- Global central bank policies have helped create conditions under which the complacent can exist and thrive.
- Markets have responded to ample liquidity and low interest rates with a desire for more. Easy money policy has become instilled as the most important marginal factor in determining asset.
- There is debate over who should take responsibility for this: central banks for fostering the conditions, or market participants gaming the system, unable to keep their greed in check.
- If the unfortunate human condition of greed is found more to blame, then only superficial changes, such as regulatory band aids, are applied to deter future financial instability.
- If central banks are concluded to play a larger role in the conditions we face today, it is logical that stakeholders should move forward with more drastic solutions.
"What worries me however is how lazy investors have gotten, totally dependent on the Federal Reserve… Are we vulnerable in my personal opinion to a significant equity market correction? I do believe we are. And the reason for that is, is people have gotten lazy. They've depended totally on the Fed… This market is hyper overpriced"- Retired Dallas Fed Chief Richard Fisher – March 20, 2015.
"I think, increasingly, bankers are discomforted more than anything else (it's not just the ex central bankers but increasingly the people that are still holding the levers)… they are starting to ask whether they have somehow been backed into a place where they don't really want to be…. Unfortunately, [it] is getting bigger and bigger. There is a possibility at least that this whole exercise could end very badly." – William R. White, former Economic Adviser at the Bank for International Settlements (BIS).
The Bull Market in Passive Investment
The word is out: "Passive" investment is thriving in today's equity and bond markets, and at the current rate of conversion, it could be expected that all remaining holdouts will be assimilated into the "passive" colony before the current bull market is over. Importantly, this is a different breed of "passive" investor than the type regularly spoken about in the world of finance. However, although this investor type is relatively new to the scene, mostly everyone reading this article will be accustomed to its characteristics:
- The "passive" investor spoken about here is characterized by a lack of investment discipline and an analytical laziness that Richard Fisher referred to during a recent CNBC television interview. "Investment strategy" for this investor boils down to allocating capital to the assets which central bank easy money policy is targeting due to their belief that the liquidity being pumped into these securities ensure positive returns despite overvaluation or other traditional investment risks. In addition, they invest in risky assets that they believe will experience a positive "spillover effect" from central policies. This is due to an understanding that six years of easy money policies since the Global Financial Crisis (GFC) have "lifted all boats," and that the performance of risky assets will be positive as long as central bankers remain supportive. They reject the idea of risk management due to their belief that markets cannot experience significant corrections during the golden age of central bank intervention. They are characterized by an apathy or "passiveness" toward investment risk.
Returning to the Richard Fisher and Rick Santelli interview quoted at the beginning of the article, the majority of their discussion was focused on the laziness of investors. Put in terms of this article, they were discussing the alarmingly widespread alteration in investor behavior toward passivity and complacency to investment risk. During their interchange, ex-FOMC member Fisher repeatedly states that what worries him is that investors are "completely dependent on the Federal Reserve," to which Rick Santelli presents an interesting question: "If I have a dog that is hungry, and every time I give him a can of food, I ring a bell, we all know that we are going to condition that dog… Has not the Federal Reserve conditioned investors to be lazy?" The debate eventually ends after Fisher retorts that he doesn't like "when market commentators come back and blame the Fed for their own problems… they want us to keep feeding them this red meat and I don't think that's the job of the FOMC."
Although the exchange was somewhat contentious, it wasn't the existence of a troubling relationship between financial markets and central banks that was cause for debate. At this point, financial market dependencies on central bank policies have become so glaring that policy setters are openly discussing the danger of the relationship. The point of contention during this interchange was the issue of responsibility. Who should be held accountable for the speculation that has led to the existing and dangerous valuations in the global stock and bond markets? Is it the central banks for creating the conditions under which these bubbles thrive, or market participants who are unable to keep their greed in check and behave in a prudent manner?
This might seem like a game of finger pointing between central banks and market participants on a question without a clear answer, rendering the discussion a waste of time. However, the question of accountability is an important one. If central bank policies are not concluded to be a major source of the problem, then we must figure the unfortunate human condition of greed has gotten us into another situation ripe for financial instability. Only superficial changes, such as regulatory band aids, are applied when blame is placed on an intractable human condition. On the other hand, if central banks are concluded to play a larger role in the creation of the conditions we face today, it is logical that stakeholders should move forward with more serious solutions. These would include breaking the systemic link between markets and central banks which are affecting the world's economic well-being.
