Mohamed El-Erian’s opinion piece on Bloomberg says it will take a huge shock to deter risk-taking investors. He cites five mantras that stock traders have followed over the years:
- Never fight the Fed.
- The trend is your friend.
- There is no alternative.
- Fear of missing out.
- Buy the dip.
For me, the first one is the most significant, “Never fight the Fed.” The Fed has become more and more important over the years. When inflation, which had started under Nixon, took off under Jimmy Carter, Fed Chair Paul Volker inflicted painfully high interest rates that got it under control. Previously at Treasury, Volker had been instrumental in making Nixon’s decision take the US off of the gold standard work without destroying the US or the world economy.
Fed Chair Greenspan was famous for holding up the stock market with the “Greenspan put,” named for a market option trade that enables an investor to avoid losses on a stock that goes down. He was tested by the 1987 stock market crash just a few months after he was nominated to succeed Paul Volker. He presided over a second crash, the dot.com bubble of 2000, and he was Fed Chair during the 9/11/2001 World Trade Center attack, which was a huge blow to Wall Street.
Ben Bernanke was Fed Chair when the housing crisis hit in 2008, which threatened to bring down many of Wall Street’s most famous banks. In the end, thanks to Bernanke, Treasury Secretary Paulson, and others at the Fed and Treasury, only one major bank failed, Lehman Brothers.
When the Covid-19 lockdown crisis hit, Fed Chair Powell reacted even more strongly than Bernanke had. Although many of the Fed measures to fight the 2008 crisis were still in place, Powell opened the flood gates of liquidity even wider, flooding the financial world with cash.
The Fed “put” still exists and is more powerful today than it was in Greenspan’s day, justifying the maxim, “Never fight the Fed.” The “put” has a double sided effect of keeping the US out of recession, but also magnifying inequality by enriching stock market investors. This is a larger group that it was in previous generations, but still by no means includes everyone, and does not benefit investors equally. It clearly favors the richest investors. It subsidizes the rich to prevent the economy from collapsing for everyone.
El-Erian mentions a phenomenon that has existed mainly since the the 2008 housing crash: low interest rates and bond yields. People are buying stocks because bonds are such a bad deal. Bond prices go down when interest rates go up. There is no way for interest rates to go but up from here, and that means there is nowhere for bond prices to go but down.
Interest rates are low for several reasons, but the main one is that the Fed buys them all as soon as they are issued by the Treasury. If there is no demand for bonds the interest rate goes up. The Feds “quantitative easing” policy of buying bonds like crazy means that there is no reason for rates to go up because the Fed buys so many bonds quickly, no matter what the interest rate is, thus preventing the normal bond market from operating for normal investors. This is a global phenomenon because almost all central banks, particularly in Europe, have programs similar to the Fed’s “quantitative easing” resulting in negative interest rates in some countries, where banks charge you for holding your money instead of paying you interest.
The loss of the bond market as an alternative to the stock market has meant that the stock market has risen even faster than in the past because of another of El-Erian’s maxims: “There is no alternative.” This is illustrated by the fact that the market has risen so much even as the Covid pandemic has played havoc with the economy. Most recently the US suffered one if its most embarrassing defeats in Afghanistan in the last few days, but the defeat has almost no effect on market optimism. The world may see the US as incompetent, weak and vulnerable, but investors see it as strong and vibrant.
US investors have turned against China in recent days because it has cracked down and restricted many of its most famous high-tech companies. They see this as a Chinese turn away from innovation toward more repressive government control. There is an element of this, but I think China may be reacting to what it sees as excesses in the world financial markets, and is trying to limit this excess in China. If this is the case, then I think it is good thing. I worry that the excessive optimism in the US markets may be leading to a fall at some point, but I thought we would have seen something crack long before now.
Finally, I think the US needs to repair its infrastructure, but I am not sure that now is the best time to do it. We have spent like drunken sailors since the Covid crisis, running up the most debt since World War II. I think this may be an overreaction. Covid has killed many, but mainly it has killed older people, while war mostly kills people in their 20s, some of their most productive years; so, there is less of an effect on the economy. Despite the fact that the damage to the economy was not as great as a war, the US government borrowed as if it were. The borrowing was encouraged by the new, trendy idea that deficits don’t matter. For some reason the economists have decided that governments never have to pay off their debts and so it doesn’t matter how much debt they have. I don’t believe this idea. I think someday interest rates will go up and it will become very expensive to pay off a gigantic federal debt. Therefore, I don’t think this is the best time to start a very expensive infrastructure project. It is as if you had just gotten out of the hospital with big medical bills and when you got home said, “Now is the time to build that new swimming pool we’ve been talking about for years.” You should spend on big projects when you don’t have extra bills, like we have for the Covid stimulus. We should get our house in order first. We can always spend on essentials, like repairing bridges before they fall down, but we shouldn’t take on big, new projects now.