Policy makers have no end game or Dont fight the Fed - Whatever it is, this time its not different !!!!!

Policymakers have no endgame, markets do. -  Stan Druckenmiller

Don’t fight the Fed – Old saying on Wall Street

So how do we reconcile the two. Like debates between efficient markets and mispricing, like Eugene Fama and Bob Shiller, both these are right at some time or the other. Most of the times, markets are efficient, hence it is very difficult to find and edge in investing or trading but there periods of huge dis-locations when Mr. Market goes like the whole world is going to end and nothing will survive. From 2008 until now, “Not fighting the Fed” has worked remarkably well. Central Banks did an excellent job of getting things back in line when they were about to fall off and bought politicians time. But what did politicians do? They did what they do, politicise, debate, procrastinate, appease to short term agendas and passed the baton back to central banks, who seem to have finally run out of ammunition and tools. And when finally a political decision had to be made, the politicians ran for the hills and it was handed over to the people and when all were focused on Grexit, Italeave etc., Brexit happened. Of what use is political leadership when decisions like these are forced upon the people? Did US Fed and Treasury undertake a referendum when they came to the rescue of the US financial system and the 1%. Maybe they should have, they might have got a different answer. But coming back to political leadership do we have any at all? So now that almost a decade is about to pass since the subprime crisis began (in 2007), what have central banks achieved after steadying the economy. Is there growth, employment, capital expenditure, consumer confidence and I can go on. But the point is that once monetary policy (fancy word for cutting and raising interest rates) and cheap money steadied the markets, what steps did the political leadership take to put the economy back on track. Zilch.

So is Brexit the canary in the mine which is telling us that the end of the very abnormal period and never seen before in our lifetime situation of negative interest rates (not in India yet) is about to end or will it get worse before it ends? Sorry, don’t know the answer to that one. It will evolve and will evolve fast. Remember the most recent crisis in 2008, well a mini crisis had already started in 2007 but equity markets didn’t take notice until 2008 but credit markets had started to take notice. So we will see an end game when enough market participants believe that this is the end game.

In a recently released transcript ,of an interview of Warren Buffett, conducted by the Financial Crisis Inquiry Committee, "The basic cause, you know, embedded in psychology, was a pervasive belief that house prices couldn't go down and everyone, virtually everybody, succumbed to that. But that's the only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise. It's quite interesting how that develops. The originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action. So the media investors, the mortgage bankers, the American public, me, my neighbor, rating agencies, Congress, you name it — people overwhelmingly came to believe that house prices could not fall significantly. And since it was biggest asset class in the country and it was the easiest class to borrow against, it created probably the biggest bubble in our history."

For those who want to read the above in Soros’ words can read the following paragraph and those who like Buffett’s folksy explanations can skip it.

Let us revisit Soros’ two core principles. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. Now let us distinguish between the objective and subjective aspects of reality. Thinking constitutes the subjective aspect, events the objective aspect. In other words, the subjective aspect covers what takes place in the minds of the participants, the objective aspect denotes what takes place in external reality. There is only one external reality but many different subjective views. Reflexivity can then connect any two or more aspects of reality, setting up two-way feedback loops between them. Feedback loops can be either negative or positive. Negative feedback brings the participants’ views and the actual situation closer together; positive feedback drives them further apart. In other words, a negative feedback process is self-correcting. It can go on forever and if there are no significant changes in external reality, it may eventually lead to an equilibrium where the participants’ views come to correspond to the actual state of affairs. That is what is supposed to happen in financial markets. So equilibrium, which is the central case in economics, turns out to be an extreme case of negative feedback, a limiting case in my conceptual framework.

By contrast, a positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction. Such initially self-reinforcing but eventually self-defeating boom-bust processes or bubbles are characteristic of financial markets, but they can also be found in other spheres. There, I call them fertile fallacies—interpretations of reality that are distorted, yet produce results which reinforce the distortion.

Both masters are saying essentially the same thing. People’s perceptions cause external events and then feedback loops take over until markets self-correct. Central Banks can suspend laws of economics but only until the feedback loop breaks or the bubble bursts. Until then dance away.

So after all the heavy lecture above let us take a step back and look at some data points 12 months prior to Brexit, at the beginning of the calendar year and post Brexit.   

	24-06-2015	01-01-2016	24-06-2016	TTM	YTD
Nifty	8350	7982	8086	-3%	1%
S&P	2108	2013	2037	-3%	1%
FTSE	6844	6093	6139	-10%	1%
Repo Rate (India) %	7.25	6.75	6.50	-10%	-4%
US 10 Yr Treasury Yields %	2.37	2.29	1.56	-34%	-32%
Gold (USD) per ounce	1172	1075	1320	13%	23%
Gold (INR) per 10 gms	26418	24943	31131	18%	25%
USDINR	63.45	66.16	67.87	7%	3%
USDGBP	0.63	0.68	0.75	18%	11%
Crude (USD)	60	37	48	-20%	30%

The table is self-explanatory. Risk assets have been under pressure the last twelve months. And treasury yields are falling and gold in every currency would be up. “Risk off” has been on for a year now. And this may be just the beginning. We cannot foresee any event or even in what sequences will events occur which lead to the inevitable correction in global interest rates. Will we as a global economy have few lost decades like Japan or will the laws of economics catch up soon and markets take control back from central banks in terms of pricing interest rates to take things back to their logical end game. We have no way of knowing so we just focus on managing risk and leave returns to the markets.