Back in May, we first reported that Goldman became the first bank to dare to ask if the Fed has lost control of the market, if in slightly more polite terms of course. This is how Jan Hatzius phrased it: “Despite two rate hikes and indications of impending balance sheet runoff, financial conditions have continued to loosen in recent months. Our financial conditions index is now about 50bp below its November 2016 average and near the easiest levels of the past two years.” Several months later, after the third rate hike, Goldman found that once again, paradoxically, financial conditions eased further, and the market rose even more in direct opposition of what Fed rate hikes are supposed to do!
Fast forward to this weekend, when we reported that that lovely word which describes the new normal so well – “paradox” – made a repeat appearance, this time in the last quarterly report by the Bank of International Settlement, which for the nth time issued an alert on the state of the stock market, an alert which will be summarily ignored by everyone until after the crash, and reminded everyone what happened the last time financial conditions eased instead of tightening when the Fed hiked rates (spoiler alert: biggest crash in modern history). This is what the BIS’ chief economist Claudio Borio said (among other things)”
Hence a paradox. Even as the Fed has proceeded with its tightening, overall financial conditions have eased. For instance, a standard indicator of such conditions, which combines information from various asset classes, points to an overall easing regardless of the precise date at which the tightening is assumed to have started. Indeed, that indicator touched a 24-year low. If financial conditions are the main transmission channel for tighter policy, has policy in effect been tightened at all? (We can see from the BIS chart below how, unlike the last 12-month period, the Chicago Fed Financial Conditions Index did actually tighten in the May 2004-May 2005 period, and especially in the January 1994-January 1995 period.)
“In fact, this paradoxical outcome is not entirely new… it is reminiscent of the Fed policy tightening in the 2000s – the phase that spawned the now famous “Greenspan conundrum”. Then, overall financial conditions hardly budged, and in some respects eased, as the Federal Reserve progressively raised rates. The experience contrasted sharply with previous tightenings, not least the one in 1994. At that time, long-term rates soared, the yield curve steepened, asset prices fell, corporate spreads widened, and EMs came under pressure.
Today’s experience is reminiscent of the repeated reassurance of the 2000s’ “measured pace”, except that the adjustment has been, if anything, even more telegraphed. If gradualism comforts market participants that tighter policy will not derail the economy or upset asset markets, its predictability compresses risk premia. This can foster higher leverage and risk-taking. By the same token, any sense that central banks will not remain on the sidelines should market tensions arise simply reinforces those incentives. Against this backdrop, easier financial conditions look less surprising.
Today, it was SocGen’s grumpy “permarealist” Albert Edwards’ turn to focus on this peculiar “paradox” in which the more the Fed tightens, the higher markets rise in the process “poisoning the market.”
Picking up on what Bank of America showed yesterday, namely that central banks broke both volatility and the market itself some time in 2013/2014…
… in his latest “weekly’ note (published about 3 weeks after the last one), Edwards writes that “so scared (or is that scarred) were central bankers after the summer 2013 taper tantrum, they have now gone out of their way to reassure financial markets. Thus recent tightenings of monetary policy, whether by the Fed, ECB or Bank of England, were all perceived by markets as “dovish” tightening – and hence led to even more buoyant financial markets. Policymakers are so scared the financial bubbles they created might burst that today what might be good for the economy is subservient to the needs of Wall Street.”
He then brings up our favorite new normal word – “paradox” of course – and lays out the problem on the chart below, stating that “the current situation is even worse than in the run-up to the 2008 crisis. At least back then rate hikes did not lead to easing financial conditions the way they do now! The Fed’?s desire to soothe the nerves of the financial markets has made a mockery of their tightening cycle.”
Naturally, Edwards was just getting started, and the furious rant continues:
You don?t have to be a genius to reach the conclusion that central banks? dovish tightening really means there has been no tightening of monetary policy at all for Wall Street. But for Main Street, interest rate hikes do have an economic impact that will ultimately end in recession, and like an increasingly stretched elastic band this tension will eventually snap with disastrous financial market consequences. Many clients we meet have similarly apocalyptic views to our own but remain fully invested. They cannot see an immediate trigger for the financial Armageddon that they accept is heading slowly our way.
And yet, despite central bankers’ best intentions to kill the free and efficient market, this time something may be changing, and may soon unleash that “shock” event that is so critical for the market to determine just what the new strike price of the Fed put is as BofA explained: that something is China.
Making the “China” case, Edwards refers to a post we published recently, and cautions that “investors are convinced that China?’s policymakers remain firmly in control of economic events.” Here’s why that is no longer the case.
But Gordon Johnson of Axiom Capital notes it may be that the China credit multiplier, after years of diminishing returns, is finally exhausted. He writes, “given what we’ve seen this year – ie 101.7% new credit issuance growth YTD through Oct. 2017 (see chart below) – it seems the level of credit necessary to stimulate growth in China could prove elusive at this point. We don’t recall any economist’s forecasts exiting 2016 pointing to China’s new credit issuance more than doubling Y/Y in 2017, yet that’s exactly what’s happened. Had this been our base case, we would have expected all economic indicators in China to be moving substantially higher at this point in the cycle.”
Edwards then goes full circle to reach the same conclusion we have referenced so many times: the next crash will come out of China, and it will be at Beijing’s doing:
On this view if China?s policymakers are now pressing hard on the policy brakes after their politically expedient puffing up of the economy, a soft landing might prove more elusive than almost any investor currently assumes. Could this yet be the trigger that blindsides investors?
It could, especially since it was -ironically enough – China which in early 2016 halted what then appeared to be a global risk crash:
… it was this February?s Shanghai G20 deal that marked the point when global investors totally removed China from their watch list of things to be concerned about. That G20 meeting saw an agreement not to engage in further competitive devaluation and helped reverse the period of sustained dollar strength that had been exacerbating the renmnibi”s problems (weaker US economic data in the face of huge dollar bullishness also helped reverse the dollar?s prior relentless rise). Hence investors are very relaxed about China at exactly the point they should not be.
Which is why it would be so delightfully ironic once the next global crash originates out of China, the same country that saved the world with its gargantuan credit creation first in 2008/2009 and the second time in 2016/2017. Ironic, or perhaps the right word is paradox…