Central Bank Policy since the Global Financial Crisis – A "Protracted Experiment in Price Control" and Behavioral Conditioning in Financial Markets
In my first article published on Seeking Alpha, I provided a partial review of research demonstrating how quantitative easing and low interest rate policy target financial asset prices. I call the first article a review because after six years of aggressive financial intervention, it seems a foregone conclusion among both market participants and central bankers that easy money policies elevate security valuations. However, although easy money policies explicitly force the valuation of targeted assets higher, this is only supposed to be a means to a more important end. It is a behavioral shift among economic participants toward greater risk-seeking behavior that is the true end-goal. A greater proclivity toward risk-taking is born out of economic necessity, when less risky assets are manipulated to overstretched valuations, and therefore, provide lower future expected returns. Corollary to this is the pushback from central bankers that "market commentators" should not blame them "for their own problems" is faulty logic, since easy money policies target a behavioral shift among investors toward greater risk-taking. Bearing this in mind, here is a review of how central banks are currently targeting asset prices, and the investment behavior of market participants:
Forcing Market Interest Rates Downward – Through Direct Intervention and Signalling
- The main channel through which central banks attempt to stimulate economic growth is by controlling interest rates. Simply put, if interest rates are lower, it is cheaper for consumers and businesses to borrow money, which aids them in the purchase of goods using credit. In addition, one of the main academic justifications central bankers commonly cite for pushing interest rates lower is originally credited to Milton Friedman. His theory called the "portfolio balance theory of monetary policy." Friedman's theory postulates that as the yield on less risky investments declines, individuals will rebalance their portfolios as they seek higher-yielding securities (i.e., more risky investments). In addition, as the yield on the possible selection set of financial assets declines, investors should move out of money and into non-monetary assets. These would include money-risking ventures, such as starting a small business etc. In summary, according to the text books, the manipulation of interest rates lower should cause a rise in price of financial assets, and eventual investment in the real economy, with wide-reaching "wealth effects." This change in economic behavior caused by the suppression of interest rates is the major benefit of easy money policy cited by Ben Bernanke in speeches throughout his tenure as chairman of the U.S. Federal Reserve.
- The first method through which central banks can affect lower interest rates is by setting their own policy rates lower. Central bank policy rates are the interest rates at which central banks lend money to domestic banks. When banks can borrow money more cheaply, they will also offer loans at a better price to businesses and consumers. Below is a list of 27 central banks and their policy rate settings at March 30 2015. Consider the number of influential central banks that are maintaining their policy rate settings below 1%, and the period of time for which their rates have been low. Of great importance here is the policy setting of the U.S. Federal Reserve, which, as stated by Richard Fisher, is the "'central' central bank of the world." Rates at the U.S. Fed have remained at 0.25% since December 2008.
- Another method through which central banks have manipulated interest rates lower is using Quantitative Easing (QE) policies. QE is a process whereby central banks buy an asset from investors, typically government bonds or other "high-quality" fixed income securities, with printed money. This lowers the supply of these bonds relative to the outstanding demand, raising their price and decreasing their corresponding interest rate. The following chart released by Yardeni Research Inc. on March 23, 2015 demonstrates the balance sheet expansion (money printing) at major central banks (U.S Fed, ECB, and BOJ) since the beginning of 2008. Broadly speaking, balance sheet expansion has been used for QE or other policies which were meant to ease economic conditions in the respective financial markets (figures in $USD trillion as of February 28, 2015):
- Additionally, although the act of lowering policy interest rates and buying bonds is important, another crucial tool used by central banks to effect change in monetary conditions is "signaling" their future intentions. These are central bank statements meant to promote confidence among market participants that they will continue easy monetary policy until economic conditions are on track. For example, according to Charles Evans, president of the Chicago Fed, although during QE3 the U.S. Federal Reserve bought assets "in large numbers," he believes it also "provided tremendous confidence to public and markets that we understood the economy wasn't performing that well … and we were going to do what it took in order to improve the trajectory." Or consider the now famous speech from Mario Draghi given during July 2012, where he vowed that the ECB was "ready to do whatever it takes to preserve the Euro, and believe me it will be enough." This speech was attributed with causing a wide-ranging rally in European assets due to market expectations that it signaled a forthcoming QE program from the ECB. In fact, ECB QE did not actually come until almost three years later when it started in March of 2015.
Jim Grant has succinctly described what central bank actions since the Global Financial Crisis boil down to: "for the interest of intellectual hygiene we should call this experiment what it is, which is a protracted experiment in price control, interests rates are prices, they are perhaps the most critical prices in finance… Central banks the world over have been suppressing them, manipulating them, and otherwise man handling them."
Financial Market Effects of the Great Central Banking "Experiment"
Aggressive easy policy settings at global central banks come at a time when developed economies are undergoing a massive shift in the age of their populations. The following chart from Bloomberg compares how the median ages of four of the world's continents have changed from 1950 to the present, and where they are expected to be in 2050:
Therefore, during a period when there are a greater number of retirees than at any time in the past 65 years, there has been the largest simultaneous move by central banks ever to diminish the future expected returns of "safe" income securities such as government bonds. The combined demand of central banks and income-starved investors has created a scarcity of "safe" investments and pushed investors into a wider range of risky assets.
