In January 2018, I saw a market inflection occurring due to Fed normalization. I wrote Market Memo: Market Inflection. The week I wrote it, the Dow hit 26,600 and then began a decline. Capital flows to where it receives the best returns. When a central bank distorts the price of credit, it distorts the flow of capital. Distorted capital begins to unwind when central banks loosen their control of commanded interest rates. Normalization is the Fed’s baby steps to return to free market interest rates. Good investments under distorted interest rates may become bad investments under free market rates. Capital allocation decisions are changed and volatility increases. The PBOC loosely links the yuan to the dollar and it imports normalization volatility to its economy. This increases trade tension with China that further disrupts markets.
The inflection occurred. The Dow remains below the inflection market high. Volatility increased with a short, sharp selloff in December 2018. The Fed can’t handle volatility because it has owned the market since it began commanding interest rates in March 2009. The Fed has already signaled the end of normalization after a very brief attempt. Normalization is the removal of excess reserves. The Fed still has $1.65 trillion excess reserves on its balance sheet. Excess reserves at $1.65 trillion are double the size of the Fed’s entire balance sheet before it started QE. Normalization is a faraway dream. The Fed can’t put the QE genie back in the bottle. In Market Memo: Market Inflection, I wrote:
Market volatility will accelerate along with the programmed increase in CB balance sheet reduction. It is unlikely that the Fed will proceed very far into its multiyear planned balance sheet reduction. A significant correction will cause central banks to return to the only arrow in their intellectual quiver: printing money.
The Fed contributed to normalization volatility by chasing the mythical “natural rate of interest.” It manipulated a series of fund rate hikes in an attempt to achieve the “natural rate.” I looked at this Fed policy detour in Trump vs the Fed. The funds rate hikes accomplished nothing under the distortion of ER, IOR, and ONRRP policy other than to invert the yield curve and to once again prove the futility of the Phillips Curve.
Now that the Fed has signaled the end of normalization it is locked into maintaining a bloated balance sheet indefinitely. The Fed will perpetually manipulate the price of interest. (A Trapped Fed.) Other major central banks are locked into the same policy. The ECB announced the end of its QE in December 2018. European markets are sinking and the ECB will no doubt return to QE purchases of government and corporate bonds. The BOJ has gone too far down the QE road. There is no longer a market for Japanese government bonds and the BOJ owns 77.5 percent of Japan’s ETFs. Japan demonstrates the power of a central bank to manipulate the price of credit and its result. At its root, it only differs from the Soviet state system in degree. It will require economic collapse and a forced reset of monetary policy for Japan to return to normalcy.
What does this mean for markets? Central bank money creation is an extremely powerful tool but like any distortion of free markets, it has limits. The market transmits Fed inflationary monetary error by increasing risk premiums on bonds. The rise of bond vigilantes during the inflationary 1970s was a direct result of monetary error. When Congress gave the Fed the ability to pay IOR, it changed the traditional balance between Fed money creation and market discipline. The Emergency Economic Stabilization Act of 2008 gave Bernanke a monetary loophole to circumvent the traditional balance of money creation disciplined by a free market. With IOR, the Fed can theoretically create unlimited base money. A substantial portion of that money will be held as excess reserves. This allows the Fed to manipulate interest rates to achieve perceived economic goals. It renders bond vigilantes impotent. The result is the hypertrophy of finance described by George Gilder in The Scandal of Money. The powerful, connected, and crony who are first in line for near free money do great. Those without access or last in line–wage earners, savers, fixed income, pensioners–not so great. Those at the bottom rung of the economic ladder have no chance. Our major cities increasingly reflect this disparity by their street inhabitant squalor. The current turn to socialism is a response to this distortion of capitalism.
All indications are that markets will soon be back on the central bank treadmill of QE money creation. Indices may resume their climb, but QE is inherently unstable because it misallocates capital. Markets discount the misallocation. We are a decade into the monetary experiment and market participants can judge the result for themselves. Speculators, crony capitalists, and passive investors riding the market indices may profit, but the poor, the middle class, standards of living, and the real economy are in decline. Interest rate manipulation is a capital control, and capital controls are antithetical to free markets. With the end of normalization and perpetual monetary intervention on the horizon, central banks will continue to inhibit sustained economic growth. The decline of an empire begins with the manipulation of money.