When an Easy Fed Doesn't Help Stocks (and When It Does)

Weekly Market Comments (click for full report)
September 21, 2015
by John P. Hussman, Ph.D.

*** Critical report for understanding Fed policy consequences *** [Lionscrest]

Last week, the Federal Reserve chose to do nothing to move short-term interest rates away from zero after nearly 6 years of extraordinary policy distortion. As detailed below, the inaction of the Fed, and the failure of the stock market to advance in response, follows the script that I detailed in February. Policy makers at the Fed actually appear to believe – contrary to historical evidence and contrary even to the recent experience of numerous countries around the world – that activist monetary policy has meaningful and reliable effects on subsequent economic activity. It’s lamentable that otherwise thoughtful policy makers, much less journalists who cover these actions, show no interest in how weak these correlations are in actual data, and seem incapable of operating even the most basic scatterplot. Despite the spew of projectile money creation around the world, the global economy is again deteriorating. The main defense of the Fed’s inaction seems to be that years of zero interest rate policy have been hopelessly ineffective, so continued zero interest rate policy is necessary.

As we’ve demonstrated previously, there’s no statistical evidence in the historical record to suggest that activist monetary policy has any relationship to actual subsequent economic activity (see The Beauty of Truth and the Beast of Dogma). Historically, monetary policy variables themselves can be largely predicted by previous changes in output, employment and inflation. That “systematic” component of monetary policy does have a weak correlation with subsequent economic changes. It’s unclear whether that’s purely incidental, or whether those systematic changes in monetary variables (such as short-term interest rates) are actually necessary for the weak effects that follow. I should be careful to note that monetary policy also seems to weakly influence confidence expressed in certain survey-based questionnaires. But that correlation emphatically does not translate into changes in actual output, income, or employment. Put simply, massive activist deviations from systematic monetary policy rules provide no observable economic benefit, but instead create fertile ground for speculative bubbles and crashes.

Despite its wild grandiosity, Fed intervention was not what ended the global financial crisis. Recall that the global financial crisis ended – and in hindsight ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned FAS 157 “mark-to-market” accounting, in response to Congressional pressure from the House Committee on Financial Services on March 12, 2009. That change immediately removed the threat of widespread insolvency by making insolvency opaque. This might not have meant much if regulators had continued to insist on mark-to-market when evaluating bank solvency. But with regulators willing to go along, the global financial crisis ended with the stroke of a pen.

Those who hail the March 2009 replacement of mark-to-market with mark-to-unicorn as a “necessary” response miss the point (though Iceland has actually done quite well relative to the rest of the world, despite initial disruption, by insisting on massive bank restructuring rather than playing extend-and-pretend). The point is that Fed intervention did not end the crisis, nor would a global financial crisis have occurred in the first place without combination of an activist Fed and a misregulated financial sector. Absent the restoration of Glass-Steagall and greater rules-based constraints on the Federal Reserve, none of the policy responses since 2009 (including Dodd-Frank) effectively reduce the risk of similar speculative bubbles and crises in the future.

Fed easing certainly increased the stock of bank reserves and enabled banks to satisfy withdrawal demands during the crisis – the legitimate function of a central bank. Ben Benanke's violation of Section 13(3) of the Federal Reserve Act (which has since been rewritten by Congress to spell the law out like a children's book) also helped some financial insitututions illegally dump bad securities onto the public balance sheet. Despite these actions, Fed intervention did not produce the economic recovery. The entire recovery we’ve observed in the economy since 2009 has actually represented standard, systematic mean reversion. Indeed, as I demonstrated in March (see Extremes in Every Pendulum), the actual progress of the economy since 2009 has actually been somewhat below what would have been predicted from past values of non-monetary variables alone. Adding monetary variables does not meaningfully improve the power to explain either recent or historical economic fluctuations.

Instead, the main impact of suppressed interest rates is to encourage yield-seeking speculation, to give low quality creditors access to the capital markets, to misallocate scarce saving, to subsidize leveraged carry trades, to reduce the long-term accumulation of productive capital, and to foment serial bubbles and crashes.

Understand this in no uncertain terms: the only economic activities that are encouraged by zero interest rates are activities so marginal and unproductive that they can’t survive even a slightly higher hurdle rate, or where the primary cost of the activity is interest itself, such as leveraged speculative “carry” trades by hedge funds and financial institutions.

What created the housing bubble and global financial crisis? The Fed’s policy of suppressing interest rates. That’s what drove investors to seek higher yields in mortgage debt (which had until then never experienced a widespread default crisis). Wall Street responded to the demand by creating more “product,” but the only way to do that was to lend to increasingly marginal borrowers – hence subprime and no-doc lending to anyone capable of drawing a breath. Institutions, largely under the protection of government insurance, then went about the slicing, dicing and repackaging of “financial engineering” to turn garbage into flowers. Other hedge funds and institutions further enlarged the bubble through speculative carry trades: borrowing heavily at cheap rates to finance massive leveraged purchases of collateralized mortgage securities.

As that yield-seeking bubble was emerging, I observed, “why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. Much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.” The repeal of Glass Steagall (which would have prohibited banks to mingle insured banking with reckless speculation), and weak regulatory oversight certainly contributed to creating the global financial crisis. But the Federal Reserve’s suppression of interest rates was at the root of all of it.

We are doing – we have already done – all of this again, only with different instruments. The low-doc loans of the housing bubble have been replaced by the covenant-lite debt of the recent bubble. Housing has been replaced by debt-financed equity repurchases and leveraged buyouts, taking the median stock to more extreme valuations than at the 2000 peak, and putting the capitalization-weighted S&P 500 within 15% of its peak 2000 valuation on measures (e.g. market capitalization to GDP or corporate gross value added) most strongly correlated with actual, subsequent total returns on stocks. From current valuations, investors should expect zero total return on the S&P 500 over the coming decade (see All Their Eggs in Janet’s Basket).

Part of the reason the Fed found it so difficult last week to justify a move away from zero interest rates is that the Fed seems incapable of recognizing, much less admitting, the speculative risks it has created. The strongest reason to normalize monetary policy was to reduce those risks, but the proper time to have done that was years ago. At this point, obscene equity valuations are already baked in the cake on valuation measures that are reliably correlated with actual subsequent stock market returns. At this point, hundreds of billions of dollars of low-grade covenant-lite debt have already been issued at risk premiums that are next to nothing. The bursting of this bubble is no longer avoidable. If history is any guide, policy makers will manage the resulting disruption by the seat of their pants, since they seem incapable of learning from history itself.

With the Fed showing no willingness to recognize the speculative risks of what it has done, it was left trying to justify a policy normalization based on an economy that remains uninspiring. Justifying a rate increase on a purely economic basis was impossible, but the logic of leaving rates unchanged was equally tortured – that zero interest rates have had so little impact on the real economy that a continuation of zero interest rates is actually justified. In the end, the Fed was forced to play the same “we expect the economy to strengthen soon” game it has been playing for years. Unfortunately, with new orders and order backlogs uniformly weak across numerous regional Fed and purchasing manager’s surveys, and with unsold inventories accumulating, the prospects for fresh economic weakness remain much stronger than the prospects for surprising near-term strength.

In the end, we expect the following outcome to unfold over the coming quarters: a) the headline economic numbers will likely weaken rather than strengthen; b) the Fed will likely discover that the opportunity to normalize interest rates has passed; c) unless investors shift back to risk-seeking preferences, as evidenced by uniformity of market action across a wide range of internals, even fresh Federal Reserve easing can be expected to be accompanied by a steep market retreat.