Based on the tremendous central bank interventions since 2008 and the ongoing shift in global demographics, the following charts and statistics demonstrating asset price distortions and increased risk taking behavior should not be a surprising:
- Developed market bonds look grossly overvalued on a broad basis:
The following charts generated on Trading Economics show the 10-year government bond yields for several developed market countries compared to their debt-to-GDP ratios. One commonality they share is that their central banks are currently, or were, partaking in quantitative easing. The 10-year nominal government bond yields of these countries all trade near record lows, despite burdensome debt-to-GDP metrics (data as of year-end 2014):
U.S. 10-Year Nominal Government Bond Yield and Debt-to-GDP
Japanese 10-Year Nominal Government Bond Yield and Debt-to-GDP
German 10-Year Nominal Government Bond Yield and Debt-to-GDP
French 10-Year Nominal Government Bond Yield and Debt-to-GDP
Italian 10-Year Nominal Government Bond Yield and Debt-to-GDP
Portuguese 10-Year Nominal Government Bond Yield and Debt-to-GDP
Furthermore, according to the following chart from the Motley Fool and sourced by Foresight Investor, close to 51% of the companies in the U.S. S&P 500 traded with a dividend yield above the 10-year U.S. Treasury note as of January 31, 2015. This is an economic situation which has not been witnessed since 1957:
The situation in Europe is even more extreme, as demonstrated by the ratio of the dividend yield on the MSCI Europe Equity Index to the yield of an index of 10-year eurozone government bonds. In this case, the ratio has never shown a more expensive valuation for eurozone government bonds at any time in history. The following chart is also as of January 31, 2015 and provided by Morgan Stanley and Foresight Investor:
Record low bond yields in the face of high debt-to-GDP ratios, and some of the most stretched valuations relative to equities ever, have prominent publications such as the Financial Times sounding warning bells regarding a "growing bond bubble."
It is evident that massive central bank balance sheet expansion and low interest rate policy has been wildly successful at helping to push up the price of "safe" income assets, despite nosebleed valuations.
- U.S. investment-grade corporate debt issuance and valuation metrics also point toward broad overvaluation:
According to David Stockman's Contra Corner Blog, total corporate and non-corporate business debt outstanding has increased approximately $3 trillion since the pre-GFC peak in late 2007. Business credit outstanding in 2007 totaled $11 trillion, and the figure has now ballooned to $14 trillion, which is an increase of almost 30%.
This bull market in corporate debt is occurring during a period of increasing leverage ratios among high-grade U.S. corporate bond issuers. The chart below from Citigroup shows the ratio of net debt among U.S. investment-grade corporations to Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) on the right-hand side. A higher ratio means that corporations have greater overall debt compared to their EBITDA, and generally implies increasing bond issuer risk. On the left-hand side Citigroup charts the borrowing costs of investment-grade credits minus the borrowing costs for the U.S. government for identical bond maturities (the "spread"). All else remaining equal, a decreasing spread indicates that financial market participants view corporate bonds to be closer in risk to those of less risky U.S. government bonds, and are therefore willing to charge the issuer a rate of interest rate closer to what they would charge the government.
This indicates a yield-starved market place treating investment-grade corporations like they are less risky borrowers, as witnessed in the "spread," despite the fact that these debt issuers' net debt-to-EBITDA ratios are deteriorating.
- Investment flows into high yield, and emerging market debt demonstrate an increased investor proclivity for risk-taking:
The following chart from page 32 of the IMFs "Global Financial Stability Report" released in October 2014 demonstrates the large flows into higher-yielding, risky debt since 2008.
High-yield bond specialist Martin Fridson states that simultaneous to the acceleration in U.S. junk bond issuance, investor covenant protections included in these deals are being systematically degraded. Bond covenants are the terms of a bond issuance. They usually require the lender to meet certain financial requirements, and are viewed as positive by investors, since they work to decrease the financial risks a lender is allowed to take. According to Fridson, "The covenant quality of high-yield new issues reached its lowest level since tracking began in January 2011" during January 2015. For the month, the series dropped to 4.31, edging out November's reading of 4.30, "for the worst reading ever":
In addition, the following chart from Sinclair & Co. graphs the average annual gross debt issuance in $USD billions for several asset classes over two periods. The 7-year period leading up to the GFC, and the 6-year time frame afterward, which corresponds with explosion in easy money policy. The yearly average gross debt issuance for emerging market corporations is over $750 billion during the second period, representing an approximate 400% increase over the average from the prior:
Once again, the intense bull markets seen in risky debt since 2009 demonstrate a willingness among investors to look past risks in order to generate a bit more income. This is a sign that they have incorporated central bank signals that rates on safer securities will be low for prolonged periods into their investment strategies, and moved out the risk curve.
