Bear Markets & Fed Mistakes

Guest Post by John Mauldin

Powell Was Right but the Fed Is Wrong

Last week. I argued Jerome Powell did the right thing by raising rates a mere 25 basis points. He forcefully declared the Fed’s independence from the market and politicians for the first time since Volcker. Greenspan, Bernanke, and, in particular, Yellen all gave the markets a “put” option—basically a third unofficial mandate to make sure that asset prices keep rising. Now, of course, that’s not the way they would express it, but that is, in fact, what they did. They created a series of bubbles, which spectacularly (and predictably) blew up, particularly screwing the little guys who didn’t know better and could least afford losses. We should not be where we are today, and we would not be here today, without their seriously screwing up Federal Reserve policy.

But they had the hubris to take credit for fixing the crises they created. Exactly like the arsonist taking credit for fixing the fire he started. They have no shame. Jay Powell is not the culprit in raising rates. The main problem is that Janet Yellen failed to raise rates before him, and I think she did so out of political bias for a Democratic president and then to help a Democratic candidate (Clinton). She would vigorously deny this, of course, but if it looks like a duck and quacks like a duck…. The Federal Reserve was not independent of either the markets or politicians during her watch. Shame on her. Double shame on her!

Now, having said Chairman Powell did the right thing, let me tell you where he and the current Fed leaders are royally screwing up making a mess. I’ve mentioned it before, but I want to highlight it as we go into the New Year. This is critically important.

No serious scientist would run a two-variable experiment. By that I mean, you run an experiment with one variable to see what happens. If you have two variables in your experiment and something either good or bad happens, you don’t know which variable was the cause. You first run the experiment with one variable, then do it again with the second one. After that, you have the knowledge to run an experiment with both of them.

The Federal Reserve is running a two-variable experiment without the benefit of ever having run a one-variable experiment to determine what the results would be. It is decidedly the stupidest monetary policy mistake in a long line of Fed mistakes.

(Like I said earlier, the gloves are off. This is my opinion. You may disagree.)

What are the two variables? They are raising interest rates (albeit slowly) and aggressively reducing their balance sheet. I think many of the problems we see in the market are results of this combination. They should do one or the other, not both.

Of these two, everybody wants to blame the last rate hike, but let’s look at the other variable.

While the Fed radically reduces its balance sheet, the European Central Bank is also ending its QE (quantitative easing), as are other central banks. They are taking away the market’s crack cocaine. Note also that all of the crack cocaine QE began to disappear worldwide toward the beginning of October. While I realize correlation is not causation, especially with only one data point, I find it suspicious that the markets turned volatile about that same time.

I find it just as plausible that the balance sheet reduction is as responsible for the market volatility as the increased rates. If QE made the markets go up, especially in concert with the ECB, the Bank of England, and the Bank of Japan, then it’s no surprise if ending it makes the markets fall.

Let’s get real. The Fed Funds target is now at 2.25%, barely above inflation. Zero real interest rates mean they are still essentially giving away free money, and free money causes bubbles. If Powell was trying to “lean into the market” and cut off budding inflation (that frankly I don’t see), he would have rates at 4% or 5%. Now that would mean we should blame the Fed for pushing us into recession and other bad things.

But, in fact, rates are still barely over inflation. Janet Yellen should have had them there four $#%%!@#$$ years ago. You want to castigate someone? You want to point fingers? Janet Yellen and the two previous Fed chairs are good places to start.

Warning: I’m next going to insult a bunch of smart, maybe even brilliant, people. This is not polite nor is it politically correct. I will try to be better in 2019, but right now, I am pretty pissed. (Again, this is Uncle John talking and not your normal, humble analyst. Uncle John uses words like that.)

Powell and the Federal Open Market Committee listen to extremely smart PhDs from all the best schools with their fabulous multi-algorithmic models, which prove that you could raise rates and reduce the balance sheet at the same time with no problems.

Bluntly, those smart people (many of whom are actually quite brilliant, and I’m sure they are nice people, and their kids and dogs love them) mistakenly trust models based on past performance, and even worse (much, unbelievably, really badly, worse, which I can’t emphasize enough!) on monetary theory that is clearly, evidently, badly, manifestly wrong.

