Investors have become like belligerent two year olds. Every time the market falls more than 5%, they throw a tantrum, banging their head on the floor and hoping their parents give into their sugar fix lest their crying wakes up the other kids up.
In this analogy, the toddlers are the equity market and other kids represent all the other asset classes that have seen their prices inflate, values built on a magical house of cards via leverage, debt, and illusive special vehicle structures. When one domino falls, it won't take much to take everything down. That is when one realizes how fragile the economy is -- and more importantly, how much leverage and free money has propped up asset prices.
Since the Global Financial Crisis (GFC) in 2008, one Fed after another has done nothing but feed the market their constant opioid fix of monetary accommodation and quantitative easing, namely the "Fed put." Over the past 10 years, traders can be forgiven for thinking there is always a support in the market, as they have seen nothing to convince them otherwise. Fed Yellen's tenure was a classic case of having the Fed put firmly in place; shifting gears to dovish when markets were about to get jittery but then leaning hawkish at highs, maintaining an upward market bias at all times.
What should a real Fed do when the economy has a robust 3.5% GDP growth, unemployment below 3.7%, and wage growth ticking higher? Raising rates is the economic textbook rule to contain an economy from over-heating. The Fed's balance sheet ballooned to over $4 trillion over the past decade to help support this growth. But now that the economy is on a real, independent, solid footing, what better time to start a rehab program for the market participants to rid them of their free money fix.
Let's ignore Trump sensationalist tweets for a moment, which represent nothing other than fooling the average American in order to seek approval ratings -- such is the beautiful process of democracy, theatrics rule more than policies. During Powell's speech and Q&A at the Dallas Fed, despite recent market volatility in U.S. markets, he maintained his stance of a gradual rate hike policy. He did acknowledge that 2017 was a strong year of global growth and that 2018 was showing signs of a slowdown, being cognizant of all the risks but also aware of the tailwinds, keeping a balanced approach.
Like a true Fed chairperson, he said the October episode is just "one of many factors in a very large pod," and that additionally, "financial conditions and financial market activity matters a lot for that, and it's not just the equity market." Basically, the Fed won't hike too fast or too slow, they are doing what is needed to get the economy back on an independent footing. If there is real growth and productivity, then that will offset the unwind of monetary accommodation.
After all, if they do not do it now, what will happen in a few year's time when there could be a real recession. They will not have any tricks left up their sleeve to rescue the market when it might really need it.
Let's not mistake ourselves. The year 2018 is not like 2008. Companies are much healthier and balance sheets stable. The housing market is a concern, which was addressed by Powell, but the Fed is on a data-dependent path, which is the most logical one. Trade war is a risk and if anything, it will show up in the inflation data later, but is not evident now.
What is perhaps unhedgeable, for lack of a better word, is how Trump's involuntary trade tariff spasms targeting the Chinese economy plays out over the next few weeks. If there is a recession in the next year, it will single-handedly boil down to President Trump's aggressive stance on China, putting an end to global trade that has taken years to establish.
Some of the points are noteworthy regarding Intellectual property theft and foreign company ownership laws that help China exploit the free market capitalism evident in our parts of the world. But going the extra mile and weaponizing the dollar, coercing nations by maintaining the dollar global reserve currency bias is taking it a bit too far. After all, why should we blame China's economic vision and strategic planning over the past twenty-five years to get them where they are today.
Now that oil prices have fallen 25% from the highs, chances of inflationary CPI prints are less, mixed with tighter financial conditions with hints of U.S. economic data slowing slightly, it seems the Fed is closer to the end of its near-term tightening bias. The U.S. debt and deficit will start to be a big problem going into next year. Judging by 10-year yields and oil prices, the risk on the dollar going into 2019 is lower, not higher. Yet the market is firmly positioned extremely long. One to think about.