Markets Reject the Fed?
On Wednesday, the Fed raised the Fed Funds rate by a quarter point as expected. The Federal Open Market Committee (“FOMC”) statement was suitably ‘dovish’ by reducing the consensus forward guidance on future rate hikes from three to two. The Fed also signalled that its Quantitative Tightening program (selling $50 billion of assets per month) would continue on “autopilot” as planned. The response was not what the Fed expected. Stocks fell hard and bonds soared.
Financial markets are now beginning to revisit some important questions.
First, does Quantitative Easing (“QE”) actually work? Does it boost the real economy or does it simply drive up valuations by encouraging speculation? We think the weakest economic recovery in two generations provides the answer.
Is the Fed right when it raises interest rates and continues to sell $50 billion in assets every month because the economy is strong? Or are the credit markets right when they bid up Treasury debt despite Fed hikes, driving down yields and flattening the yield curve because they think the economy is weakening fast? We vote with markets.
Can a weakened economy sustain Fed balance sheet and interest rate normalization? The stock market is saying no.
For 10 years, these have been Central Bank markets. Printing money in America, Europe and Japan has, in our view, created the biggest financial bubble in history. Now that the printing has come to an end, the bubble is beginning to burst. Investors are beginning to lose confidence, they are beginning to flee risk. Aversion to risk means conversion to gold. We think the gold rally of the century is soon to begin.
There is one last test. When Central Banks reverse their tightening plans and turn back to QE, which we think is coming soon, will the good times roll once again? We think not. After 10 years, we can see that QE does not translate into a stronger economy. We can see that monetary stimulus cannot be painlessly withdrawn.
Furthermore, the real issues are not in the stock market but rather in credit. QE has generated a further massive increase in the debt load that far exceeds the ability of the economy to service it. In our view, the corporate bond market is going to implode, exposing historically weak balance sheets and zombie companies that only survived because of plentiful credit priced at 5,000 year lows.
Perhaps the Fed will ride to the rescue and flood the corporate bond market with fresh liquidity. We are confident that would kill the dollar. Perhaps the Fed will decide to resist further attempts to reflate in an attempt to return to monetary sanity (which we doubt). Massive defaults and unemployment would then ensue, in our view. There is one effective response to either possibility. We think investors will reach for the security of the only asset that is no one’s liability and cannot be printed: Gold.