The Patient Never Left the Hospital

Let’s get this straight.  Real rates never became positive in the U.S. in this cycle and overall financial conditions indicate policies are quite easy while the federal deficit skyrockets in a supposed boom, yet somehow the Fed needs to become more dovish after behaving incredibly irresponsibly for a decade.  If participants refuse to see the problem with that, we can’t help them. 

The Fed’s dovish turn this year went too far, too fast.  It panicked after the late-year equity swoon highlighted that the financial system suffers from a lack of liquidity when real selling begins.  Translation: The Street does not take the other side of trades like it used to in down markets and contrarian investors are a rare breed these days. 

The Fed is finally realizing that normalization is not possible and that must be concerning to it. Because it became too dovish, too soon given the landscape, it risks having to move to the hawkish side if economy bounces like stocks have.  Regardless, the current M.O. is talking about not tightening while still shrinking its balance sheet for a few more months. That is not easing, though participants act like QE is back already. 

It is late cycle, not mid-cycle, so the challenges are immense.  Many professional investors feel trapped by the monetary shenanigans.  Play along with stocks broadly trading at 2-3 times normal valuations or risk losing clients.  Long-only managers mostly refuse to go to cash, feeling compelled to chase an expensive market even when the downside risk is high. Remember most of the gains of a cycle are usually erased by the end of the cycle, but that is ignored in every cycle.

Treasury bonds and stocks can’t both be right after each rallied strongly in the first quarter.  The recent unusual inversion of the curve between bills and the 10-year Treasury that typically marks a cycle that is long in the tooth would suggest that stocks may have it wrong.  We have always put a lot of credence in this measure as an important sign that risk needs to be reduced, especially when economic indicators are softening like they are now. For instance, the current annual rate of employment growth of 1.4% is usually only seen near recessions, but you’d never know that listening to the pundits who mostly still sound ebullient.

The legacy of the Fed is that it taught the masses to ignore risk and short volatility (VIX), betting that rain will never come after so many sunny days.  Hedging equity exposure is supposedly for suckers even with stocks at expensive levels late in a cycle.

So, here we are again at levels of complacency that have proven troublesome in recent years.  At the same time, the push towards the highs is again being led by a somewhat narrow group of stocks like last fall before the correction.

We got here because of the Fed pivot and a big jump in Chinese lending in recent months. China regularly manages its economy with bursts of lending when growth softens.  All it took was a decent equity selloff late last year to force the Fed to fire almost every bit of ammunition that it could, at this point, just shy of more QE.  It’s kind of an unflattering policy reversal even for an institution that has failed so miserably for thirty years. 

Suddenly, the Fed wants to stop normalizing its ridiculously large balance sheet, one well beyond what was needed for decades when GDP growth was a lot stronger.  While we expected this reversal, it does not make it any less noteworthy and historic that what were once termed emergency measures must now remain in place according to those in the Eccles Building.  It’s like the patient never left the hospital.  

The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.