Exit Strategies for Central Banks and for Investors

by: Prieur du Plessis

The end game for this bullish phase [on stock markets] needs to be considered well before the event. While the timing is largely guesswork at this stage, the usual causes are not. Bull markets are usually assassinated by tighter monetary policy.

- David Fuller (Fullermoney) said from across the pond.

Exiting an accommodative policy setting prematurely can have dire consequences. A change in stance derailed the recovery in the late 1930s and led to another leg of the depression, as highlighted yesterday in a short report by BCA Reseach:

By mid-1936, the Federal Reserve lifted bank reserve requirements in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces.

Obviously the economic relapse in the 1930s is an extreme example. Nonetheless, it does highlight the risks of authorities exiting prematurely before the economy and banking system are ready (even after an extended period of healthy growth).

Currently, US and UK money multipliers are still impaired, although aggressive easing has allowed some liquidity to flow through to the real economy. A decline in U.S. M2 growth would be a major warning sign. U.K. broad money growth has plunged in recent months, presenting a significant threat to the economy.

Policymakers will need to continue to curb investor expectations for an early exit in order to allow a sustainable recovery to materialize. It will likely be at least until the end of next year before growth conditions in the US and UK are robust enough to withstand a reduction in stimulus.

Click to enlarge:

bca-22-aug

Source: BCA Research, August 21, 2009.

Back to David Fuller:

A good, although not precise, indicator of bear market risk will be provided by the yield curve, currently showing the premium of U.S. 10-year over 2-year government yields. Years often go by before this chart shows anything important but it should not be forgotten by any of us. When this next approaches 0.0, we should have at least trailing stops, mental or actual, for all of our equity long positions. When it inverts to negative, indicating that 2-year rates are higher than 10-year rates, and the longer it stays negative, the more we should assume that a bear market is approaching.

Click to enlarge:

bca-22-aug-pic-2

Source: Fullermoney.com

Fuller continues:

The good news today, is that the next inverted yield curve is probably years away. Consequently, it would most likely take a true ‘black swan’ to derail the current bull market anytime soon. These are unpredictable by definition so I would not worry about them without evidence of a game-changing event. Meanwhile, setbacks in response to normal ‘wall of worry’ market volatility can be regarded as buying opportunities in favored assets.