The old rules for evaluating market performance no longer apply. From 1973 to 2008 one could predict market performance based on understanding the gold signal, how fiscal and geopolitical policy affected the supply and demand for base money, and how the Fed responded. During this period, the market determined interest rates, the price of interest. The rise of the bond vigilante was a direct result of the end of Bretton Woods which maintained dollar stability. The price of interest was stable during the BW years because the dollar’s value was stable. The value of the floating fiat dollar, that began with the end of BW, constantly changes. Market set interest rates reflect a risk premia associated with a constantly changing dollar value. When the dollar’s value changes, one side of a contract always loses. The price of gold signals changes in the value of the dollar. When BW ended, the POG went from $35/oz to $850 before eventually settling at $350/oz. Likewise, rates on the 10 year treasury went from 6 percent to 15.3 percent before beginning its long decline during the great moderation of 1983-2005 and the deflation of 1997-2001.
Reagan’s philosophy of small government, beneficial regulation, and the 1983 tax cuts combined with Greenspan’s rough dollar stabilization around $350/oz of gold unleashed two decades of global growth. With the dollar semi-stable in value, changes in fiscal and Fed policy became a predictive art for evaluating market performance. Market rises and declines went hand in hand with fiscal policy that rewarded or punished producers.
The decline in the POG in 1997 indicated incipient deflation. Gold fell to $250/oz by July 1999. Dollar deflation wrecked emerging markets linked with the dollar. The 1997 Asian financial crisis was a direct result of Greenspan’s deflation error. Deflation drives down the price of physical commodities. Capital flowed into intellectual technology. The personal computer revolution fueled the technology boom with capital thrown at everything tech related. Deflation favors creditors over debtors. When tech boom debtors could not pay back their creditors with increasingly more valuable dollars, the tech boom crashed.
Again, this was predictive by understanding the gold signal and its relationship to fiscal policy. Regardless of central bank monetary error or legislative fiscal or geopolitical policy error, understanding the relationship between them and their effect on the producer makes it possible to accurately predict market changes.
This relationship holds as long as markets are free. The price of interest is the preeminent signal in an exchange economy. A distorted price of interest short circuits the natural ability of the market to efficiently reflect real value. Once the primary signal for free market exchange becomes distorted, everything gets distorted.
Bernanke’s Fed began manipulation of the price of interest as policy after the 2008 financial crisis. Fed policy drove global interest rates toward the zero bound. Other major central banks imported the Fed’s QE policy and interest rates turned negative. The Fed’s initial list of lending facilities to support bankrupt entities began with the onset of the financial crisis and expired at the end of 2012. Other liquidity creation programs continued. The Fed has done this through a litany of non-traditional policy actions; IOR, LSAP, QE1-2-3, operation twist, ONRRP, mortgage securities and agency debt purchases, principle reinvestment, and rolling over securities. The Fed continues to directly target the price of interest across the yield curve by reinvesting principle and rolling over securities. The result is a balance sheet that the Fed maintains at $4.5 trillion, up from $.8 trillion at the beginning of the crisis.
Fed manipulation of the price of interest distorts capital allocation. It shrinks investment timelines from the future to the present. Capital flows into front-running central bank purchases. Corporations borrow virtually free money to buy back their stock and inflate their market value rather than invest in R&D and capital expansion. IPOs—investment in the future—dried up in favor of M&A—investment in the present. Capital flows to financialization instead of the productive economy. Interest rate derivatives, foreign exchange, the carry trade, arbitrageurs, and high-frequency-trading “flash boys” churn the vast shuffle of money that subsumes the exchange of goods and services and keeps the global fiat central bank edifice afloat. Woe is the bond vigilante, wage earner, pensioner, saver, and productive class.
Market indices reflect the central bank liquidity flood. The proverbial seed corn is being eaten. The time horizons of economic activity have shrunk from decades to microseconds. The search for yield among commanded interest rates has diverted capital to riskier equities. Stock buybacks elevate equity prices. Access to central bank commanded free money diverts precious capital to prop up zombie companies. The SNB directly purchases equities with Swiss francs conjured out of thin air. The BOJ owns 67 percent of the Japanese ETF market and growing. IOR distorts lending and depository institutions valuations with literal free money. The Fed creates money out of thin air, drives interest rates lower, and pays banks IOR not to lend. The S&P has risen perpetually upward along with the global central bank liquidity flood and manipulation of the price of interest.
Investors have to adjust the old rules of predicting market moves for the hybrid system of central bank commanded interest rates. Like the 80s, positive fiscal policy reform through tax cuts, less regulation, and smaller government are expected to fuel the next market boom. Yet the market is at historic highs amid a continuous rise in negative fiscal policy. Dodd-Frank is a regulatory nightmare. Companies opt to remain private rather than absorb its compliance costs. Dodd-Frank creation of the CFPB further adds economy sapping regulation. Obamacare cost the Democrats control of Congress. It distorts vast sums of human and financial capital to unproductive entities and now consumes 17 plus percent of GDP. Obamacare becomes less sustainable with each passing day. Perpetual war and entitlements result in massive debt financed by central bank commanded interest rates. With interest rates near zero, the debt increases without immediate costs and accrues to future generations. Without real growth, a return to market set interest rates will divert budget expenditures to debt service. Amid this near decade of negative fiscal policy, market indices continue to rise uninterrupted.
Positive fiscal policy changes along the Laffer Curve are always stimulative. With commanded interest rates though, market indices reflect temporary capital misallocation rather than real growth. Combined with the instability of the dollar, Fed nomalization—the slow, eventual return to market set interest rates—portends an unwind of nine years of economic distortion and capital misallocation.
This is historically uncharted territory. A hybrid era of free markets with global central bank control of the price of interest has never happened before. The old, predictive rules of evaluating markets do not apply until markets again set the price of interest. Without an immaculate return to stable money and stimulative fiscal policy—impossible in our Congressional stalemated, demand-side monopoly world—the Fed’s proposed attempt to unwind commanded interest rates via “normalization”, no matter how slowly, will be highly unstable. Fiscal policy cannot do it alone. This is not a repeat of the 80s.