Little Meat for Kremlinologists

The central planners have struck again, and surprised no-one, as the outcome of the most recent FOMC meeting was well telegraphed in advance. As the trusty WSJ FOMC statement tracker reveals, we are once again in a phase when very little in the statement is changed from month to month.

Apart from the widely expected announcement of additional 'QE tapering', the only difference to the last statement could be found in the first paragraph (the altered sentences are highlighted below):

“Information received since the Federal Open Market Committee met in March indicates that growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Household spending appears to be rising more quickly. Business fixed investment edged down, while the recovery in the housing sector remained slow.”

Aren't weather conditions always 'adverse' in the winter? The mixture of increasing consumption and falling business investment could be an early warning sign of an economic upset. Let us not forget, relative prices and the economy's production structure have once again been severely distorted by monetary pumping, arguably more than ever. In the past several years, the boom-bust cycles seem to have become ever more extreme.

At some point these distortions will once again come home to roost. Once a boom is in its latter stages, it becomes increasingly difficult to sustain bubble activities, and they tend to require ever larger doses of credit and money creation to continue. Any voluntary reduction in monetary pumping will eventually unmask the fact that these activities would have been unprofitable under free market conditions and that they have consumed wealth rather than creating it.

The bursting of the housing bubble and the associated mortgage credit bubble in 2007-2008 was in fact such an 'unmasking'. The losses that were revealed in the course of the bust masqueraded as profits during the boom, but these only represented illusory accounting profits – the result of falsified economic calculation.

Policy Becomes Tighter

The current FOMC voting roster includes two very vocal and determined 'hawks', Richard Fisher and Charles Plosser. Both have been very uncomfortable with  Ben Bernanke's policy of 'extraordinary accommodation', and rightly so. Since the Fed is quite concerned about its credibility, it will find it difficult to reverse the current 'tapering' path before there are clear signs of an economic downturn.

As long as the data remain 'mixed', the policy will likely continue. We want to reiterate that this indeed represents 'tightening', even though the Federal Funds rate is set to remain near zero for a long time. 'QE' has been almost the sole driver of money supply growth in the US in recent years, and less QE should therefore lead to a further slowdown in money supply growth (it could be that the commercial banks will increase the pace of their inflationary lending, but evidence for this is so far scant).

Regarding the post-winter season pickup in economic activity mentioned in the FOMC statement, there has indeed been a slight improvement in 'economic surprises' as the Citigroup economic surprise index shows – however, so far this is only a small blip and the index remains in negative territory (which means that negative surprises have outpaced positive ones over the past three months).

The Citigroup economic surprise index – click to enlarge.

The index tends to move strongly in one direction and once it reverses, usually moves just as strongly in the other. This is due to the fact that most economists tend to adapt their forecasts of economic data releases by extrapolating what has happened very recently. Once they have over- or underestimated things for a while, they tend to 'catch up' with the trend just as it is about to reverse again. One  could well conclude that the main message of this indicator is that most economists are lousy forecasters.

What is interesting though is that the stock market has on many occasions lagged relative to the 'surprise index' in recent years. In other words, it confirms something we have remarked on previously: the stock market no longer seems to be a reliable leading indicator of economic activity.

More Price Distortions due to Heavy Interventionism

We believe the reason for this phenomenon is that central banks have sharply increased the pace of their monetary pumping since the peak of the late 1990's tech stock mania. As a result, ever more markets experience price distortions, with prices often bearing very little or no relationship to the underlying reality. In this context readers may want to consider the odd behavior of the JGB market we discussed yesterday, which is quite an extreme example of such a distortion of prices induced by central bank policy.

With regard to the JGB market, a friend mentioned the following interesting data points to us. They are from a survey of Japanese bond investors taken in March, who were asked about their 'inflation expectations' (expected future CPI) over different time horizons:

“1 year average expectations accelerated to 1.97% from 1.82% the  previous month, while 2yr average expectations rose to 1.81% from 1.72%. Both 1yr and 2yr inflation expectations are their highest level since mid-2004 when the data began. 10 year average inflation expectations also rose to 1.39% from 1.36%, but the level is still slightly lower than the recent peak of 1.45% in December 2013. As actual inflation remains strong, it is not surprising to have higher inflation expectations for near future."

It is quite obvious that a 10 year JGB yield of 60 basis points makes not the slightest bit of sense under these circumstances. It is solely the result of intervention by the BoJ.

Investors must consider that the same thing applies to current stock and bond prices (especially corporate bonds of the high yield variety). Since the policy that has produced the distortions is slowly being reversed, there will at some point be a price adjustment, and given the staggering leverage in the financial system – which is at a new all time high – this future price adjustment is unlikely to be a peaceful or modest affair.

Also, the idea that 'fundamentals' such as current earnings (which are going hand in hand with extremely elevated profit margins that have historically always mean-reverted) are supporting valuations is misguided. One must always keep in mind that the accounting profits booked during an inflationary boom are illusory to varying extents. This isn't going to apply to all companies or sectors to the same degree, but the recent boom has been quite diffuse in its effects, i.e., the effects have been distributed over a wide range of industries.

Conclusion:

With every new round of 'QE' tapering, the air is getting thinner for the markets. 

The Russel 2000 index vs. the SPX (RUT-SPX) and the NDX-SPX ratio. Weakness in previously leading small caps and tech stocks relative to big caps is very likely a warning sign for the market – click to enlarge.

Charts by: stockcharts, sentimentrader