Yellen risks making the same mistake as Greenspan in 2004
FEARS that the US recovery may falter were reawakened last week, with the advanced estimate of first quarter GDP coming in at an annualised 0.1 per cent, down from 2.6 per cent in the final quarter of 2013 (see chart). The dollar fell by 0.4 per cent against a basket of major currencies, and the Centre for Economic and Business Research said that “this is likely to spark fears that the US recovery is more vulnerable to negative shocks than previously thought.” But worries over a major setback for economic growth in the US are misplaced. As pointed out in the Fed’s statement last week, economic activity picked up towards the end of the quarter, after a slow start due to the arctic weather over the winter.
Instead, a growing chorus of high-profile investors and commentators warn that the tide of central bank liquidity built up in recent years presents a far greater risk for markets. With more details emerging in recent months about the Fed’s planned exit strategy from monetary stimulus, it’s clear that the bias will be towards a very slow, smooth exit. Rate hikes aren’t likely until 2015, and the Fed’s stock of assets bought through quantitative easing (QE) will be held until maturity, rather than being sold back into the market. According to Lombard Street Research’s Dario Perkins, the current course looks set to create the “perfect environment for new bubbles.”
THE GREAT ESCAPE
Of course, monetary normalisation is already underway. The Fed is reducing its monthly stock of asset purchases by $10bn (£5.93bn) each month, with QE set to be tapered out completely in the fourth quarter this year. Recent comments by Yellen suggest that the first rate hike (from the current near-zero level) could then come around six months after that – in the first or second quarters of 2015. Even then, however, overall policy looks set to be highly accommodative for some time to come.
According to March’s Federal Open Market Committee meeting minutes, the majority of members judge the appropriate base rate levels at the end of 2015 to be 1 per cent or less. And even when tapering is completed and rates are on the rise, the Fed will still have a heavily bloated balance sheet by historical standards. In the original 2011 exit plan, the idea was to sell assets purchased under QE back into the market, getting the Fed’s balance sheet back towards a manageable size quickly. This decision has been reversed, and the stock of assets will now be held to maturity, shrinking the Fed’s balance sheet passively, and much more slowly than was originally planned.
There are good reasons for doing this – it’s difficult to calculate how quantitative tightening (selling the assets) would affect markets, compared to the tried and tested route of rate rises. But taking all this into account, the overall stimulus the Fed is providing the economy will remain generous for years, far more so than a conventional Taylor Rule for setting monetary policy would suggest (see chart).
2004: A CAUTIONARY TALE
This could be dangerous, argues Perkins – and he’s not alone. Just last week, Apollo Global Management co-founder Marc Rowan said that he sees signs of a bubble brewing in credit markets, potentially sowing the seeds of a future crisis. In raising concerns, he joins Nobel Prize winning economist Robert Shiller, former US Treasury secretary Robert Rubin, and economist Nouriel Roubini. Former Fed governor Jeremy Stein, who resigned only last month, warned that easy money policies aimed at reducing unemployment risked inflating market bubbles that would ultimately lead to financial instability.
Perkins says the risk is that the Fed makes the same mistakes as former chairman Alan Greenspan in 2004, when a “gradual tightening cycle” left money too loose. Combined with a glut of savings from emerging markets flowing into bonds, this encouraged excessive risk taking in the financial sector, and stoked a housing market bubble that would ultimately collapse after 2007. Not only is the pace of tightening eerily similar (Perkins calculates that the current likely trajectory would average around 0.2 percentage points of tightening each month, compared to 0.25 for Greenspan), but global capital flows could begin to show a resemblance as well.
The global savings rate is now higher than it was in the run up to 2008, and China seems on course to allow greater capital outflows through its liberalisation programme. Some of those funds would likely find a home in safe US assets, pushing other investors into riskier ones, and leaving Yellen with a similar headache to the one Greenspan faced towards the end of his term. Rabobank strategist Richard McGuire points out that the possibility of QE from the European Central Bank this year only adds to this dynamic.
FUNDAMENTALS OUT OF THE WINDOW
Few see equities in general as a bubble fit to burst, but there’s no shortage of warnings in particular sectors. David Einhorn of Greenlight Capital recently announced that he is shorting tech stocks, claiming that there is “clear consensus” that the sector is in a bubble. But Perkins says that, while expensive, stocks in general don’t seem to be in bubble territory quite yet. On the Shiller price-earnings ratio, the S&P 500 trades at 25.3, more than 53 per cent higher than the historical mean of 16.5. It’s still a long way off all-time highs of 44, reached during the giddy days of the first tech bubble, but valuations are certainly stretched at the moment.
Worryingly, McGuire and Rabobank’s quantitative strategists see signs that liquidity could again have taken over the reins as the key market driver in recent months, despite the ongoing taper. Calculating the co-movement of the prices of the largest stocks in 10 sub-sectors of the S&P 500, he finds that price movements are highly correlated with one another, implying that blanket liquidity, rather than company-specific fundamentals, is the main driver. Traders may be tempted to call a bubble and short stocks, he says, “but the danger is the market can stay irrational longer that you can stay solvent.”