Undermining the Intergrity of Financial Markets

THIS MATERIAL HAS BEEN PREPARED BY A MEMBER OF SCOTIABANK’S US RATES TEAM AND DOES NOT

CONSTITUTE INVESTMENT RESEARCH

THIS PAPER CONTAINS THE PERSONAL OPINIONS OF GUY HASELMANN AND NOT NECESSARILY THE VIEWS OF SCOTIABANK

Undermining the Integrity of Financial Markets

Introduction

Financial markets are broken. Fundamental analysis and Modern Portfolio Theory are relics of the past. Investors used to care about maximizing a portfolio’s expected return for a given amount of targeted risk. The goal used to be that prudent diversification through the analysis of security correlations could move the Efficient Frontier Line ‘up and to the left’. In other words, improve returns per unit of risk.

Today, Fed policies have commandeered investor thinking and altered investor behavior. The powerful driver of moral hazard has fueled greed, and imbued more fear of underperforming peers and benchmarks, than fear of downside risks. Some investors are buying the riskiest assets simply because prices have been rising. Some investors say they are buying equities instead of Treasuries because ‘equities have upside, while bonds yields are puny and their prices are capped at par’.

Fed policies have led to (investor) herd behavior that has plunged market volatilities and manipulated asset prices and correlations to lofty levels. The rallying cry has simply become “don’t fight the Fed”. Relative return - without regard for risk - is all that matters. As a result, future return expectations have fallen with ever-rising prices; correspondingly, risk levels have risen in parallel. The allure of the Fed’s magic spell has lapsed investors into a soporific state of cognitive dissonance, with them focusing more on trying to justify valuations, rather than on the Upside Downside Capture Ratio.

Markets have thus mutated into one of two possible combustible states. Either financial assets have all transcended into prodigious bubbles, or stocks and bonds are signifying two completely separate outcomes. Either possibility will have dangerous repercussions for the economy, and for portfolios and investors. At the moment, I believe that the Treasury market has it right, signifying concerns about disinflation and future growth.

Using Financial Asset Prices as a Policy Tool

Uber-accommodation and aggressive promises by the Fed have been successful at chasing money into equities and the lowest part of the capital structure - as was its intent - but the stellar performance of equities have been divorced from the underlying economy for the last few years. (Note: better earnings from improved margins are unsustainable without revenue growth.)

Fed policies have also laid the foundation for debt issuance to fund private sector share buybacks and mergers, creating the self-reinforcing illusion that all is well. Super-subsidizing the cost of debt destabilizes the basic tenets of investment. By

Capital Market Comment Undermining the Integrity of Financial Markets

Guy Haselmann(212) 225-6686

Director, Capital Market Strategy

THURSDAY, AUGUST 28, 2014

Undermining the Integrity of Financial Markets Thursday, August 28, 2014

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creating an environment, whereby investor decisions are enticed into the junkiest credits and equities (the junkier the better), and whereby financial market manipulation is being used as a policy tool, the Fed is undermining the integrity and foundation of financial markets.

Investors have also been led to believe, that should pressures build on those risky securities, more subsidies will be offered. This dangerous feedback loop is unsustainable. At some point - probably in the very near future - investors will lose faith in the central banks’ ability to support the economy through higher financial asset prices.

It is far too early for history to judge the success (or lack thereof) of QE policy. The smug references of claiming victory by some FOMC members likely derives not from comprehensive faith in their success, but rather from attempts at maintaining confidence in the institution. After all, Fed policies are experimental, have had questionable success, and the unintended consequences of the actions have yet to be felt.

On balance, markets have too much faith in the FOMC, which is over-promising on what can reasonably be delivered with such limited powers. Bigger than the bubble in financial asset prices is probably the bubble in Fed-confidence.

Big Objectives, Limited Tools

As far as economic management is concerned, the Fed really only has one basic instrument: managing liquidity through managing the supply of money. How does it make sense that the Fed can achieve its dual mandate objectives of price stability and full employment with this one blunt tool? When all you have is a hammer, than everything looks like a nail. With this one tool in mind, it seems silly to think that heated debates arise after each new piece of economic data, on how much to tweak money supply. A $17 trillion economy cannot be micro-managed.

Debate even shifts between the focus on the price mandate and the employment mandate and whether there is a trade-off between them. It does not require much thought to realize that the ‘dual mandates’ of the Fed are bewildering and illusory and in need of a face-lift.

Even more problematic is the prospect that FOMC analysis could be faulty. In 2012, I wrote that “the Fed should not confuse good deflation with bad deflation in that good deflation is a drop in prices caused by technology-enhanced declines in the costs of production. Trying to fight such imagined deflation would lead to asset bubbles and problems elsewhere”. Bad deflation is when the consumers stop spending because they believe prices will be lower in the future. Globalization and technological


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advancements result in the ‘good type’ of deflation. Zero interest rate policy expedites the process, rather than reversing or easing price pressures.

Dubious Economic Ideology

The group-think FOMC has perpetuated this state of being, because Fed leadership believes in the same outdated economic theories popularized over a half-century ago. Bernanke and Yellen, among others, were influenced by a few Noble Laureates during their studies in the 1970’s; those such as, James Tobin, Paul Samuelson, and Bob Solow. Samuelson was credited with creating ‘Neoclassical Synthesis’, which all policymakers use as their basic approach (they also use faulty neoclassical full-employment optimization models).

