Monday, April 20, 2015

Not Quite Like Before: The Dollar and the US Economy at Odds

 The dollar is currently rising through levels not seen since the mid to late 1990s. That of course was a time of great optimism, inspired by a wave of economic development and expansion, not just in the US but across the globe as a whole. Since then we’ve seen the dollar peak and drop to lows made just prior to the onset of the Global Financial Crisis of 2008. Along the way, the tech bubble burst, the housing bubble burst, and finally the commodity bubble burst. The bubbles themselves representing the peak of the dollar, the accelerated decline, and reversal respectively over time. Now, the dollar is once again appreciating steadily versus the currencies of US trading partners.

On the surface, this looks like the US economy is standing out as a place where an investor can earn a reasonable return when adjusted for risk, as was possible in the late 1990s. With a few details missing this time of course. For starters, the economy is just not growing with the same enthusiasm as it did back then. Unemployment is not providing upward support for wages and consumption now as it did in the 1990s, while short and medium term inflation in not expanding providing support for interest rates and monetary. This much being obvious, the financial markets have been able to steady the course to higher prices for both stocks and bonds. Albeit, a sizable chunk of the financial asset price increases can be attributed to the mechanical requirements of administering the Federal Reserve’s Quantitative Easing programs by the Federal Open Market Committee (FOMC), the remainder can be attributed to investors underpricing risks of future price decreases by continuing to transact at the elevated price levels.

As with most aspects of human existence, this too is unsustainable. The complexity of the moving parts that influence the macroeconomic, and monetary equilibrium of an economy like that of the United States will undoubtedly continue to make deciphering a clear narrative a daunting task.

Wednesday, April 8, 2015

What Really Happens to Asset Prices?

If you subscribe to the conventional dialog about the normalization of monetary policy by the Federal Reserve, the so-called ‘lift-off’ should be this summer or thereabouts. I’m not necessarily convinced that the timing is best, but I digress. The primary result of the Quantitative Easing programs utilized by the Federal Reserve was an enormous increase in excess reserves in the banking system. A secondary effect was the run-up in financial asset prices, as a result of the open market actions of the Fed to influence the levels of long-term interest rates. Economic Commentaries from the Federal Reserve Bank of Cleveland suggest that the target of Fed tightening will be the excess reserves within the banking system, and not necessarily interest rates from the onset.

When the vast amounts of liquidity that the banks hold starts to collectively dry up due to the change in the Federal Reserve’s stance on monetary policy, the transactions that have been supporting financial asset prices will begin to slow. At that point, what happens to asset prices? Equities prices on one hand, are at record highs and likely to drift higher. Without the technical demand from the banking system, the fundamental demand in relation to household savings levels will not be enough to keep equity prices at or above current levels.  Debt prices on the other hand, are at record highs and likely to drift higher. It is important to note, that the rebalancing effects of the Federal Open Market Committee’s (FOMC) actions in the debt markets to influence long-term interest rates pushed bond prices to now elevated levels.

Quantitative Easing was a necessary evil on the part of the Federal Reserve, as doing nothing would have been even less palatable. Now, we’ve arrived to the point of dealing with the aftermath and eventual unwinding of the policies. Without the implicit and at some points explicit support of the Federal Reserve, financial markets in the US and by extension the rest of the world would be forced to stop pretending. A more realistic picture of the economy may have a chance of emerging. Monetary policy unwinding does not necessarily turn into a market crash, it would simply effect a realignment of Wall Street with Main Street.