Think for a moment …
Everyone who worries about the market is worried about one thing, really …
What happens when central banks run out of ammo?
Yeah, I know. We’ve been asking that question since 2008, when Hank Paulson brought out the bazooka and blew the federal government’s proverbial wad in a matter of days.
That’s because, since the U.S. bailout bazooka left some nasty gunshot residue inside the nostrils of the American public, the Feds smartly stepped off the firing line. And they made way for, well, the Fed.
As in, the Federal Reserve.
From then on, save for China where a major stimulus would be unleashed, the future of accommodation would be provided mostly by central banks.
Out came the Fed’s QE bazookas.
Mario Draghi, head of the European Central Bank, has since brought out a few bazookas of his own.
With a looming Brexit, would Mr. Draghi break out the bazooka once again?
If you ask central bankers, they’ll tell you that monetary policy accommodation has been largely successful.
Especially recently, Mr. Draghi has been playing up the easier financial conditions in the Eurozone as a result of the transmission of ECB accommodation through the financial system.
In March, with perhaps his last bazooka episode, Draghi said:
"… the experience that we had in our case with negative rates has been very positive in easing financing conditions and in its transmission of this better financing conditions to the real economy."
He did offer a disclaimer along the lines of, in my words, "it’s all good now unless something changes."
I’m going to go out on a limb here and say things could quickly change if the transmission of monetary accommodation is shut off.
Which brings us back to the same question: What happens when they run out of ammo?
If they step away and the world realizes major economies depend on the debt and borrowing made possible only by artificially low rates, then what?
Then lower rates?
Then more bond-buying?
The Fed has said they are done buying bonds, after having dramatically altered the make-up of that market.
It feels like the Bank of Japan is buying everything.
The European Central Bank is now buying corporate bonds. To that point, here is some commentary I received last week:
"The ECB is keeping pressure on interest rates to stay low globally. Due to the ECB’s actions, it’s now cheaper for European companies to borrow cash.
If the U.S. Federal Reserve (the Fed) did the opposite and raised its interest rate, that would make it more expensive for U.S. companies to borrow money — which would hurt their profits.
In a world as globalized and competitive as ours, Europe’s low interest rates make it difficult for the U.S. Fed to raise their rates without making life more challenging for American companies (and the U.S. economy) — which is one major reason why the Fed is struggling to raise its interest rate."
The more directly central banks become involved in the markets, the more direct the consequences of withdrawing.
The head of the Reserve Bank of India acknowledges it:
"Monetary policy works through the public’s expectations … [and it’s bad] if the public believes that policies will never change, and takes on leverage and positions in assets commensurate with that. While this may help the central bank achieve its objectives in the short run, the shifts in asset price when policy does inevitably change, with effects exacerbated by enhanced leverage, could create enormous dislocation."
In other words: Central banks can’t keep going forever … and the market will decide when they stop.
So what’s the answer, then?
Government to the Rescue?
What a relief. (Or not.)
I argued earlier this year — when the market started worrying about China’s debt burden again — that China would be able to kick the can and avoid major turmoil in the near term. That’s because it would be able to alleviate financing pressures on the private sector by transferring debt obligations to the public sector.
Now it’s time for the rest of the world to take a page out of China’s book, or so it seems:
That chart shows that governments are finding it possible — that is, politically palatable — to spend again.
If you remember, 2010 marked a Tea Party revival in the United States that attached a somewhat-welcomed stigma to the face of government largesse. A rare instance of We the Feds throwing We the People a bone.
The same Bloomberg article where I found the above chart stated:
"This news is music to the ears of international organizations such as the International Monetary Fund as well as financial heavyweights like former Fed Chair Ben Bernanke and BlackRock’s Larry Fink, who have long argued that governments should play a larger role in driving growth."
Oh, crap —
Does this mean markets are hung out to dry?
The Fed is running out of monetary bullets. But stocks don’t seem to care as much as perhaps they should
Monetary accommodation will not be withdrawn hastily just because the Feds are transitioning in to take the reins of economic stimulus.
Monetary policy simply is unlikely to maintain its accommodation trajectory IF government spending does indeed assume the responsibility for economies around the world.
Certainly, that will impact markets. Starting with currencies where exchange rates might take on a positive correlation with fiscal accommodation … as opposed to the current negative correlation with monetary accommodation (low interest rates).
There are a whole lot of moving pieces there, but it assumes government officials can actually convince the world they are taking prudent, effective steps.
As with the ECB’s purchases of corporate bonds, fiscal policy must at least appear to be creating economic opportunities in the domestic economy. These types of things will boost asset values in those economies on a relative basis.
The broad takeaway, though, won’t be as discriminating … yet.
If central banks hold tight with current policy and don’t do anything rash (they won’t), then markets in general should feel good about the willingness of policymakers to keep hope alive.
Many, many investors remain bearish on the markets despite its ability to shake off the risks.
Some analysts did, however, just propose the markets are approaching a "melt up" phase. That’s where prices slowly and steadily climb beyond what’s generally expected as possible in the current environment of lofty valuations and mediocre earnings growth.
Preparing for Melt-Up
Now, I don’t know if the markets will begin their melt up immediately. Actually, I think a correction might be in order first, and the melt up will commence in the fall, a few months from now.
I’m not sure the last time I shared this chart with you:
This bull market reveals a pattern that eerily resembles other patterns in market history. Namely the U.S. market’s supercycle spanning the 19th century and the Dow Jones Industrials supercycle spanning the early 1930s through the late 1970s.
If history repeats, U.S. stocks make a new high in the near term.
Then they fall sharply similar to what we saw in January.
After that, a longer-term move to the upside would commence and produce the final wave of this bull market — the so-called "melt up" that would catch many investors off-guard.
Indeed, another 18 months of bull market sounds crazy, but the fact that so many investors are sour on this market already suggests a lot of buying can rush in when the world internalizes what fiscal and monetary policies makers are ready and willing to do to keep the music playing. (With or without bazookas.)
Don’t rush into shares just yet. But be ready to in the coming months.