These Fake Rallies Will End In Tears

New York Stock Exchange 1963 (Photo: Wikimedia; US News and World Report; Library of Congress)

Investors and speculators face some profound challenges today such as figuring out how to deal with politicized markets that are continuously “guided” by central bankers and regulators. Also questions such as “To what extent do prices reflect support from policy, in particular super-easy monetary policy?” And, “How is all this market manipulation going to play out in the long run?”

It is obvious that most markets would not be trading where they are trading today were it not for the longstanding combination of ultra-low policy rates and various programs of ‘quantitative easing’ around the world, some presently diminishing (US), others potentially increasing (Japan, eurozone). As major US equity indices closed last week at another record high and overall market volatility remains low, some observers may say that the central banks have won. Their interventions have now established a nirvana in which asset markets seem to rise almost continuously but calmly, with carefully contained volatility and with their downside apparently fully insured by central bankers who are ready to ease again at any moment. Those who believe in Schumpeter’s model of “bureaucratic socialism”, a system that he expected ultimately to replace capitalism altogether, may rejoice: Increasingly the capitalist “jungle” gets replaced with a well-ordered, centrally managed system guided by the enlightened bureaucracy. Reading the minds of Yellen, Kuroda, Draghi and Carney is now the number one game in town. Investors, traders and economists seem to care about little else.

“The problem is that we’re not there [in a low volatility environment] because markets have decided this, but because central banks have told us…” Sir Michael Hintze, founder of hedge fund CQS, observed in conversation with the Financial Times (FT, June 14/15 2014). “The beauty of capital markets is that they are voting systems, people vote every day with their wallets. Now voting is finished. We’re being told what to do by central bankers – and you lose money if you don’t follow their lead.”

That has certainly been the winning strategy in recent years. Just go with whatever the manipulators ordain and enjoy rising asset values and growing investment profits. Draghi wants lower yields on Spanish and Italian bonds? – He surely gets them. The US Fed wants higher equity prices and lower yields on corporate debt? – Just a moment, ladies and gentlemen, if you say so, I am sure we can arrange it. Who would ever dare to bet against the folks who are entrusted with the legal monopoly of unlimited money creation? “Never fight the Fed” has, of course, been an old adage in the investment community. But it gets a whole new meaning when central banks busy themselves with managing all sorts of financial variables directly, from the shape of the yield curve, the spreads on mortgages, to the proceedings in the reverse repo market.

Is this the “new normal”/”new neutral”? The End of History and the arrival of the Last Man, all over again?

The same FT article quoted Salman Ahmed, global bond strategist at Lombard Odier Investment Managers as follows: “Low volatility is the most important topic in markets right now. On the one side you have those who think this is the ‘new normal’, on the other are people like me who think it cannot last. This is a very divisive subject.”

PIMCO’s Bill Gross seems to be in the “new normal” camp. At the Barron’s mid-year roundtable 2014 (Barron’s, June 16, 2014) he said: “We don’t expect the party to end with a bang – the popping of a bubble. […] We have been talking about what we call the New Neutral – sluggish but stable global growth and continued low rates.”

In this debate I come down on the side of Mr. Ahmed (and I assume Sir Michael). This cannot last, in my view. It will end and end badly. Policy has greatly distorted markets, and financial risk seems to be mis-priced in many places. Market interventions by central banks, governments and various regulators will not lead to a stable economy but to renewed crises. Prepare for volatility!

Bill Gross’ expectation of a new neutral seems to be partly based on the notion that persistently high indebtedness contains both growth and inflation and makes a return to historic levels of policy rates near impossible. Gross: “…a highly levered economy can’t withstand historic rates of interest. […] We see rates rising to 2% in 2017, but the market expects 3% or 4%. […] If it is close to 2%, the markets will be supported, which means today’s prices and price/earnings are OK.”