They have been using these models to forecast future market actions and the economy for decades, and they are about 0 for 300 in being right. It is statistically impossible to be that bad unless your models/assumptions are fundamentally flawed, which they are. Their underlying economic theories manifestly don’t work. Because they have no politically and academically acceptable theories to substitute, they are slaves to their own mal-education. They think this makes them smarter than the markets. I can’t say it any stronger than that. I have actually been in the room when someone was aggressively (I use that word precisely, as it is the correct word for that particular conversation) remonstrating a Federal Reserve economist about said models. He went so far as to say that the best thing that Powell could do would be to fire all those PhDs and ignore their models.

As you might imagine, the Fed economist was not happy with that analysis. The veins in his neck were popping, he was red faced and his voice was raised. Having known him for 10 years, I was rather shocked. He is actually a rather mild-mannered guy. But this clearly got his goat.

Now, here’s the shocking thing… and the lesson that I learned, which was burned into my brain. He asked a very simple question, (neck veins popping): “You can’t take away a model without replacing it with another model. What model will you replace it with?” The interlocutor, who is perhaps the best observer of the bond markets I know, stammered a little bit and then forcefully said, “You can’t actually model the future,” or something to that effect. (This was back when I was drinking, it was later in the evening and more than a few bottles of wine may have been involved. As you might guess, like me, he was not a fan of models. And it was the nature of this gathering to disagree with each other late at night…)

Personal sidebar: my day job for the last almost 30 years has been to look at money managers, who usually have a model that looks at past performance and projects it into the future. Every hypothetical performance model I have ever seen looked absolutely awesome. I can’t say that I’ve seen a thousand of them, but it is not an exaggeration to say that I’ve seen more than a few hundred… well, maybe many hundreds. And then I have observed the performance of those models after I have seen them. Bluntly, it makes me skeptical of all models—including the ones that I build myself.

When I say the words “past performance is not indicative of future results,” I damn skippy mean them. All past performance models were built in a particular macroeconomic environment. Unless you can find a macroeconomic environment that is similar (as in, very closely similar) to where we currently are and where we are currently going, your particular model deserves a tad bit of skepticism. Maybe it will work and maybe it won’t. It is up to the macro analyst (that would be guys like me) to try and figure out which one will work well enough to confidently invest your money (as in, your money and mine).

I can’t tell you how hard and difficult and truly daunting that is. Especially after you have done it for many years and have the scars to prove it. I know, I know, I should write a rather lengthy essay/book on choosing money managers. Let me just leave it at this: If you have a buy-and-hold, 60/40, traditional portfolio, I think you are going to be hammered in the future. It will not serve you or your retirement well. You may not like what happened to your portfolio this month and we’re not even in a recession. Not even close. Well, maybe closer than we would like but it is still in our future. But I digress…

I’ve also looked at a lot of macroeconomic models. You can’t understand the depths of how much I would deeply love to find a macroeconomic forecasting model that was actually reliable. To have such a crystal ball would not only be soul soothing but also extremely profitable for my clients and, admittedly, me. It would be the Holy Grail.

All those PhDs at the Fed still haven’t found the Holy Grail after 40 or 50 years. Hell, they haven’t even found a decent cup of coffee. But they think they have, so their bosses confidently run a two-variable experiment with our economic system.

Time for an Emergency Fed Meeting

Just between you and me, I think the Fed has raised rates for the last time this cycle. I think in the first quarter of 2019, the FOMC members will begin to see the data weakening and realize that further hikes would make the situation worse, not better. But in any case, they should use their best judgment and ignore both political pressure and market volatility. If inflation rises and the economy strengthens, then hike another time. I don’t expect either to happen. (My actual forecast is next week. I have to save something for that letter.)

However, they also need to end this two-variable experiment nonsense. It is a major monetary policy mistake. Powell should call an emergency FOMC meeting (as in, next week) at which they suspend the balance sheet unwinding. One thing at a time. That is not responding to the markets. It is correcting a prior policy error.