by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· A well-known central banker once said to me, “if you don’t have a Plan B, then you don’t have a plan”. When he spoke those words over a year ago, he was referring to the Fed’s lack of an exit strategy from zero rates and its QE-swollen balance sheet. He was telling me that the Fed was so focused on bettering ‘today’ through aggressive stimulus that it could not worry about ‘tomorrow’. He speculated that central banks were “terrified of looking as if they were doing too little”.
· Part of the Fed’s aggressiveness entailed waiting as long as possible to initiate its first hike. However, many believe that the Fed waited much too long, and in doing so missed the ideal window of opportunity to hike (for the first time in almost nine years). Some would even characterize Twist, QE2 and/or QE3 as unnecessary, labeling it monetary over-reach and the underlying source of the violent market behavior observed since the hike in interest rates.
· It is likely that a non-linear direct correlation has existed between the length of time the Fed maintained its extreme accommodation and the market’s reaction at the point of rate ‘lift-off’. If this is true, then financial risk assets would have been even more adversely affected if the Fed had waited longer to hike; alternatively, markets would have had a lesser reaction if the Fed had hiked back in 2013/14. This formula likely became even more precise the further nominal GDP underperformed rosy forecasts.
· Paradoxically, the quick and sharp declines in equity and credit markets have caused many pundits to allege the opposite point of view - that the Fed made a ‘mistake’ by hiking rates in December. It is counter-factual to know for sure, but I maintain that the market reaction would have likely been much less severe had it come earlier, and much more severe had the Fed delayed the inevitable even further. Therefore, if there was a ‘mistake’, it was hiking too late, rather than hiking in December. There is never a “good time” to hike rates (reduction ad absurdum)
· It is easy to play ‘armchair quarterback’, but few would disagree that ‘good’ policy leads to good outcomes. By waiting so long to shift gears, debt levels increased further, global and US economic growth waned, China and Japan stumbled, and geo-political tensions increased. One thing seems clear, the Fed’s timing became ‘less good’.
· Some of you may be thinking that the factors just listed would suggest that no hikes would have been best. I disagree. Monetary policy has been unfairly called upon to fix all which ails economies and financial markets. There has to be some tipping point where too much monetary stimulus – via QE or negative rates – ensures negative long-term benefits and great risks to financial stability. Where exactly is this point? Are we there yet?
· The Bank for International Settlements (BIS) warns against asymmetric monetary policy’s ‘propensity for hugely damaging financial booms and busts’. The BIS believes such policy entrenches financial instability leading to chronic economic weakness, and ruptures the open global economic order (translation: leads to currency wars and protectionism).
· Markets have developed an unhealthy dependency on central banks to provide ever-greater stimulus with each decline in financial market prices or ebb in economic activity. A highly-combustible paradigm exists when risk assets perform better as economic performance wanes (like today), simply because of the expectations of further central bank support.