- The broad-based rally in global equities despite stagnating earnings also points toward investor complacency to risks due to the guiding hand of central banks:
The chart below demonstrates that earnings of all companies in the MSCI World Index have barely increased since October 2011, while the stock market has soared, which points toward the portfolio rebalancing effect of QE programs. Worded differently, stock market gains since 2011 are predominantly due to investors paying a greater and greater amount for a flat-lining MSCI World earnings stream, and not for improving net income resulting from better business prospects:
The S&P 500 Index has now gone 42 consecutive months without a 10% correction, the fourth-longest streak in history.
- As central bank policies "lift all boats," indicators of equity investor optimism continue to surge higher:
The following chart from Goldman Sachs shows that hedge fund positioning in U.S. equities has never been higher over the last five years:
The amount of New York Stock Exchange (NYSE) margin debt continued to surge coming into the month of March 2015. Margin debt levels, and their rate of change, are sometimes used as an indicator of investor sentiment, because margin debt rises when investors feel good about the prospects in the stock markets. In the past, margin debt levels have peaked at the same time as market indexes reached relative peaks:
The Advisors Sentiment report survey, which shows the market views of over 100 independent investment newsletters (those not affiliated with brokerage houses or mutual funds), has not reported lower levels of bearish market sentiment among investors for the last 35 years:
Finally, S&P 500 index levels continue to surge higher, despite collapsing U.S. 2015 GDP expectations and macroeconomic data. This corresponds with investor expectations that weaker economic results will force the Federal Reserve to prolong its low interest rate policy or introduce new stimulus. Bad news is good news for financial markets addicted to Federal Reserve easy money:
The Trillion Dollar Question – Who is Culpable for Dangerous Market Conditions – Central Banks or Market Participants?
After providing a rough skeleton of central bank actions during one of greatest monetary experiments in history, and some of the outcomes, it should be clear that the answer to this question is more nuanced than its the market's "own problem." The two quotes at the beginning of this article show that on one hand, central bankers feel market participants have acted irresponsibly and are pushing them into more accommodative policy. On the other, central banks have "manhandled interest rates lower" in an effort to encourage risk-taking, and results demonstrate that this has indeed occurred.
With the benefit of having the time to think things over, I believe the Pavlov's dogs analogy used by Rick Santelli during his interview with Richard Fisher is somewhat appropriate. My original issue when I reflected on his use of the analogy was that the Pavlov's dogs comparison didn't do justice to the aggressiveness of the central bank experiment. That was until I read an article in The New Yorker which details how Pavlov starved the dogs he used in his studies so that he could more strongly reinforce the behaviors he wanted to condition. The "portfolio balance theory of monetary policy" being directly implemented on markets by major central banks such as the Fed, BOJ and ECB, is similarly aggressive to Pavlov's experiments. It works to "starve" investors of safe investment choices, with the hopes that they will take more risk in financial assets and eventually put capital back into the real economy.
However, the difference between central banks' attempts at conditioning and Pavlov's is that Pavlov was able to produce the effects he desired, while financial policy makers embark upon their missions only with "hope" that their efforts will have the desired consequences. As Ben Bernanke has testified, "monetary policy is a blunt tool," and a Federal Reserve paper studying Japan's aggressive monetary policy from 2001-2006 have called the connection between QE and macroeconomic recover "flimsy." The natural follow-through from this is that although central banks know themselves capable of lowering interest rates on a wide variety of fixed income securities, they are, at best, unsure of whether this can prompt investment booms in the real economy by igniting "animal spirits."
What global central bank policies have without a doubt accomplished is incubated the conditions under which the apathetic investor thrives. By overwhelming capital market pricing mechanisms with liquidity, another entire series of asset bubbles have quickly emerged after the last ones deflated in 2008, and easy money policy has instilled itself as the most important marginal factor in asset price returns. In a world where financial security prices have already been manipulated so far away from economic fundamentals, what becomes the key variable in the next move higher in asset prices? It certainly is not the delta in economic conditions – unless, of course, it is expected by market participants that the change in economic conditions will somehow affect future monetary policy actions.
Although central banks have been criticized by governments for their possible roles in previous crises, their involvement in financial markets has only accelerated since that time. Indeed, there has been stress put on central banks to act due to political inaction. However, it now appears we could be on the heels of another bust, which central banks will undoubtedly have a starring role in.
Richard Fisher stated during the interview I cited that "just saying it's up to the Fed, and the Fed has to save the world, I think that's an undue burden and that's an unfair burden." Indeed, the entire notion of the usefulness of central bank policies needs to be flipped on its head as this next stage in financial market history plays out. As the old saying goes, "You should never let a good crisis go to waste." It would be irresponsible and lazy not to take a close look at the institutions we have been expecting "to save the world," when evidence comes to light that they have been doing the opposite.