February 9, 2016

“My name is The Market and I’m a Fedaholic.”

Since the Fed raised interest rates in December, many market participants must be feeling as though they just went cold turkey. In less than two months, the S&P500 is down nearly 10%, the VIX has surged and the gold price, the barometer of falling economic confidence, has risen sharply off its lows.

The bad news is that this is just the beginning of a long and painful process. Over the past ten years, global markets have become addicted to a combination of drugs. Now, for the first time in nearly a decade, the market is facing the real possibility that those drugs are denied.

The first drug is low short-term interest rates. In truth, the markets have been experimenting with this drug for many years, so much so that much of its potency has worn off.

The second drug, a far more dangerous and potent drug, is monetary base expansion. Monetary base expansion has been used by the Fed to suppress long-term interest rates. Long-term rates have a far more potent impact on equity markets than short-term rates because the long-term risk free rate is a key input into the required cost of long-term risk capital, a key factor in the determination of stock prices.

Any attempt to wean the market from these drugs is going to be difficult. Indeed, saying that it will be “difficult” is like saying that breaking an addiction to heroin is “difficult”.

Breaking and recovering from a serious drug addiction is a process, a long and painful process. Breaking the markets addiction to the Fed drug cocktail will involve many difficult and painful steps and is unlikely to be a simple, linear process.

Moreover, equity market investors who think, “the worst may be over”, are in for a rude shock. We will discuss the economics of this in more detail shortly, but first a simple analogy.

Let’s imagine that the market is the drug addict and the addict is being dragged off to rehab. The view of The Money Enigma is that the Fed’s action in December was the equivalent of getting the addict into the car and fastening the seat belt. Not only have the markets not begun the process of rehabilitation, they haven’t even reached the rehab center.

The first series of Fed rate hikes that are expected this year (2016) are the equivalent of getting the addict to the door of the rehab center. But the real rehabilitation process doesn’t begin until the Fed begins to reduce the size of the monetary base.

The big question for investors over the next two years is not so much whether the Fed will drive the markets to the rehab center, i.e. whether the Fed will raise the fed funds rate by 100-150 basis points, but whether the Fed will have the courage to get the markets out of the car and into the rehab center when they arrive at the door, i.e. will the Fed actually reduce the size of the monetary base.

If the Fed buckles under the pressure of the screaming addict in the back seat of the car and decides not to drag the addict out of the car, or worse, turns the car around before they even get to the rehab center, then the long-term future for the addict becomes dire. We will discuss this alternate future at the end of this article, but first, let’s discuss the market’s addiction to “easy money” and the path to sobriety.

The Growth of an Addiction

It has been widely noted by many market commentators that the direction of the global equity markets has become increasingly dependent upon Federal Reserve policy over the years.

Back in the 1990s and 2000s, the market became increasingly reliant on the economic stimulus created by manipulations in the fed funds rate. As Washington became increasingly dysfunctional and unable to provide clear leadership regarding economic stimulus, the markets turned to the their friends at the New York Fed and convinced the Fed that their primary role was to smooth out the economic cycle, particularly on the downside.

The Fed, under the leadership of Alan Greenspan, was more than happy to take on its new celebrity status and the Greenspan Fed created an art form of justifying sharp moves in the fed funds rate under the premise that “the Fed knows best”.

For our purposes, what is interesting about this first drug (manipulation of the short-end of the interest rate curve) is that it primarily operated through the impact it would have on lending and economic growth. In other words, this drug operated somewhat indirectly upon stock prices: lower interest rates drove higher lending and economic growth that boosted confidence in the long-term cash flows of equity securities.

The problem with this first drug is that the addict (the markets) became so accustomed to it that lost its potency. During the 2008 crisis, the Fed cut the fed funds rate to zero, but this alone wasn’t enough to provide the rush that the market (and the economy) needed to overcome the fallout from the excesses that had occurred over the previous two decades (notably, Tech Boom 2000 and Housing Boom 2006).

What was the Fed to do? They came up with a new drug: quantitative easing or “QE”.

