Recommended Links: A Sense of Ending, Misplaced Belief in Central Bankers and Dangerous Delusions

Bond Maven William H Gross believes that the endgame for central bank magic nears. Selected excerpts from his monthly outlook at Janus Capital, (bold mine)

A “sense of an ending” has been frequently mentioned in recent months when applied to asset markets and the great Bull Run that began in 1981. Then, long term Treasury rates were at 14.50% and the Dow at 900. A “20 banger” followed for stocks as Peter Lynch once described such moves, as well as a similar return for 30 year Treasuries after the extraordinary annual yields are factored into the equation: financial wealth was created as never before. Fully invested investors wound up with 20 times as much money as when they began. But as Julian Barnes expressed it with individual lives, so too does his metaphor seem to apply to financial markets: “Accumulation, responsibility, unrest…and then great unrest.” Many prominent investment managers have been sounding similar alarms, some, perhaps a little too soon as with my Investment Outlooks of a few years past titled, “Man in the Mirror”, “Credit Supernova” and others. But now, successful, neither perma-bearish nor perma-bullish managers have spoken to a “sense of an ending” as well. Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others warn investors that our 35 year investment supercycle may be exhausted. They don’t necessarily counsel heading for the hills, or liquidating assets for cash, but they do speak to low future returns and the increasingly fat tail possibilities of a “bang” at some future date. To them, (and myself) the current bull market is not 35 years old, but twice that in human terms. Surely they and other gurus are looking through their research papers to help predict future financial “obits”, although uncertain of the announcement date. Savor this Bull market moment, they seem to be saying in unison. It will not come again for any of us; unrest lies ahead and low asset returns. Perhaps great unrest, if there is a bubble popping…

At the Grant’s Conference, and in prior Investment Outlooks, I addressed the timing of this “ending” with the following description: “When does our credit based financial system sputter / break down? When investable assets pose too much risk for too little return. Not immediately, but at the margin, credit and stocks begin to be exchanged for figurative and sometimes literal money in a mattress.” We are approaching that point now as bond yields, credit spreads and stock prices have brought financial wealth forward to the point of exhaustion. A rational investor must indeed have a sense of an ending, not another Lehman crash, but a crush of perpetual bull market enthusiasm.

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Sovereign Man’s Simon Black on Walter Bagehot’s exposition of the public's halo effect on central banking (bold mine)

Bagehot was Editor-in-Chief of The Economist at the time. He was a brilliant finanical thinker, and the book, Lombard Street: A Description of the Money Market, was his masterpiece.

For example, the book describes how, even though the British banking system was the most widely used and powerful in the world, it was dangerously overleveraged:

“There was never so much borrowed money collected in the world as is now collected in London,” writes Bagehot.

He further shines a huge spotlight on the risks of illiquidity, describing how Britain’s largest banks only held a very small percentage of their customer’s funds in cash:

“[T]here is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England.”

He continues:

“[T]he amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.”

…

Bagehot also blasts the central banking system (dominated by the Bank of England) which had effective control over the economy:

“All banks depend on the Bank of England, and all merchants depend on some bank.”

Of course, no one truly understood how that system worked. Everyone just had confidence that the central bankers were smart guys and absolutely would not fail:

“[F]ortunately or unfortunately, no one has any fear about the Bank of England. The English world at least believes that it will not, almost that it cannot, fail.”

“[N]o one in London ever dreams of questioning the credit of the Bank, and the Bank never dreams that its own credit is in danger.”

But as Bagehot points out, the data showed otherwise:

“Three times since 1844 [the Bank of England] has received assistance, and would have failed without it. In 1825, the entire concern almost suspended payment; in 1797, it actually did so.”

Clearly these central bankers weren’t particularly good at their jobs. Bagehot sums it up like this:

“[W]e have placed the exclusive custody of our entire banking reserve in the hands of a single board of directors not particularly trained for the duty—who might be called ‘amateurs’. . .”

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Former Chairman of Morgan Stanley Asia, now senior fellow at the Yale Institution worries over the world having gone mad, excerpts from the Project Syndicate

But fear not, claim advocates of unconventional monetary policy. What central banks cannot achieve with traditional tools can now be accomplished through the circuitous channels of wealth effects in asset markets or with the competitive edge gained from currency depreciation.

This is where delusion arises. Not only have wealth and currency effects failed to spur meaningful recovery in post-crisis economies; they have also spawned new destabilizing imbalances that threaten to keep the global economy trapped in a continuous series of crises.

Consider the US – the poster child of the new prescription for recovery. Although the Fed expanded its balance sheet from less than $1 trillion in late 2008 to $4.5 trillion by the fall of 2014, nominal GDP increased by only $2.7 trillion. The remaining $900 billion spilled over into financial markets, helping to spur a trebling of the US equity market. Meanwhile, the real economy eked out a decidedly subpar recovery, with real GDP growth holding to a 2.3% trajectory – fully two percentage points below the 4.3% norm of past cycles.

Indeed, notwithstanding the Fed’s massive liquidity injection, the American consumer – who suffered the most during the wrenching balance-sheet recession of 2008-2009 – has not recovered. Real personal consumption expenditures have grown at just 1.4% annually over the last seven years. Unsurprisingly, the wealth effects of monetary easing worked largely for the wealthy, among whom the bulk of equity holdings are concentrated. For the beleaguered middle class, the benefits were negligible.

“It might have been worse,” is the common retort of the counter-factualists. But is that really true? After all, as Joseph Schumpeter famously observed, market-based systems have long had an uncanny knack for self-healing. But this was all but disallowed in the post-crisis era by US government bailouts and the Fed’s manipulation of asset prices.

America’s subpar performance has not stopped others from emulating its policies. On the contrary, Europe has now rushed to initiate QE. Even Japan, the genesis of this tale, has embraced a new and intensive form of QE, reflecting its apparent desire to learn the “lessons” of its own mistakes, as interpreted by the US.

But, beyond the impact that this approach is having on individual economies are broader systemic risks that arise from surging equities and weaker currencies. As the baton of excessive liquidity injections is passed from one central bank to another, the dangers of global asset bubbles and competitive currency devaluations intensify. In the meantime, politicians are lulled into a false sense of complacency that undermines their incentive to confront the structural challenges they face.

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