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.
