In spectacular fashion, over the past few weeks, stark reminders emerged on how fast confidence unravels in the midst of a slowdown, particularly so, when the slowdown is doused with policy response errors. A conflux of negatives compounded to send US financial markets into bear market territory, ultimately, calling into question the economic expansion since 2009.

What happened?

What started with a run of the mill correction, due to slowdown fears, turned into an all out rout in risk assets. The economy and financial system is more fragile than previously perceived. Since the financial crisis, an implicit “fed put” has cushioned the downside of every economic slowdown, and market pullback. The thought process goes something like: every time something bad happens, the fed will accommodate, so why purchase downside protection (a put option) since the Fed has my back. The recent Fed meeting amounted to the first time (this economic cycle) that the Fed surprised, in a genuinely hawkish fashion, during a rough patch in the market. The action led to a bear market.

To be fair, the bear market dynamics have 3 main causes:

1) A peaking of economic growth / peaking of earnings growth

2) A tone deaf Fed

3) Donald Trump

All three factors became greater concerns/risks at the same time. The first factor, slowing growth, was inevitable; after all, we are 9-years deep into an economic expansion. Donald Trump being a destabilizing factor isn’t new, and isn’t unexpected. An overly hawkish Fed is a new development and tipped markets, and confidence, over the edge, exposing fragility.

Bernanke and Yellen consistently erred on the side of dovish caution. In 2007, the Fed incorrectly assessed the economic meltdown based on housing but did respond aggressively with quantitative easing. The idea of quantitative easing: to lower interest rates, narrow credit spreads, support housing, boost stock prices, and support consumer spending. In short, it worked. After Bernanke’s reign as Fed Chairman, Yellen was excessively gentle with normalizing monetary policy. Bernanke and Yellen were students of the mistakes made by the Bank of Japan (too tight policy) which led to a decade of lost economic growth. With QE so successful, it is reasonable to believe that the unwind, quantitative tightening (QT), the reduction of the Fed balance sheet, will have a severe dampening effect and should be approached with extreme caution. Jay Powell’s tone deaf response, that QT would continue on auto-pilot, after markets already had been crashing, and credit conditions deteriorating, amounted to a push over the precipice. The current cycle being fueled by excessively easy monetary conditions, for close to a decade, makes the recovery fragile. The air needs to be let out of the balloon slowly.

NY Fed President, John Williams, attempted to walk back the hawkishness of Powell by stating that QT would be evaluated based on current conditions. So the “Fed put” still exists, it is just struck lower than the current level of stress. Markets have an uncanny way of forcing the correction of bad policy. The environment is likely to get worse until the Fed’s hand is forced, and QT is put on pause indefinitely.

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1 Comment

  1. Charlie Brown on December 27, 2018 at 11:56 pm

    All true, but astutely apolitical. The deeper question is about positional power over the population in the next decade. Who has the ability to shake the markets like this, to tip the first Domino? Darth Soros, The Fed, Google, Facebook, and Chinese investors have now made their move on the American population, restricting and controlling conservative info, destabilizing stocks, all to murder the recovery that was beginning with Trumps stamp of approval. The American people are so overworked and underpaid that many teachers, technicians, and municipal workers literally have no idea what has taken place at the NYSE this week, they are too busy. But rest assured, this only serves to clarify that the investment class are in their own little world, high above us, while the serfs grow poorer by the digital minute. Civil war is the underlying conversation in every senate and congress office, if this continues. Shortly put. these financial overlords are leaving us behind. Will Americans allow corporations to rape their futures; and will the social network corporate Left acknowledge that it is using fascist tactics by ghettoizing and deleting speech of the Right. Ofcourse not. So off we go into this constructed famine, yet again.

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