Quantitative easing is a much more potent drug than simple fed funds rate manipulation because it acts as a direct shot in the arm for the equity markets. Whereas old school fed funds rate manipulation tended to act indirectly upon the financial markets, QE had a very direct impact upon the securities markets.

Why is this the case? Well, in order to understand how QE acts on stock prices, we need to go back the basics of securities valuation. Those that are interested in a detailed discussion of this topic should read “Has the Fed Created the Conditions for a Market Crash?” But for now, we will just touch on the key points.

In essence, the price of a business depends upon the sum of the discounted future cash flows of that business. There are two keys items that determine this calculation: (a) the future cash flows of the business and (b) the discount rate.

As discussed earlier, manipulation of the fed funds rate operated primarily by influencing the first item in that calculation, expected future cash flows. When the fed lowered short-term interest rates, economic growth would rise and people become more optimistic about the long-term path of future cash flows for the market.

QE is different because it acts directly upon the second item in our calculation, the discount rate. Why does QE have a greater impact on the discount rate than changes in the fed funds rate? QE is more potent because stocks are long duration assets, i.e. the value of the typical stock depends critically upon long-term expected cash flows.

What is the discount rate used to discount these long-term future cash flows? The long-term required return on risk capital. QE acts by forcing down the long-term risk free rate, thereby lowering the long-term required return on risk capital.

In other words, QE acts as a direct shot in the arm for equity markets. By expanding the monetary base and using this money to buy long-term government debt, the Fed forces up not only the price of “safe” assets (debt) but also the prices of “risky” assets (stocks).

If you don’t believe that this theory is plausible and you doubt the impact of monetary base expansion on the stock market, then I would encourage you to have a hard look at this next chart that plots the recent growth in the monetary base against the recent performance of the S&P 500 (all data is from the St. Louis Fed).

The Markets are Tweaking

The view of The Money Enigma is that the recent volatility experienced in global financial markets represents just the beginning of a long withdrawal process. In simple terms, the markets are “tweaking” as they begin to come off the “easy money” high.

Indeed, there is a strong analogy that can be made between the use of monetary base expansion and the markets dependence upon that stimulus and the experience of the typical methamphetamine addict. More specifically, monetary base expansion (or “money printing”) is a potent drug that creates exhilarating highs and debilitating lows.

We can apply the seven stages of addiction model for methamphetamines to the market cycle associated with easy money. As described in an article published in July last year, “Monetary Base Expansion: The Seven Stages of Addiction”, there are seven stages in the easy money cycle.

In the first stage, “the Rush”, the immediate pressure of an economic crisis is relieved by central bank intervention in the markets, i.e. creating money and using this money to buy bonds.

In the second stage, “the High”, the markets are in a more optimistic state and decide that the risks of monetary intervention (drug use) are low, i.e. “this time is different” and “we can handle it”.

In the third stage, “the Binge”, the overconfidence created by the first experimentation (QE1) leads to a period of poorly controlled use of the drug (QE23/QE3), or a “binge”. Typically, this is the point where the user becomes delusional and aggressively overconfident. (Does the chart below suggest any of this type of behavior in the last few years?)

Today, we find ourselves in the fourth stage, “Tweaking”.

Tweaking occurs as the level of the drug in the users system begins to decline below a critical level. For the markets, the Fed’s first interest rate rise in December triggered the realization that the easy money drug cocktail is going to be slowly withdrawn. In essence, the Fed has bundled the markets into the car and told them they are going to rehab.

In the tweaking phase, addicts become increasingly nervous and erratic. The market volatility over the past couple of months is symptomatic of this kind of behavior. But this is unlikely to be the worst part of the experience.

In the fifth phase, appropriately called “the Crash”, the positive impacts of the drug wear off and the addict, at least temporarily, becomes unable to complete the simplest of tasks, i.e. market failure occurs, at least temporarily.

