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Trusting the Fed: Will the White Knight Save the Day?

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As we reported last week, investors are in an era of “irrational exuberance.

The US stock market is at all-time highs. Meanwhile, market volatility is at lows not seen since the 1990s. In an odd juxtaposition of seemingly contradictory points of view, investors realize the market is overvalued, but at the same time, they believe it will continue to go up. According to a Bank of Ameria survey, 56% of money managers project a “Goldilocks” economic backdrop of steady expansion with tempered inflation.

In an article published at the Mises Wire, economist Thorsten Polleit adds some further analysis and asks a critical question.

Credit spreads have been shrinking, and prices for credit default swaps have fallen to pre-crisis levels. In fact, investors are no longer haunted by concerns about the stability of the financial system, potential credit defaults, and unfavorable surprises in the economy or financial assets markets.

“How come?”

In simplest terms, most investors now believe the Federal Reserve will ride in like a white knight and save the day.

After all, the Fed saved the day before. Surely it will do it again.  Peter Schiff put it this way during an interview on The Street.

I think one of the reasons is because the last two times the market went down, the Fed was able to bail out investors who bet on one bubble by inflating a bigger one. So, a lot of investors may have been conditioned to believe that even if the market implodes, if they hold on, they’ll get their money back. But you know, the third time may not be the charm.”

Polleit has come to the same conclusion.

The truth is that investors expect central banks to provide a ‘safety net.’ This expectation encourages them to make risky investments again (which they would otherwise have declined). That said, central banks have caused a colossal ‘moral hazard’: Investors feel pretty much assured that the risk-reward profile of their investments has become more favorable — that they can enjoy a considerable upside, while the downside is limited.”

“As a result, investors drive asset prices upwards. As stock prices rise, firms’ cost of capital falls, encouraging risky investments. Consumers, with their real estate assets appreciating, go into even more debt. Maturing debt is rolled over at low interest rates, and borrowers’ spending capacity increases. In other words: The downward manipulation of interest rates and the decline in risk aversion translates into a cyclical strengthening of the economy.”

The problem here should be obvious. The Fed is now pushing to “normalize” rates. It is nudging interest rates up and has tentatively started shedding assets from its balance sheet. Shouldn’t that cause concern?

Not if you have faith in the fidelity of the white knight. Polleit believes most people in the mainstream investment world do.

The crucial point is the Fed’s safety net: If investors continue to assume that the Fed willingly remains the ‘lender of last resort’, even a monetary policy of some short-term interest rate hiking is unlikely to do much harm to the current recovery. Here is why: If things turn sour, the Fed is expected to reverse its restrictive monetary policy. This may well explain why financial markets have remained rather relaxed in the light of the Fed’s current hiking cycle, which has begun back in December 2015. And markets haven’t become unsettled because of the Fed’s plan to shrink its bloated balance sheet, which means, inter alia, a reduction of liquidity in the US banking system and the quantity of money.”

So far, the Fed has taken a cautious approach to raising rates. But despite all the Goldilocks optimism in the investment world, Polleit sees warning signs flashing.

Many people welcome output and employment gains, coupled with decent investment returns in asset markets, which have been brought about by the Fed’s ultra-expansionary monetary policy. However, the downside of all this should not be overlooked. Central banks around the world, under the leadership of the Fed, have in fact orchestrated yet another artificial boom — which, sooner or later, will falter and turn into bust.

“This is, by no means, a pessimistic prediction. But it is based on sound economics: A policy of artificially lowered interest, a relentless increase in the quantity of money and politically manipulated market prices simply cannot bring about greater prosperity and higher employment in the long run. To think so is delusional. The truth is that such a monetary policy will cause another round of trouble further down the road.

Here Comes the Risk

“Higher interest rates have the potential to make the credit pyramid coming crashing down. They would make it hard for many consumers to service their debt, would reveal malinvestment and result in corporate losses, and stock and housing prices would ultimately follow the law of gravity. Credit markets could become jittery as borrowers run the risk of defaulting on their debt, with banks having limited capacity to absorb payment losses in their loan books.

“This is the scenario if central banks take away the Halloween candy (aka low interest rates). Higher interest rates are one thing. Another thing is the flattening of the yield curve (meaning the difference between long- and short-term yields). A decline in the yield curve makes banks to reign in their credit supply. As bank credit supply dries up, financial market liquidity drops. The party comes to an end. Asset prices start nosediving.

“As the graph below shows, a flat or even negative yield curve has in the past been accompanied by a stock market crash. Since early 2014, the yield curve has been declining, basically because short-term interest rates have gone up, while long-term interest rates have been declining. Even though the Fed’s interest rate increases have not translated into higher borrowing costs, an ongoing flattening of the yield curve remains a reason to expect the unexpected.”

Despite the warning signs, a lot of people cling to the notion that “this time will be different.” After all, the central bankers have learned so much since the last crash. Maybe the white knight will save the day. But Polleit doesn’t share the optimism.

The Fed’s slow and gradual approach to tighten monetary policy might indeed be reducing the risk that it could “be raising interest rates too much too fast,” pricking the credit bubble, and bringing down the house of (credit) cards. However, a considerable risk remains that the Fed will once again turn the boom into bust. And let’s be honest: In view of its track record, there is little reason to expect that the Fed won’t mess things up this time.”

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