The Samuelson ‘synthesis’ basically says that with skillful monetary and fiscal policy, the economy can be kept close to full employment and will behave as the models of long-run growth suggest it will. However, every now and then (like the present), the emphasis will have to be on the short run. Few would argue that the Fed has taken this path, and in doing so, has created a ‘time-inconsistency’ problem whereby it is trying to bring demand forward at the expense of the future.

In past speeches, Yellen has blamed the Fed’s extraordinary measures on the underutilization of labor resources (slack). It was interesting, however, that when Yellen presented at Jackson Hole in front of the foremost academic experts on labor markets, she did not reveal any biases regarding the amount of labor slack. Had she regurgitate any of her earlier assumptions (that were used to justify current policy), she would have likely opened herself up to criticism; especially given the complex relationship between employment, wages, inflation, and growth.

By showing more ambivalence and lacking the confidence to share those assumptions with this group of academic ‘experts’, she exposed the dubious and experimental nature of FOMC policies. It can therefore be argued that the FOMC is basing the greatest experiment in Fed history on low-confidence assumptions about labor market slack and Phillips Curve trade-offs.

Solow, Samuelson and Tobin explicitly acknowledged the non-static nature of the Phillips Curve due to shifts in expectations and to hysteresis. Yellen seemingly ignored this aspect of their work, because it did not jive with the Fed’s policy actions.

(For review and emphasis) ‘Hysteresis’, according to Investopedia, is: “the delayed effects of unemployment. As unemployment increases, more people adjust to a lower standard of living. As they become accustomed to the lower standard of living, people may not be as determined to achieve the previously desired higher living standard. In addition, as more people become unemployed, it becomes more socially acceptable to


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be or remain unemployed. After the labor market returns to normal, some unemployed people may be disinterested in returning to the work force.”

Counter-productive Policy

The Fed cannot do anything about hysteresis and has had little, if any, help from the fiscal tools that could help. Using monetary tools where a fiscal solution is required has consequences, and further enables fiscal stalemate. Furthermore, it could be argued that holding interest rates at zero for a prolonged period of time is actually counter-productive.

As mentioned earlier, corporations have been incentivized to issue cheap debt, but those who are not buying back shares or increasing dividends are using the proceeds to modernize plant and equipment. Improved productivity has resulted, but those gains have not spilled into wage improvement; hence, feeding the Fed’s argument of ‘slack’.

As a matter of fact, gains in productivity through modernization have exposed production redundancies, allowing firms to lay-off workers and cut prices. Certainly capitalist societies always strive for advancement in this manner, but Fed policy has turbo-charged the process. Without new and modernized job training, old jobs become outdated, unemployment swells, and hysteresis results.

Conclusion

The FOMC has backed itself into a predicament where there is no easy escape. Its policies might be counter-productive for the economy and harmful to financial markets, which will likely to lead to tarnished credibility in the near future.

If the economy muddles along or stalls, the effectiveness of QE will be questioned. In the unlikely possibility that the economy grows satisfactorily, the Fed will be accused of being behind the curve.

Investors betting on Fed promises, and its hopes of navigating economic ‘lift-off’, will likely have a difficult path going forward. Investors smart enough to have believed in the implicit information embedded in (unloved) long dated Treasuries (+25% YTD) should continue to reap the best reward per unit of risk.

Since February, I have predicted that 30-year Treasury yields would drop below 3% before the end of year. The yield reached 3.05% today; earlier than anticipated. I expect 30-year yields to outperform for a while longer, and continue the march to lower yields. Those expecting much higher (back end) yields will likely be waiting quite a long time; possibly even a year or more. Waiting for inflation in recent years has been like waiting for Godot (he never shows up).


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Investors are advised to distinguish between interest rate risk and credit risk. Unwinding of Fed policies is likely to trigger an expansion of the collapsed capital structure. Better credits should outperform and liquid assets will command higher premiums.

Fed policy normalization could have the opposite market impact that uber-accommodation had; i.e., a meaningful negative impact on the prices of the riskiest assets. Market volatilities will likely rise from suppressed levels.

Portfolio managers should ask themselves today if they are being adequately being compensated for the risks of trying to capture the ‘upside’ from current prices. Historically, participating in downside corrections has typically meant a 7 to 10 year period before portfolios are able to return to prior high water marks. In the meantime, during this period of capital preservation, parking funds into long-dated Treasuries, offers optionality, liquidity, upside potential, and opportunistic flexibility.

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Disclaimer

This publication has been prepared for Major U.S. Institutional Investors by Fixed Income Strategists of the Bank of Nova Scotia, New York Agency. (“BNS/NYA”). BNS/NYA Fixed Income Strategists are employees of Scotiabank’s Fixed Income Credit Sales & Trading Desk and support the trading desk through the preparation of market commentary, including specific trading ideas, and other materials, both written and verbal, which may or may not be made publicly available, and which may or may not be made publicly available at the same time it is made available to the Fixed Income Credit Sales & Trading Desk. Fixed Income Strategists are not research analysts, and this report was not reviewed by the Research Departments of Scotiabank. Fixed Income Strategist publications are not research reports and the views expressed by Fixed Income Strategists in this and other reports may differ from the views expressed by other departments, including the Research Department, of Scotiabank. The securities laws and regulations, and the policies of Scotiabank that are applicable to Research Analysts may not be applicable to Fixed Income Strategists.

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Undermining the Intergrity of Financial Markets