Before we developed a modern
understanding of chemical processes,
the notion that there might be some way
to cook base metals and turn them into
gold must have sounded plausible. Now
we know better. Sure, the ingredients can
always be made more esoteric, the
cooking more complex: still, you can
never obtain any gold from the pot,
unless you already had put some in.
Nature’s conservation laws inform us
that regardless of the skill of the chemist,
elements cannot be created nor
destroyed, merely re-arranged. Finance
has conservation “laws” as well, though
our central bankers theorize that their
power to “optimally” steer short-term
rates is a 21st century philosopher’s
stone. Given that asset markets have long
since learned to do as the Fed says rather
than as the fundamentals do, the
credibility of Fed policy now dictates its
durability. So, are the Fed’s actions
credible? Can we investors rely on the skill
of the Governors to see around corners
and guide the economy and capital
markets into the next Great Moderation?
Call us Thomas on this one. If there were
but a single lesson to be learned from the
last bull market it is this: extended periods
of low volatility eventually self-immolate.
This empirical observation is grounded in
simple common sense. Volatility is an
inherent feature of capital markets
because volatility is life. Circumstances
fluctuate, prospects for one industry rise
as another falls, the business cycle
matures, leverage grows. When capital
markets are doing their job, they are
properly reflecting reality by appropriately
pricing risk and opportunity. Markets are
information engines and what they have to
say matters. Prices are not supposed to be
arbitrary constructs. Just as a high stock
price tells a management team to keep
doing more of the same and then some,
a stock price falling into the tank triggers
self-reflection and hopefully self-correction.
Higher asset prices are not “better” than
low asset prices and the “best” asset price
is the one that appropriately reflects what
investors think and believe based upon the
information they have available to them.
Thus, if capital markets are to “mean”
anything, or to “be” anything other than a
souped up casino, market pricing must
reflect the fundamentals and, when found
to deviate from said fundamentals, must
necessarily re-price. To believe otherwise
would be tantamount to saying that the
asset markets are not, in fact, signaling
devices but rather just random number
generators. If that were indeed so, then, to
paraphrase Simon and Garfunkel, analysis
would not be worthwhile.
Since the financial crisis, markets have
co-habited with a central banking partner
that expects trust but that does not
trust. Rather than hear what capital
markets have to say about rates, risk
premia, and volatility, the Fed has
preferred to “optimally” guide the capital
markets to the “right” result. Problem is,
the whole reason we have markets in the
first place is because no one knows what
the “right” price for capital assets is
supposed to be. Markets are the means
by which we collectively discover where
prices should be, so that accurate
signals get sent, and properly informed
decisions can be made. Since 2009, the
Fed’s actions are very much at odds with
this view of finance.
The Fed’s thinking goes more this way:
the 2008-09 economy suffered a shock to
aggregate demand causing asset prices
to fall, unemployment to rise, and the
economy to fall well below its potential
output. If rates were kept down, asset
prices would rally causing a wealth effect,
contributing towards a renewal in
aggregate demand. Ergo, low rates are
“better” than higher rates, higher asset
prices are “better” than lower, and
volatility can be managed out of the
system by the Fed’s very own masterful
forward looking guidance on rates. While
the Fed’s intentions are laudable, history
and logic argue that the volatility you
suppress today isn’t destroyed but merely
re-arranged in time. In short, a Fed that
denies the capital markets the freedom to
adjust interest rates and risk premia in
accord with ever changing fundamentals,
is preventing the capital markets from
producing the information needed by the
entirety of the economy. Rather than let
the mirror reflect that which is, the Fed
distorts the mirror to reflect the prices
that it believes are “better.”
Investors are being led down the primrose
path. In denying markets their freedom of
expression, the chasm between that which
is real and that which is priced into the
markets gets wider with time. But unless
the Fed intends to build a new kind of
capital market, maybe one that never
knows a bear market in risk, the day must
surely come when capital market prices
are unshackled from the Fed’s guidance
and re-anchor themselves in the
fundamentals. As the latter and the former
have already substantially diverged,
investors should expect that such an
adjustment will be neither smooth nor very
much fun. Volatility suppression is a policy
that has always failed. Like a caged tiger,
volatility will spring forth, angrier and
hungrier than before it was confined.
Perhaps the Fed understands its can’t
have your cake and eat it conundrum: if
rates are going to be renormalized say
back towards its current guidance of
3.25% by 2017, then the longer it waits,
the faster rates have to be raised. Less
volatility in short rates today would
necessarily mean more volatility
tomorrow. Or, perhaps the Fed “gets” the
notion that inflated asset prices and
suppressed yields are subject to the law of
unintended consequences. Just what will
happen to the balance sheets of millions
of companies and individuals after a rate
re-normalization now that they have spent
years “filling up” on low rate long duration
assets? Or, who says that low rates have
not helped form asset price bubbles?
Does a doubling in Shenzhen stock prices
over the past six months sound like a
move based on fundamentals?
Face it: a gulf between asset prices and
their fundamentals cannot be reconciled
absent an elevation in volatility. Hence,
investment strategies whose success is
predicated on picking up yield by
“selling” volatility in the form of
incremental credit or prepayment risk are
headed for a reckoning. Relatively modest
sacrifices in yield today can be thought of
as buying rate and risk insurance for the
inevitable. One of the legacies of this
cycle will be that using extraordinary
monetary policy to abolish volatility will
prove as futile to the central bankers as
were the attempts to transmute lead into
precious metals to the alchemists.
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