Adventures in Quantitative Tightening

Adventures in Quantitative Tightening by MN Gordon – Acting-Man

Flowing Toward the Great Depression

All remaining doubts concerning the place the U.S. economy and its tangled web of international credits and debts is headed were clarified this week. On Monday, Mark Yusko, CIO of Morgan Creek Capital Management, told CNBC that:

 

“…we’re flowing toward the path of 1928-29 when Hoover was president. Now Trump is president. Both were presidents with no experience who come in with a Congress that is all Republican, lots of big promises, lots of things that don’t happen and the fall is when people realize, ‘Wait, it hasn’t played out the way we thought.’ [By the fall], we’ll have a lot more evidence of declining growth. Growth has been slipping.”

 

A famous bad juju moment – the crash of 1929. Two of the annotations require a bit of elaboration. The so-called “Babson break” was a large down day on September 5 1929, two days after the market had peaked. Roger Babson was an entrepreneur (he inter alia invented the parking meter), an economic theorist and a famous skeptic who had already voiced doubts about the stock market bubble of the 1920s on numerous occasions before that day. This was the first time the market didn’t shrug his warnings off, and although it recovered most of the loss on the next trading day, it was the beginning of the end. “Fisher” refers to economist Irving Fisher, who famously announced “stocks have reached a permanent plateau” two weeks before the top. Fisher was a very wealthy man at the time, but lost the bulk of his fortune in the ensuing bear market. Although he couldn’t forecast his way out of a paper bag, his work has become the foundation of much of what is considered “orthodox” economic theory these days. His contemporaries Hayek and Mises, who like Babson warned of the coming crash, are shunned by the prevailing central planning paradigm. Hayek did so in the spring of 1929, when he said that there was no chance of a recovery in Europe unless interest rates decreased, which would require the collapse of the boom in the US; he added that this was very likely going to happen later that year. Mises was offered a well-remunerated post at Creditanstalt in the summer of 1929 and declined the offer. When asked why, he replied that he thought a great crash was coming soon and he didn’t want his name to be associated with it. Of course, Mises himself would probably point out that “prediction” is not a task of economic science. We just wanted to note in passing that these great economic theorists were also quite adept at sussing out what nearly everybody else missed at the time. Causal-realist economic theory does provide some advantages. [PT] – click to enlarge.

 

If you recall, autumn of 1929 is when the U.S. stock market commenced a multi-year swan dive and the economy commenced a decade long Great Depression. This is the path Yusko believes we’re on. To be clear, this is a path that can be extraordinarily hazardous to your investment wealth.

For example, from September 3, 1929 to November 13, 1929, the DOW lost 48.9 percent. Then, as rarely noted, it rallied 48.1 percent through April 17, 1930. This had the adverse effect of luring the buy the dip crowd back into the stock market just in time for the next massacre.

In the end, it turned out to be the ultimate sucker’s rally. The stock market subsequently crashed 89.2 percent from its initial peak, along with the hopes, dreams, and aspirations of an entire generation. Such a colossal collapse could never, ever happen again, right?

 

The 1929-1932 decline – the percentages show the size of the declines and rallies from interim peaks to interim lows and back again. As bad as this bear market was, there were even worse bear markets in Western countries within the past decade (namely in Greece and Cyprus). [PT] – click to enlarge.

 

Unknown Road

Indeed, the possibility of even a partial repeat of the 1929-32 stock market crash is something to be wary of. Remember, if it happened before, by definition, it could happen again.

In addition to the political similarities Yusko mentioned, including a fiscal policy flop overseen by a Republican President and Republican Congress, the economy is also faced with a tightening of monetary policy, as it was in 1929. However, this time the path has several new twists and turns that are leading down an unknown road.

The Federal Reserve has quite a task ahead of it to achieve its goal of policy normalization. Raising the federal funds rate is one thing. But the Fed must also pioneer a new path of quantitative tightening. This is something the Fed has no experience with.

According to Jamie Dimon, CEO of JPMorgan Chase & Company, the effects of reversing QE are “unknown”. Speaking at a conference in Paris on Tuesday, Dimon remarked that:

 

We’ve never had QE like this before, we’ve never had unwinding like this before. Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.

When that [quantitative tightening] happens of size or substance, it could be a little more disruptive than people think. We act like we know exactly how it’s going to happen and we don’t.”

 

It is true that no-one knows what will “exactly” happen when the Fed puts QE into reverse. But QE has directlyincreased the US money supply – and the increase in the money supply has distorted relative prices in the economy, inter alia creating the mother of all bubbles in stocks and bonds. This bubble cannot possibly be sustained under the “reverse QE” plan. [PT] – click to enlarge.

 

Adventures in Quantitative Tightening

No doubt, Dimon is right. No one, including the Fed, knows exactly how reducing the Fed’s balance sheet will play out. This has never been attempted before.

But Dimon misses the mark. You see, quantitative tightening won’t “be a little more disruptive than people think,” as Dimon suggests. More accurately, it will be much, much more destructive than most people are capable of imagining.

Still, Dimon’s remarks caught the attention of Representative David Kustoff of Tennessee. On Wednesday, during Fed Chair Janet Yellen’s semiannual Congressional testimony, Kustoff asked her if she shares Dimon’s concerns about moving assets off the Fed’s balance sheet.

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