What’s really eating at markets?
Last week’s little panic is already retreating into the distance. Markets are bouncing back and the “buy the dip” mentality is reaffirming itself as the only game in town.
But while I don’t think we’ve seen the top, I do think that something important shifted last week.
Let’s dig a bit deeper.
There’s no need to panic, but that shouldn’t stop you from being curious
A lot of financial bloggers – particularly those who are financial advisers on the side – like to adopt a tone of worldly detachment at times like these. They say that it doesn’t matter why the market sold off. Sometimes, it just happens.
That’s because they want to keep their clients from panicking. And there’s nothing wrong with that. Whether you decide to buy, hold, or sell, you shouldn’t panic.
However, having at least a theory about why the market is falling can help you to avoid panic by giving you a sense of control. And while it’s true that the market falls for many reasons, having an awareness of the underlying trigger is useful. It might give you a better understanding of just how temporary the panic will turn out to be.
For example, if you’d realised – as was pretty obvious at the time – that the underlying problem during 2007 was that the US housing market was infecting the credit markets, then you could have kept an eye on that rather than blithely regarding every fresh banking scandal as a buying opportunity.
Today, the surface issue is volatility. Markets have spent a long time assuming that volatility would be kept low. Those bets have been more or less explicit – spread betting the Vix is a very obvious bet on volatility remaining low, whereas being leveraged long equities is a less obvious bet on volatility remaining low. But they are both “low-vol” strategies.
But why the fondness for betting against volatility? Relentlessly rising markets have encouraged investors to make ever bigger bets. And make no mistake, the rise has been relentless.
In reality, we’ve only really had two significant periods of the jitters since 2009. There were all the ups and downs associated with the eurozone crisis, mostly in 2011. And there was the China panic in the second half of 2015 and early 2016 (the “taper tantrum” in 2013 was more of a blip than anything else).
And what is all of that down to?
Central bank policies, of course. And the “Greenspan put”, specifically.
The death of the Greenspan put
When Alan Greenspan was boss of the US Federal Reserve, he made it policy to bail out stockmarkets every time they looked like they were going down. He did so by cutting interest rates.
Ben Bernanke carried on the policy – when he couldn’t cut interest rates enough, he printed money instead. And Janet Yellen took up the torch after him.
But something has changed.
Economists spent a long time going on about how difficult it is to be a central banker during a deflationary period. You have the “zero lower bound” and all that stuff.
However, that only matters if you genuinely think a central bank is powerless at 0%. But it’s clearly not. Any institution that can print money and buy assets with it has all the firepower it needs to defeat deflation. It just needs to be brave (or foolhardy) enough to use it.
And the nice thing for financial markets is that money-printing is good for them. The rest of the economy can be wading through quicksand, but as long as they’re mainlining quantitative easing, then they’ll keep going up.
Inflation, on the other hand, is easy for central banks to tackle (or so the economists keep telling us). They just raise interest rates.
Trouble is, that’s not so good for financial markets. Higher interest rates means tighter monetary policy which means less money to flow into financial assets. In an over-indebted economy it also means margin calls, and unaffordable interest bills.
And it means something else. Inflation means the Greenspan put is no longer in play. When inflation becomes the enemy, the only solution is tighter monetary policy. And that means that the main thing underpinning bets on low volatility is in danger of being kicked out from under the market.
The risk now is that you get into a positive feedback loop (“positive” makes it sound like a good thing, but it’s not – it just refers to a process that is self-amplifying rather than self-negating). So a jump in volatility begets more volatility as investors are either forced out of positions, or opt to get out of positions.
So the fundamental question right now is: how restricted is the Fed in its ability to restore market’s faith in the Greenspan put?
I expect inflation to ‘run hot’
And this is why I think we’re still to see the true top for this cycle. Because I don’t yet think the Fed will have entirely given up on the Greenspan put.
Regardless of how tough Jerome Powell thinks he is, he is unlikely to want to go down as the man who ended the bull market prematurely. So I would still expect him to tolerate more inflation than markets perhaps expect right now – especially if stockmarkets continue to swoon every time the economic data is a bit better than expected.
It’s one thing to be a principled hawk while you’re on the back benches of the Fed. It’s quite another when you’re the one in the firing line when markets fall.
Last week’s panic was a warning shot across the Fed’s bows. If inflation data comes in strong (there’s a big US number due tomorrow, for example), and the Fed fails to make soothing noises, don’t be surprised to see another jolt, only harder this time.
I’d bet that the Fed will blink first. And inflation will be allowed to take off. But tomorrow’s inflation data will give us a better idea of what to expect.