I had two reactions as I watched the markets puking their guts up. I had the strong urge to buy undervalued assets, and I periodically cursed the Fed and other central banks.
I don’t think central bankers are stupid, out-of-touch, or somehow divorced from economic reality. They appear to be bright people who are trying to do the best they can. But none of them seemed to have learned the one word we try to teach our children… No!
We established the central bank in the U.S. to protect the currency. Within 20 years, the bankers saw themselves as the protectors of the economy, working to eliminate the business cycle, although they never seemed to succeed. The bankers should have said no.
Then, during FDR’s profligate spending years before WWII, the Fed became the federal government’s enabler, holding long-term interest rates at 2.5%. This went on until the Korean War. After 17 years, central bankers finally, for once, said no.
In the 1970s, Congress tasked the Fed with moving the economy toward full employment, because if a bunch of lawmakers who can create tailored fiscal policy can’t move that needle, then maybe bankers who control just interest rates and a few financial tidbits can get it done… right? Again, the governors of the Federal Reserve should’ve told members of Congress to do their jobs.
Then we get to the great financial crisis. It made sense to print money and buy mortgage-backed bonds in a concerted effort to unfreeze that corner of the market. The Fed actually returned to a shade of its original purpose, buying good assets at distressed prices to add liquidity.
But everything since then has been nothing more than a concerted effort to levitate the economy. After more than a decade of sub 3%, and often sub 2%, growth, it should be clear that it’s not working! Instead, we’ve seen financial asset prices skyrocket. Fed buying sent bond yields through the floor, and cheap debt gave companies a way to buy back their own shares… $4 trillion worth.
Investors are stuck in the middle. We can’t buy bonds because they don’t provide enough yield to live on, but equities are fully priced. What’s a retiree to do? Investors were almost forced to buy stocks. They’ve been rewarded, but now the coronavirus has changed investor sentiment from risk on to risk off.
We’re suddenly value investors, and there’s not a lot of value to be had. Interest rates are headed to zero in the U.S., following yields in Europe and Japan.
But hey, don’t worry, the Fed can “fix” this. Or can they?
Traders expect the Fed to lower rates by 0.75% at their meeting this month, which will do nothing more than bring overnight rates in line with the rest of the yield curve, and cut into bank profits for at least the rest of this year. The Fed guarantees bank profits by paying interest on excess reserves, but if that interest rate falls to 0.375%, it won’t be enough to keep earnings rolling in, which is why the financial sector is reeling.
The big question is, what happens next? On a day in which Saudi Arabia isn’t out for revenge against the Russians, and the coronavirus fears subside, do we just race back to the top? It doesn’t seem likely because it will take time to understand the extent of the economic damage to the supply chain as well as consumer sentiment.
But the problem we’ve had for much of this decade remains. There is no alternative (TINA) to equities if your looking for growth. Now that the 10-year and even the 30-year Treasury bonds trade with a zero handle (less than 1%), what’s an investor to do?
We can curse the central bankers for creating this mess with continued interventions, and do our best to resist buying (too much) in this market as we wait for the dust to settle.