What would it take for the markets to enter the “Crash” phase? It isn’t entirely clear. Will the Fed need to reduce the size of the monetary base before the cost of capital resets and the markets fall accordingly? Or will simply the promise of monetary base reduction and a few more interest rate rises be enough to trigger such an event?

Nevertheless, while the precise path to recovery may not be clear, the markets will need to go through the recovery process at some point, a process that involves not just a “Crash” phase, but also prolonged “Hangover” and “Withdrawal” phases.

Undoubtedly, there are those that will argue that the market is a discounting mechanism and the withdrawal of monetary stimulus is “priced in”. While this may be true about the upcoming series of Fed rate hikes, it seems unlikely to be true when applied to the possible reversal of QE over the next 3-5 years. Not only is a reversal of QE a more distant possibility, but also it still isn’t clear that market participants really understand how QE acts on the long-term cost of risk capital and how a reversal of QE will significantly raise this cost of capital, thereby placing the equity markets under enormous pressure.

If it doesn’t sound like a good future, it isn’t. But, what happens if the Fed doesn’t “normalize” monetary policy, i.e. if the Fed doesn’t raise rates and substantially reverse QE? What if the Fed doesn’t force the markets into rehab? What if the Fed doesn’t even make it to the rehab center? Well, then a worse long-term fate awaits the markets.

The Addict that Didn’t Make It

In the media, we hear a lot of stories about addicts that have recovered from their terrible and self-inflicted drug addictions. What we don’t hear about as often are the ones that don’t make it. Amy Winehouse, writer of the song “Rehab”, was one the famous exceptions to this rule.

Perhaps this bias in the media has contributed to the idea, not endorsed by The Money Enigma, that “drugs are OK, I can deal with it, after all, I can always go to rehab and get clean just like the celebrities do”.

Interestingly, this same sense of recklessness and self-confidence seems to be a hallmark of the historical experimentation with money printing. No society starts the process of money printing believing that it will all end in disaster. Rather, money printing is always presented as a necessary solution to a crisis and, at least in the initial phases, it is generally met with widespread popular approval.

Unfortunately, monetary base expansion is an experiment that seldom ends well. Just like drugs, the problem with monetary base expansion wouldn’t be so serious if the experiment was truly a “one off”. But inevitably, experiments with temporary expansions in the monetary base end up becoming permanent addictions to higher levels of money creation.

If you go back to early 2009, you might remember that QE1 was promoted by the Fed as an emergency solution to a crisis that genuinely threatened global financial markets, i.e. it was a temporary response to a temporary problem. Similarly, QE2 and QE3 were advertised as temporary measures to get the US economy back on track. All of these were noble goals, but the problem is that, nearly seven years later, none of these “temporary” measures have been reversed.

Why does this matter? Well, the problem with permanent expansions of the monetary base is that, sooner or later, they have a severely negative impact on the value of fiat money and, as the value of fiat money falls, prices as expressed in money terms rise.

The view of The Money Enigma is that fiat money represents a proportional claim against the future economic output of society (see “Theory of Money” section). What this means in practice is that the value of fiat money depends upon expectations regarding the long-term future path of two variables: real output and the monetary base. The value of fiat money is positively correlated to long-term expectations regarding real output and negatively correlated to long-term expectations regarding the size of the monetary base.

If an expansion in the monetary base is expected to be temporary, then this will have little impact on the value of fiat money. However, if an expansion in the monetary base is expected to be permanent in nature, then this will have an immediate negative impact on the value of money.

Moreover, if an expansion in the monetary base that was advertised as “temporary” suddenly becomes “permanent”, then the value of money can collapse quite quickly, triggering a dramatic acceleration in the rate of inflation.

And here, in a nutshell is the problem for the Fed and the addict in the back seat of the car. If the Fed sends the markets to rehab, it will be an unpleasant experience for financial markets and the economy, but at least a “survivable” experience. However, if the Fed flinches and fails to send the markets to rehab, then the dollar will collapse and the rate of inflation in the US will soar. In this second scenario, the Fed will lose control of the economic agenda and the markets will find that living with the drug is worse than living without it.