The problem with authority

Five years into a great bull run for the stock market, equities might seem invulnerable. Many believe they are the only game in town. With deposit rates at rock-bottom levels and the yields on traditional government bonds (and therefore also most corporate bonds) pitifully low, there’s a superficial logic to the equity story. But it critically ignores one gigantic elephant in the room: the future path of interest rates.

I think it’s time to make some pre-emptive action against rates. Call it too much belief in authority. We only need to look to history for evidence. One of the most famous examples was the Milgram tests, a series of experiments run by Yale psychologist Stanley Milgram in 1961.

The Milgram tests

Each test involved three participants. Two of them – the one co-ordinating the experiment, and the so-called ‘learner’, were ‘in’ on the experiment. The third, the supposed ‘teacher’, was the unwitting subject of it.

So, the teacher began by reading a list of word pairs to the learner. Then they would read the first word of each pair again, and four possible ways to complete it. The learner would press a button to indicate his response.

If the answer was incorrect, the teacher would be instructed to deliver an electric shock to the learner. Each wrong answer increased the voltage by 15 volts.

The ‘teacher’ participants believed the shocks were real. They weren’t. The ‘learners’ were all actors, the electric shocks faked. But that didn’t stop 65% of the participants in Milgram’s first experiment administering the final massive 450-volt dose.

Every time any teacher was hesitant to continue delivering (and enhancing) the shocks, he was told by the experimenter:

2. The experiment requires that you continue.
3. It is absolutely essential that you continue.
4. You have no other choice, you must go on.

If a teacher still wanted to stop after receiving all of these verbal cues, the experiment was halted. Otherwise, it was halted only after the learner had received the maximum 450-volt shock three times in a row.

Milgram’s experiment started three months after the trial of the German Nazi war criminal Adolf Eichmann began in Jerusalem. Milgram set out to answer the question: could it be that Eichmann, and those like him, were simply ‘obeying orders’?

In the Milgram experiment, the bogeyman authority figure was not a senior army officer. It was just a man in a white coat, armed only with a clipboard.

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Obedience and the system

Summarising his experiment, Milgram wrote: ”Stark authority was pitted against the subjects’ strongest moral imperatives against hurting others, and, with the subjects’ ears ringing with the screams of the victims, authority won more often than not.

“Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”.

Milgram’s results are hardly unique. Before this type of experiment was banned, they were carried out in universities around the world. The results were remarkably similar.

But what does all this mean for investment?

For Stanley Milgram, authority was a man in a white coat. For me, authority is the US Federal Reserve. In fact, it’s any central banker. And they are all just as susceptible to the corruption of power as the participants in the studies listed above.

The individuals working at central banks are probably normal and well-intentioned. But they operate within a perverse system, which does the world a great deal of damage.

Western central banks are dangerous for a number of reasons.

Quantitative easing (QE) - The QE programmes they have pushed so aggressively have distorted relative prices across all asset types. They have only delayed the inevitable deleveraging.

Artificially low rates - Having driven policy rates down to zero, they have forced investors to chase yield. That means exposing themselves to higher degrees of risk than they might have otherwise. That’s because cash deposits have effectively been eliminated as a viable investment choice.

Kicking the can down the road - In pumping up the money supply (and their balance sheets), they have set the scene for a potentially dangerous inflationary mess further down the line.

A false sense of security - Many investors accept that the central banks know what they are doing. Even that “they have everyone’s back”, or what used to be known as the ‘Greenspan put‘ – supporting equity markets – is alive and well. That’s even as his successor, Ben Bernanke, passes the baton to Janet Yellen.

Don’t fight the Fed

In the markets, there’s a simple rule of thumb: don’t fight the Fed.

Given its almost unlimited monetary firepower, it has never made sense to bet against Fed policy. But that was before the Fed and its international peers went ‘all-in’ with quantitative easing.

Now the West’s central bankers have an existential problem: their influence over markets only works while investors believe that that influence still holds.

The Fed is now faced with a market that expects a ‘taper‘. It won’t be disappointed. It will be a modest one, though, with monthly monetary stimulus and credit purchases falling from \$85bn to \$75bn.

Any abandonment of tapering runs the risk of spooking markets, like last summer. Back then the Fed blinked in the face of a nervous bond market. The result was a market rout, and ten-year US Treasury yields shooting up – from 1.6% in May to 3% in September.

An eye on 2014

Long story short – I think the lesson for 2014 is clear.

Be wary of rising interest rates. Short-term monetary policy rates can stay anchored near zero in both the US and the UK, even though such emergency measures are no longer warranted.

