
RMG Wealth Management
