Jackson Fork

With Labor Day fast approaching, and kids back to school, eyes turn to what happens when everyone is back in front of their screens. Or their investment and risk committees. And what will the question be? There will be two, interconnected questions: Can the rally into risky assets sustain itself? When will the Fed next hike rates?

Given that Blondemoney suspects the Fed is about to tear up the rule book at Jackson Hole this weekend, these questions are kind of irrelevant. The point is that even if the Fed are hiking soon, there’s not much to come afterwards. Equally, monetary policy is a busted flush and the baton falls to fiscal. (Note that the FT yesterday turned its op-ed over to a multi-asset fund manager, Euan Munro,  arguing for fiscal stimulus to revive the economy).

So the question instead should be, when will the driver of asset prices shift? Or at least when will perceptions of what the driver is, shift?

If we are about to enter a vacuum, between monetary and fiscal policy, then the market could go two ways:

1) Risky asset correction, as confusion reigns
Without monetary policy as the trigger, and with fiscal policy a process that takes time to implement let alone demonstrate impact, confusion could fill the vacuum. If the world ahead looks completely uncertain, cut half your positions, go defensive, and come back later when it’s clearer.

OR

2) Risky assets continue, with no catalyst to change the outlook
Yes it could be the return of Sid James, as we Carry On Carrying, safe in the knowledge that monetary policy is now completely predictable, and fiscal policy, while unclear, would only be used to restore growth and inflation.

Blondemoney is no scientist, as is abundantly obvious, but the 2nd route is the Newton’s First Law of markets.

‘an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.’

So, if you’ve got cash to put to work, then do so, and keep doing so, unless you hear anything different.

Of course, there are plenty of risk events on the horizon that could provide fresh information – but most of them are political, which (as BM readers know) is difficult for the market to price. A Trump Presidency; a new Italian PM after the constitutional referendum; a polarised French Presidential election; a breakdown of Russia/Turkey/US/EU geopolitical relations.

As the WSJ pointed out, the S&P 500 has never moved so little in a 30 day period. Usually we feel markets then become uber complacent, ready for the pullback. But what if that pullback is met by Newton’s First Law of Carry Trade Lovers… if it’s not volatile enough, then it doesn’t force that world to retract, it forces them to get back in, more, and quickly.

Irrational exuberance it may look to some; but with interest rates negative and the future still too far away, why not get stuck into some serious carry? Does a Fed rate hike in Sept or Dec stop that, if they’re about to announce they’re not doing many more than that?

 

How quiet is too quiet?

image

The WSJ carried a story yesterday that it is scarily quiet in the stock market. Realised volatility over the last 30 days has never been lower in 20 years…

Then BAML flagged the attached chart, showing that shorts in the VIX have never been so extreme, with punters selling the index to juice up yield.

But with central banks on hold, and awaiting the market to spot that monetary has passed the baton to fiscal policy as a driver, can this continue?

what do you think, dear reader?

Low Forever

We all fall into lazy behaviour, and never more so on a bright sunny London day with the mercury predicted to hit 30. (That’s a science reference by the way, not some allusion to a winged messenger battling 30 Spartans or something. Blondemoney might be liberal arts but didn’t forget everything from Science GCSE. (Except the bits about physics, they were confusing)).

And so the market has fallen into some lazy tropes:

– everyone is cutting interest rates except the US

– So buy USDs and go short of funding currencies

– and if vol remains low then you’re allowed to extend this into long anything with yield (from dividend paying stocks to any basket case EM), which might look like a short USD thing but that’s just a temporary thing, refer back to point 1

But what if the edifice of this assessment, largely profitable for the past 3 years, is about to be shaken down?

What if it’s not “lower for longer” from almost everyone but just “low forever”?

What if monetary policy goes into stasis because it’s done enough, and the baton has to be passed to fiscal policy?

Beware not just this potential shift from the Fed at this weekend’s Jackson Hole symposium. Note also the comments from the RBNZ Governor Wheeler overnight – a deliberately scheduled last minute speech where he argued that ‘rapid easings’ of rates aren’t likely. That’s because they’re not the answer.

The edifice is trembling. Don’t get too lazy now.

r*

Oh John Williams, you little tinker! One of Blondemoney’s favourite central bankers has only gone and chosen one of Blondemoney’s favourite central banking solutions. In his latest paper, San Fran Fed’s Williams suggests the option of Price Level Targeting as a way to solve the current lowflation conundrum. Yes!! Go on son!!! Blondemoney argued for this back in 2009 – for the full details check out this policy paper. The point is that with inflation targeting, bygones are bygones – we start each year at zero, looking for +2%. With price level targeting, you take into account that we went up 2% last year, so we go from a base level of 100 to 102, then another 2% takes us to 104.04 and so on; we don’t lose the inflation that’s been created, and it smoothes it out over time.