Prevailing economic conditions are improving. But neither the Fed nor the Bank of England can prevent yields from rising in longer-dated government debt markets. And if higher bond yields do arrive this year, equity markets are unlikely to be immune to it.

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10 Responses

1. 22/01/2014, Jim C wrote

“But neither the Fed nor the Bank of England can prevent yields from rising in longer-dated government debt markets.”

Sorry Tim (much as I agree with most of this article) both CB’s are perfectly capable of suppressing rates. They can do so with jawboning ie, announcing that they’ll be buying longer dated gilts, which encourages investors to try to front-run them, thus pushing down yields. Or they can do it with more outright QE and just buying more of them whenever longer dated rates start getting higher than they want them to be.

Interest rates will only be allowed to rise once the CB’s own a sufficiently large proportion of them that the increased debt repayments won’t cripple their respective governments’ budgets. Are you arguing that we’re at that point already? I don’t see it, myself.

• 23/01/2014, tot777 wrote

The FED already owns over 1/3 of US treasuries on a duration weighted basis. How much more can they buy before they before it’s no longer a free market, but state-sponsored deficit monetising? What happens if the FED own all US treasuries? Will the USD still be treated as a reserve currency if all of the treasury issuance is monetised? Don’t banana republics engage in the same practice and get crucified in the currency markets for it? If bond prices fall, where will the money come from to cover all the losses in the FED’s balance sheet?

• 23/01/2014, Jim C wrote

Good questions. But what happens if yields rise and we have a cascade of bank defaults?

Fiat currencies typically last 40 -60 years. The USD went fully fiat back in 1971 when it was no longer tied to gold… and no country has ever managed to retain reserve currency status forever, either.

The principle thing underpinning the USD’s reserve status is petrodollar recycling. Oil is not only priced in dollars, most of its producers demand it’s paid for in USD, too.

Iraq and Libya are two countries that decided they’d take other currencies… notice what happened to them? There’s a reason the US spends as much on ‘defence’ as the rest of the world combined… and it ain’t ‘defence’ in the normal use of the word.

2. 22/01/2014, Orb wrote

Japan got away with it for 2 decades, ruining much of the private sector in the process by forcing business to cut profits to the absolute bone, driving many enterprises to the wall in the process. Now there is no way out; the day of reckoning beckons… what a mess!

Thanks be for central bankers – my JPY shorts are doing VERY well =)

3. 23/01/2014, GordonC wrote

This is for Bengt – any comment about our old friend HRT?

4. 24/01/2014, Ellen12 wrote

Mark Carney says there is no immediate need to increase borrowing costs now that unemployment looks set to fall below his forward guidance rate of 7% and any decision will be made at next months meeting of ‘High Kings and Druids’. Thats it – there is ‘no need’ – that is the only explanation he is prepared to offer. I cannot think of another person in the country that lacks accountability in the way he does. We all wait, like small children, for his arbitrary decision that are not even based on his previous decision of dictate of ‘forward guidance’. The Queen, and modern monarchies in general, try hard to fit the idea of a monarchy with the democratic idea of enabling all citizens of the country participation. But Mr Carney bears more of the hallmarks of emperors or kings of previous centuries who are simply not challenged and are free to dictate and implement their policies without needing to be held accountable to anyone.

5. 24/01/2014, Mr Tweet wrote

I agree with Jim C that the CB can manipulate the bond market all it likes, however it cannot do so with impunity: pressure that should be alleviated by movements in the bond market will ultimately start to show up as a fall in the currency if the CB starts to intervene ‘excessively’ – the actions of an insolvent nation. The actions of the CB in buying bonds will precipitate the very thing it is trying to avoid as it will stoke inflation through falls in the currency and prompt investors to offload bonds meaning the CB would have to buy even more to steady yields, and round it goes. And a CB has absolutely no chance of manipulating a currency market as we saw with the ERM fiasco. It’s a dangerous game.

• 24/01/2014, tot777 wrote

What if all central banks buy bonds at the same time? Then there is no fall in the fiat currencies relative to each other.

• 27/01/2014, Jim C wrote

But the CB’s (and the BIS) also intervene in currency markets (and gold, as GATA has conclusively documented). So if a currency is ‘important’ enough, they can and will intervene to prop it up.

But I agree, they are not masters of the universe; eventually all the monetary inflation that is required to enable these proppings-up will begin to manifest in the form on accelerating price inflation.

It’s hard to be sanguine about what lies ahead; we have huge debt overhangs; increasingly masked price signals; fairy-tale official statistics regarding GDP, inflation, and unemployment; and unelected bureaucrats essentially running our so-called ‘capitalist’ economies.

I see increased inflation, defaults, bail-ins, capital controls and general financial repression ahead.

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