Losing Control

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by: Eric Parnell, CFA

Summary

The Fed was once the primary game in town.

Today, it is an afterthought.

Investors may have become complacent just as the punch bowl may get snatched away.

Investors worried for years during the post crisis period about Fed policy. All along the way, investors hung on their every word, and the Fed utilized this control by trying to micromanage the markets in an effort to spark a sustained economic recovery. But after years of relentless stock market gains, the bulls have become so intoxicated by the seemingly endless rise in the U.S. stock market that they seem to no longer really care about the monetary policy committee that had them so anxious for so many years. As a result, it appears that the Fed and other global policy makers are not only falling increasingly behind the curve in tightening monetary policy but may also be losing control over markets altogether.

Party All The Time

The U.S. Federal Reserve has control issues.

First, it thought it could control the business cycle. Why do we even need recessions? If we apply our monetary policy in just the right way, the economy can continue to grow uninterrupted.

Next, it thought that if the economy need not feel pain, then why should investors? If we provide the right amount of liquidity into the financial system, then stock prices no longer need to go down in any sustained way.

The fact that we have appointed government officials that are allowed to go unchecked in implementing their policies and pursue such fundamentally misguided thought processes is extraordinary. Sure, it would also be great if the sun could shine 24 hours a day and I could get in great shape by sitting on my couch all day long eating chips. And, imagine how much more productive I could be if I took those pesky six hours that I use sleeping every day and decided to stay awake instead?

But life and nature do not work this way. There is a reason why we have expressions like "no pain, no gain" and "character building experience". And, there is a reason why we don't let our children run wild and eat cotton candy for their meals every day. It is because imposing discipline, enduring challenges, and exercising prudence help make us stronger and more fundamentally sound as people. There is also a reason why we sleep at night, as the body needs the opportunity to slow down and repair itself so that it can start the next day stronger and refreshed.

The economy and its markets are no different. Recessions and bear markets are good things, as they allow a healthy cleansing of the system where inefficiencies are wrung out, excess capacity is worked off, and misallocated capital is redirected toward more appropriate uses. By preventing the ability to effectively rest and repair through recessions and bear markets, monetary policy makers are rendering the economy and its markets much weaker and broken in the end than they could otherwise be. There is, after all, a reason why the sustained economic recovery during the post crisis period has remained so elusive.

Instead, the U.S. Federal Reserve, along with other central banks, through its endless efforts to defy the business cycle and not allow capital markets to correct in any meaningful way, is destructive, as trying to repeal the laws of nature is an effort that is destined to end badly. By feeding endless servings of stimulus and easy monetary policy, the Fed is effectively rendering the economy and the stock market (NYSEARCA:SPY) sleepless while allowing it to stay firmly planted on the couch with a smorgasbord of pizza and punch. Sure, it's a fun party while the good and easy times last. But eventually, the economy and its markets will end up having a massive heart attack.

We've seen two such coronaries already in recent years with the bursting of the tech bubble and the housing bubble. And, unfortunately, in each past instance, the Fed immediately returned to its greasy dietary program. For while most people have the good sense to not keep serving up even more fried chicken, buttery biscuits, and booze to the recovering heart attack victim, for some reason, those at the Federal Reserve think different principles apply. And, when the investor patient never learns and seems not to know any better in repeating over and over again the same behaviors that landed them in the stock market hospital twice already in the past two decades, it is an even greater abdication of responsibility in the way the Fed insists on trying to continue carrying out monetary policy in support of the profligate and at the expense of the prudent.

Punch Anyone?

So, where do we stand today? We are currently in the second longest stock bull market in history with its start dating back to March 2009. And, we are also in the third longest economic expansion in the nearly 250-year history of our nation. While this all sounds great on the surface, what this really means is that the economy and its financial markets have gone a particularly long time without a meaningful restorative cleanse. And, the longer the latest excesses are allowed to accumulate, the more dramatic the eventual cleansing process is likely to be once it finally takes place.

How has the Fed and other central banks fostered this outcome? By tripling their collective balance sheets through adding a total of $12 trillion in assets over the past nine years. To put this into context, global central bankers have effectively created out of thin area and injected into the economy money that is equivalent in size to the annual output of the second largest economy in the world in China (NYSEARCA:ASHR). In short, they've printed a ton of money.

Given that global fiat currency system is still effectively a baby at less than 46 years since the collapse of the gold (NYSEARCA:GLD) standard in 1971, the fact that financial markets maintain continued confidence in a system where central bankers have spent roughly a fifth of this entire time period now since the financial crisis nearly a decade ago, debauching these same fiat currencies beyond all recognition is remarkable in and of itself. One wonders how all of this relentless money printing will play out in the end. In the meantime, the punch continues to taste oh so good for investors. If only the economy was responding with even a fraction of the same euphoria.

Losing Control

Up until a few months ago, one point of reassurance about the Fed's post crisis actions was that it at least appeared that it was in control of financial markets. More specifically, the Fed could apply its foot to the stimulus accelerator and stocks (NASDAQ:QQQ) would rise. Conversely, it could remove its foot from the accelerator and stocks (NYSEARCA:DIA) would go flat. And, if they started to fall, all policy makers needed was a hot mic and a few winks and nods about more stimulus or rate hike delays, and the market was quickly back on its feet. But all of that appears to have changed in the last few months.

