The last couple of weeks have been very interesting. Remember that, certain regional differences aside, Japan has, for the past two-plus decades, been the global trendsetter in terms of macroeconomic deterioration and monetary policy. It was the first to have a major housing and banking bubble, the first to see that bubble burst, to respond with years of 1 percent interest rates, then zero rates, then various rounds of quantitative easing. The West has been following Japan each step on the way – usually with a lag of about ten years or so, although it seems to be catching up of late. Now Japan is the first developed nation to go ‘all-in’, to implement a no-holds-barred money-printing regime to (supposedly) ‘stimulate’ the economy. This is called Abenomics, after Japan’s new prime minister, Shinzo Abe, the new poster-boy of policy hyper-activism. I expect the West to follow soon. In fact, the UK is my prime candidate. Wait for Mr. Carney to start his new job and embrace ‘monetary activism’. Carnenomics anybody?
But here is what is so interesting about recent events in Japan. At first, markets did exactly what the central bankers wanted them to do. They went up. But in May things took a remarkable and abrupt turn for the worse. In just eight trading days the Nikkei stock market index collapsed by 15%. And, importantly, all of this started with bonds selling off.
Are markets beginning to realize that all these bubbles have to pop sometime and that sometime may as well be now? Are markets beginning to refuse to dance to the tune of the central bankers and their printing presses? Are central bankers losing control?
‘Sell in May and go away’
Let’s turn back the clock for a moment, if only just a bit. Let’s revisit April 2013 for a moment. At the time I spoke of central bankers enjoying a kind of ‘policy sweet spot’: they were either pumping a lot of liquidity into markets or promising to do so if needed, and all of them were keeping rates near zero and promising to keep them there. Some started to consider ‘negative policy rates’. Yet, despite all this policy accommodation, official inflation readings remained remarkably tame – indeed, inflation marginally declined in some countries – while all asset markets were on fire: government bonds, junk bonds, equities, almost all traded at or near all-time highs, undeniably helped in large part by super-easy money everywhere. Even real estate in the US was coming back with a vengeance. And then, in early April, central bankers got an extra bonus: Their nemesis, the gold market, was going into a tailspin. I am sure Mr. Bernanke was sleeping well at the time: financial assets were roaring, happily playing to the tune of the monetary bureaucracy, seemingly falling in line with his plan to save the world with new bubbles, while the cynics and heretics in the gold market, the obnoxious nutters who question today’s enlightened policy pragmatism, were cut off at the knees.
But then came May and everything sold off.
However, that is not quite how the media presents it. Here, one prefers the phrase ‘volatility returned’, as that implies that everything could be fine again tomorrow. And it certainly can. Maybe this is just a blip. But what if it isn’t? And, more importantly, what is driving it?
A widely debated theory is that the prospect of the Fed ‘tapering’ its quantitative easing operation, of it oh-so carefully, ever-so slightly removing its unprecedentedly large and more than ever alcohol-filled punchbowl could end the party. There has for some time been concern about and even outright opposition to never-ending QE within the Fed. So there is, of course, a risk (a chance?) that the Fed may reduce or even halt its asset-buying program. (As a quick reminder, since the start of the year, the Fed has expanded the monetary base already by more than $340 billion, and at the present pace, the Fed is on course to create $1,000 billion by the end of the year.)
Ben Bernanke – tough guy?
However, I do not think that markets have a lot to fear from the Fed. Should a pause in QE lead to a sell-off in markets, to rising yields and rising risk premiums, then, I believe, the Fed will quickly revert course once more and switch on the printing press again. The critics inside the Fed will be silenced rather quickly. Remember that most of them seem to argue that additional QE is not needed; they do not appear to reject it on principle. Ultimately, nobody in policy circles is willing to sit on his or her hands when the markets seriously begin to liquidate. The ‘end’ to QE, if it is announced at all, is likely to be just an episode.
The last central banker who had the cojones to take on Wall Street was Paul Volcker. Ben Bernanke, as well as his predecessor Alan Greenspan, have been nothing but nice to the speculating and borrowing classes. Both subscribe to and have, on numerous occasions, articulated the notion that it is part of the central bank’s remit to bring good cheer to households and corporations by lifting their house prices and inflating their stock prices and executive option packages. What the country needs is optimism and what is more conducive to optimism than a rising stock market and happy faces on CNBC? Bernanke declared that boosting financial assets can kick-start a virtuous circle of borrowing, investing and self-sustained growth. David Stockman has aptly called this approach ‘prosperity management’ through ‘Wall Street coddling’. Of course, Greenspan tightened in 1994, and again very carefully in 2005, and yes, both times financial markets caved in. But this only serves to illustrated how unsustainably bloated and dislocated the financial system has become, and how addicted to cheap money from the Fed. I think the Fed will be very careful to reduce the dosage of its drug anytime soon.
Although he didn’t quite put it in those terms, global bond guru Bill Gross, founder and co-chief investment officer at asset management giant PIMCO, seems to see it similarly. In an interview with Bloomberg in the middle of May, he confirmed that he and his team saw “bubbles everywhere”, which certainly implied that everything could go pop at the same time. He also stated that the Fed would “not dare” to do anything drastic anytime soon as the system is so much more leveraged now than it was in 1994, when Greenspan briefly tried to play tough and tighten policy.
My conclusion is this: if market weakness is the result of concerns over an end to policy accommodation, then I don’t think markets have that much to fear. However, the largest sell-offs occurred in Japan, and in Japan there is not only no risk of policy tightening, there policy-makers are just at the beginning of the largest, most loudly advertised money-printing operation in history. Japanese government bonds and Japanese stocks are hardly nose-diving because they fear an end to QE. Have those who deal in these assets finally realized that they are sitting on gigantic bubbles and are they trying to exit before everybody else does? Have central bankers there lost control over markets? After all, money printing must lead to higher inflation at some point. The combination in Japan of a gigantic pile of accumulated debt, high running budget deficits, an old and aging population, near-zero interest rates and the prospect of rising inflation (indeed, that is the official goal of Abenomics!) are a toxic mix for the bond market. It is absurd to assume that you can destroy your currency and dispossess your bond investors and at the same time expect them to reward you with low market yields. Rising yields, however, will derail Abenomics and the whole economy, for that matter.
It is, of course, too early to tell. The whole thing could end up being just a storm in a tea cup. It could be over soon and markets could fall back in line with what the central planners prescribe. But somehow I doubt that this is just a blip – and interestingly, so does Mohamed El-Erian, Bill Gross’ colleague at PIMCO and the firm’s other co-chief investment officer. In an interesting article on CNN Money yesterday, he contemplated the possibility that markets were beginning to lose confidence in central bankers.
If that is indeed the case it won’t be confined to Japan but will rapidly reverberate around the world. This is a much bigger story than a modest slowing of QE in the US. Could it be the beginning of the end?
I think the central bankers may not be sleeping so well now.