So, do you know the subtitle to the novel “Frankenstein” by Mary Shelly? I didn’t. Turns out it’s: “The Modern Prometheus”. This is, of course, a reference to the consequences of hubris – in the sense of human arrogance – and how mankind quite frequently creates its own monsters. How is this relevant to you? There are many examples but let’s stick to some recent examples: the BP Gulf spill, the Fukushima reactor, and The Federal Reserve.
I couldn’t help being struck by recent headlines about the now famous reactor in Japan. It’s been a month, and the situation is still not completely in control. Do you think, given what we know now, perhaps the Japanese were overly confident in their ability to deal with a potential crisis? It’s not as though they didn’t know about the potential for both earthquakes and tsunamis (a Japanese word). I’m not suggesting one should never build reactors because occasionally drastic things happen. I’m saying the full cost of clean-up and loss of life needs to be baked into the decision to implement the technology. Can we also agree this should now be our attitude regarding deep water drilling?
I think we need to have the same attitude about the Federal Reserve. Again, I am not, advocating for its demise, just warning you about the limits and consequences of its power.
I submit the following: the cause of the “housing bubble” and its aftermath was largely a function of complacency born of hubris; specifically, overconfidence in the Fed’s ability to manage large financial/economic crisis. Evidence of this complacency can be found in historically low risk premiums for almost all assets immediately prior to the collapse. “Don’t worry that the market has sucked the guy at the burrito shop into flipping condos, if things go wrong the Fed will cut and all will be well.”
Why did people think that way? Well, if you look back at the three major crisis prior to the Lehman Blowup, the Fed was credited with saving the day: 1) 1987 stock market crash – Greenspan saved the day; 2) LTCM blow-up – the Fed organized a bailout, and 3) NASDAQ crash – the Fed cut to 1% and then slowly raised rates at a moderate pace. It’s human nature to treat the past as prologue and give tremendous weight to track-record without really establishing causation (as opposed to merely correlation).
So, in 2006 when all the classic signs of a bubble were evident, the Cassandra’s of the world were told, “Don’t worry about it. When things go sideways, the Fed will step in and all will be well. While you’re at it, go buy another house.” This was the majority opinion, and from a trading perspective, this was the right view for a time. You should have been long risky assets from 2003 through 2007. But, you also should have gotten short some time in 2007, right when confidence was at its highest. In addition, from a societal point of view, however, this volatility is a problem.
Now, just as we’ve had a good run off the bottom in 2009 I find it not un-reasonable to ask ourselves if markets are properly accounting for the Fed’s ability (or lack thereof) to keep things on an even keel. My favorite thing to watch is US TIP spreads. This table was taken at 4pm on Apr 7:
It strikes me as important, because while the Fed can buy a bunch of treasuries, it can’t buy them all. i.e. if these indicators are being distorted, they are skewed toward lower inflation expectations. So, we can take these numbers as optimistic.
There are two things to note about the 5 year TIP spread: 1) after turning lower due to the twin Middle East/Japan crises, the spread is making new highs toward 3.00%. This will force the Fed to tighten liquidity ahead of schedule, i.e. while un-employment is still very high. Whatever the underlying economic consequences, I think markets will end up being surprised by this; and 2) the 5yr TIP spread is higher than the 10yr or the 30 year. It has been for a while and it’s the greatest indication the markets thing the Fed will ultimately win this battle. Given this curve, the markets clearly think inflation will go up and then come back down. i.e. inflation might be elevated for a bit, but it will not get out of control.
I hope we’re not being overly confident, again…
Similar Posts:
- Brazil, Miami & The Fed
- Blowing Bubbles
- Are we about to see another property price bubble?
- The Rising Cost of Insuring Against US Government Debt
- Single Tenant Net Lease Cap Rates Now, And Later
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