One of the things that were curious earlier this year was the sudden change in tone from the U.S. Federal Reserve about monetary policy. After so many years of being almost ridiculously cautious about even mentioning the possibility of an interest rate hike out of concern of upsetting its precious stock market, it suddenly hard charged the speaking circuit in late February with bolder and more resolute language about the path of future interest rates heading definitively higher. What was notable at the time was the fact that the economic data really had not changed. In fact, it was getting marginally weaker.

So, what exactly changed then? Put simply, the stock market that for so long moved at the pleasure of the U.S. Federal Reserve was suddenly breaking away on its own path to the upside. It seemed that the Fed was finally waking up to the fact that it might have a budding mania on its hands, as investors abruptly no longer really seemed to care if the Fed was planning on raising interest rates or not.

In the months since, the U.S. stock market has continued to rise. And, suddenly, we don't really hear much of anything about the U.S. Federal Reserve anymore. I mean, did investors pay attention or even care that the FOMC held a policy meeting last week on May 4? This time, just a year ago, such a meeting would have been a huge deal. Today, it hardly got mentioned.

Looking ahead, the probability for more aggressive rate hiking activity from the U.S. Federal Reserve continues to rise. At present, the market, according to CBOE Fed Fund futures, is pricing in an 83.1% probability of another quarter point rate hike from the Fed coming out of its next press conference meeting on June 14. In other words, it is hiking rates at its next meeting barring something extraordinary.

Looking ahead to September, futures are pricing in a 41.6% probability of yet another quarter point hike emerging from its September 20 press conference meeting. This is the highest probably for a third 2017 Fed rate hike in September that we have seen since the very start of the year.

And, if the Fed skips in September, the market is pricing in an even stronger 59.1% probability for a rate hike coming out of its December 13 press conference meeting.

The odds of four rate hikes by the time 2017 is out? The market is only pricing in a 17.2% probability for such an outcome. But a lot can change between now and December, and the stock market is showing no signs of letting up as we continue through May.

The Trouble With Monetary Impairment

Why does a more aggressive Fed matter today, particularly when investors are increasingly tuning the Fed out? Because investors are ironically starting to ignore the actions of the U.S. Federal Reserve almost precisely at the moment when they should be paying much closer attention. For it's not likely to be a geopolitical event or drama in Washington or a series of earnings misses that are likely to deliver the latest cardiac event to financial markets. Instead, what is likely to finally make stocks (NYSEARCA:IVV) buckle is the withdrawal of the liquidity on which it has become so addicted and dependent for nearly a decade now.

Central bankers are now actively involved in withdrawing liquidity. The People's Bank of China has been shrinking its balance sheet for nearly two years now. And, the U.S. Federal Reserve is likely to add balance sheet shrinkage to its steady interest rate hike path in the months ahead. And, while the European Central Bank and the Bank of Japan continue to feed stimulus to the investment market pig, both are actively working to extract themselves from adding stimulus for much longer.

Put simply, if the liquidity steadily flowing in helped to lift stock prices, the liquidity flowing back out is likely to lead to the opposite result. This, of course, was the phenomenon we saw play out both in 2000 and 2007. Maybe this time will be different, but I suspect it will not.

Too Hot And Heavy

An added risk for global financial markets going forward is the following. Central bankers have certainly succeeded with the easy part, as they have juiced global stock markets in general and the U.S. stock market, in particular, beyond all reasonable expectations. But they are now increasingly facing the hard part, as they are trying to slowly steal the candy from investors' plates and replace it with spinach. But what is potentially now materializing that could make this switch all the more challenging is that stocks are starting to look increasingly euphoric. Not a full blown mania, mind you, but still quite blissful.

In many respects, global central banks have been behind the curve in tightening monetary policy for some time and are falling increasingly behind the curve with each passing week now. And, if stocks take that next step and start to rise into a full blown mania, then once reluctant monetary policy makers that have recently been showing greater pluck may eventually be forced to make a more abrupt grab for the punch bowl. And, the more violently policy makers are required to act, the greater the possibility for punch to spill all over the floor and taking stocks down with it.

We're not there yet, but the further global stock markets (NASDAQ:ACWI) heat up, the more the pressure will build among policy makers to take more decisive action.

The Bottom Line

The party continues to rage across capital markets, and global central banks continue to supply the punch. But just because an economy has not experienced a recession for some time and the markets remain in a relentless bull market does not mean that the probability of it continuing is increasing. To the contrary, the longer the economy goes without recession and the longer stocks go without a sustained bear market, the greater the excesses accumulated and the more profound and dramatic the next bear market is likely to be. And, policy makers from the Fed and the PBOC are now taking actions that have historically led to more sustained corrective periods in the past.

So, while the ongoing stock market party is likely to result in fresh new highs for U.S. stocks in the near term, the underlying fundamental reality amid an interest rate hiking cycle suggests that an entirely more challenging outcome for stocks could be currently building momentum in the shadows. And, if policy makers have determined that they are losing control of capital markets, then all bets are off with current valuations so historically high.

Disclaimer: This article is for information purposes only. There are risks involved with investing, including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long PHYS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.