But more importantly than the toot on the BM trumpet, is why the Fed’s Williams is writing this essay, right now. Only last week he said that he thought another hike this year would be required and that he didn’t want the Fed to get behind the curve. He is not, however, being inconsistent. He is moving the debate on from details over the timing of the next hike, to the big picture framework of monetary policy overall. He argues:

1. The world has changed – The neutral rate of interest is just lower, OK?

‘The underlying determinants for these declines are related to the global supply and demand for funds, including shifting demographics, slower trend productivity and economic growth, emerging markets seeking large reserves of safe assets, and a more general global savings glut (Council of Economic Advisers 2015, International Monetary Fund 2014, Rachel and Smith 2015, Caballero, Farhi, and Gourinchas 2016). The key takeaway from these global trends is that interest rates are going to stay lower than we’ve come to expect in the past’

2. So monetary policy needs to change

‘Although targeting a low inflation rate generally has been successful at taming inflation in the past, it is not as well-suited for a low r-star era. There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low’

– So unconventional policy will become conventional
– Central banks could ‘pursue a somewhat higher inflation target’
– OR ‘inflation targeting could be replaced by a flexible price-level or nominal GDP targeting framework’

3. But Monetary Policy is not the only answer

‘We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability’

He goes on to offer fiscal policy solutions, such as forcing countercyclical fiscal rules to automatically get governments to spend more in downturns and save in growth periods. Or to invest in research and development to boost the natural interest rate of the economy.

–> But the big picture is why he is saying this now. Jackson Hole takes place the weekend after next, and it’s clear that the Fed are now accepting their view on inflation needs to change. Yes, on one level you could take this as the simple point that if the natural rate is permanently lower, then monetary policy doesn’t need to normalise so quickly. In other words, expectations of rate hikes will be phased out and US interest rates and the US dollar will fall.

Yet the conclusion could be so much bigger than that. It suggests interest rates should barely move ever again; it suggests QE is a permanent policy tool; it suggests lower-for-longer becomes “lower-forever”. And the final hurrah: that monetary policy is pretty much impotent anyway. Fiscal policy must now do the work.

When the market tunes into this, it doesn’t just spell the end for any rally from the US Dollar: it mandates a new asset price boom. Go get yield, anywhere, at any cost. Use dollars to fund it. In fact use dollars or pounds or euros or yen because the G4 central banks just hoisted the white flag of surrender.

The central banks aren’t going to stop you, and there will be a vacuum of power from policymakers until governments pick up the fiscal baton. Exuberance just got a little bit more rational.

 

When will the penny drop?

We have spoken many times, you and me, about how market prices are a reflection of the ongoing assimilation of all the future paths of probability. Right now we are going through a path of “interest rates continue to be lower for longer and any issues with that can wait for another day”. In a perfectly rational world, of course, the far future would be discounted and weighted alongside the near future. In other words, we would price in everything, now. But sometimes that far future feels too distant. Its weighting is too small. It just feels too unlikely and too irrelevant. This is where we can be suddenly surprised, even by an event that we know about. Donald Trump for President? Nah, it’s priced at only 25% and November is cold and wintry, whereas today I’m all about cooling off with my pina colada.

Thus we saw a 10% decline in GBP on the Brexit result. That’s where the unexpected future comes careering into the present. But now we are into a new zone with the Great British Pound. This is where the reality starts drip feeding into the present. We are only just starting to get data from the post-vote period; and decisions on investment are only in the process of being taken. The UK packaging firm DS Smith have said today that losing single market access might cause them to move abroad. House prices are falling, but slowly – down this month but still up on last year.

Then beyond that, the politics. Theresa May has already had to issue a warning to her Brexiteer ministers to “stop playing games“, in a potential sign of the chaos to come, as the UK embarks on a negotiation process with an end-result that is as yet unclear.

Now, Blondemoney isn’t making a judgement on all of this; whether it will be good or bad for the economy, or the rights and wrongs of the decision. But the point for the markets is that the probabilities of the outcomes are not  yet fully reflected in the price of UK assets. Yes, GBP has suffered, but is it a full reflection of the potential future path of the economy, with so much still unknown? Yes, the BOE cut interest rates, but how much further down could they go? There seems to be a sense that “The Brexit Adjustment” has happened. But no, we just priced in a risk that Brexit could happen. Now we have to price in what it might actually look like.

The penny is only just starting to drop.