One of the most famous cats in the world was one owned by Erwin Schrodinger. In 1935, Mr. Schrodinger, a German physicist, devised an experiment. He would put a cat in a box. As long as the cat remained in the closed box, it would be alive. The moment the box opened and we could observe it, the cat would die (no ESG awards for Mr. Schrodinger). Illustrating a quantum physics paradox, the cat was, both alive and, at the same time, for any observer, dead.
It may come as a surprise, but financial markets are less interested in interest rates (which take a lot of time to feed into the real economy, especially from such low levels), and more about two other factors: Quantitative Tightening (QT) and the Fed Put. The former will determine how liquid markets will remain and who will buy US Treasuries. Currently, markets are pricing in roughly a year's worth of QT.
More importantly, investors care about the Fed Put. We believe that the Fed Put is now in roughly the same place as Mr. Schrodinger's cat.
Much like Mr. Schrodinger, for the past few months, the Federal Reserve has kept us speculating whether its 'Fed Put', a promise to put a floor under risk assets, is alive or dead. The S&P 500 has dropped nearly one thousand points, yet the Fed remains hawkish. Nevertheless, after thirty years of life, the Put has not been pronounced dead. Much like Schrodinger's cat, we assume it exists in the Fed's black box, but we can't see it.
Does the Fed care for its Put?
Last week's US payroll numbers coming in stronger than expected are doing little to sway the Federal Reserve from its hawkish course, despite some indications of slower wage growth. Nor are they likely to do so in the near future. Pandemic-related disruptions are over and most workers are back to full employment, yet labour conditions remain tight. The Fed will stick to the letter of its mandate and focus on inflation, at least while unemployment remains low. Thus, volatility is set to continue.
But one questions: How can the Fed not care about markets panicking or crashing growth? How can it disregard the worst market in nearly twenty years, compared only with the 2008 financial crash? How does a roomful of some of the world's smartest minds talk of a 'soft landing' when no evidence exists that central banks can control the process once it has started? And where was that inflation focus during the last fourteen years of unfettered Quantitative Easing - and low employment conditions?
The answer, dear Brutus, might in the end be in our stars, and not us. And by ‘stars’ we are talking not about the people, but about the legal mandates from which central banks are legitimised. The Fed, like other central banks, is a national organisation, trying to influence a globalised economy. It knows that inflation is due to the confluence of arrhythmic supply chains, a ‘stealth’ Chinese slowdown and a war in Eastern Europe. But its mandate says "you have to try, that is your job". So it tries to treat a global problem with a local remedy. After all, the world's biggest consumer market may well influence global demand enough for inflation to subside. Of course, if such pressure was to be applied on the US consumer that it could curb global inflation, then a deep recession would be all but assured.
We predicted this before, and are happy to do it again. For fourteen years, global central banks printed money to keep the financial system stable, well beyond any evidence that it was unstable, at least after the Euro crisis had passed. As the money was being kept in a closed system, what occurred was asset inflation, a very insidious form of inflation. While it doesn't increase prices in the super-market, it increases prices for risk assets. Owners of financial assets saw significant gains. As a result, home prices rise. Great if you are an owner of the asset, bad if you try to acquire it. Many millennials are already priced out of the housing market. It's even worse if you are a pension fund and need high long term yields to fund your liabilities. As this was a game for stock markets, not real investments, capital expenditure remained low. As a result, inequality rose, the quality of jobs deteriorated and populism and political instability, fuelled by the corrosive effect of unfettered social media, became the norm even for developed markets. Now that inflation is further eroding real incomes, dissatisfaction is rising even further.
Already, the central banks are under attack, for failing to predict inflation. Their past policy of quantitative easing is increasingly seen as the culprit. Their supporters, financial markets and their agents, are already frustrated with central bank behaviour. This narrative will be difficult to refute, especially as central banks are considered independent, and governments have little incentive to support central bankers. After all, the impact of inflation on approval ratings is well documented, and they need to put out their own fires.
And here is the risk which investors should start pricing in: An overhaul of our political and financial institutions. A time when the international nature of the economy clashes with the national nature of rules and regulations. It won't happen in a day. But the social changes and distrust of institutions we witnessed after 2008, could well be with us again. If one believes that these confidence issues are transitory, then one has but to look at the impact of Brexit, near-dissolution of the Eurozone and the culture wars that continue to hamstring US legislation. Unhappy markets make for unhappy headlines, and years of resentment may be unleashed within a matter of days.
This is where things are headed, especially if we assume that the Fed's Put is dead. If however, Mr. Powell decides to let the Fed Put out of the box, much like I assume Mr. Schrodinger eventually let his cat out, and markets get their 'proof of life', then investors would once again put their weight behind institutions and portfolio holders could experience a significant rebound in risk assets. As for significant political change?
This usually doesn't happen in Bull Markets…