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Clash of the Titans: Fed vs. Wall Street



June 25, 2013 – Comments (0)

Board: Macro Economics

Author: yodaorange

The US bond, stock and commodity markets did not respond positively to Chairman Ben’s talk about “tapering” down asset purchases. One point I find interesting is that all of the correlations have once again gone to “1.” Remember all of those tables of correlation coefficients that were supposed to tell you when A zigged, B would zag? Does not seem to be holding up too well these days.

Recall the last time all correlations went to 1? It was right before the 2008 crash. We saw how that worked out.

Richard Fisher, President of the Dallas Federal Reserve Bank, had some interesting comments on the market reaction to Ben’s comments: [1]

“Markets tend to test things,” Mr Fisher told the FT. “We haven’t forgotten what happened to the Bank of England [on Black Wednesday]. I don’t think anyone can break the Fed?.?.?.?But I do believe that big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”

Funny that Richard would mention the Bank of England and Black Wednesday. That was when George Soros “broke the Bank of England” with a currency bet. [2] He reportedly made 1 billion pounds back in 1992 when that was a lot money.

Richard had an interesting choice of words that “I don’t think anyone can break the Fed.” Which makes you wonder how the Fed will react if markets continue to fall. For example, will Ben standby and allow equities to drop by 50% again? How about letting 10 year rates go back to 4% or 5%?

How would Ben’s “wealth effect” speech go over then? You remember that speech that he has given several times. Part of it is that rising stock prices validate a positive growth outlook for the country. And this will cause both businesses and consumers to spend more, creating a virtuous circle of growth.

Do you think Ben will give a new speech: “Yes, I understand stock prices have dropped in half, but businesses and consumers are still optimistic. They will spend more because of . . . I can’t remember why, but just have faith.”

I would propose three possible short term outcomes:

1) The “feral hogs” keep selling the markets hard. And the fed does NOTHING, just sits back and says “prepare for tapering to begin.” The feral hogs are the George Soros of 2013 and they “break the Fed.”

2) Ben and the Fed draw a line in the sand, actually a number on the chalk board. Ben gives the verbal order: “If the SP drops below X, you know what to do” which is code for buy the heck out of it. Don’t let the line in the sand be crossed.

3) Do nothing and wait to see if any of this affects the “real economy” as opposed to asset prices. This will be a slower, more drawn out outcome. Maybe Japan or Greece or China or the EU implodes and really does cause a contagion problem. Maybe consumer spending heads south. Maybe the Affordable Care Act really does have a negative effect on the economy. Or a million other possibilities. In this scenario, Ben and the boys probably wait until it is TOO late, and the US heads into a recession. Then they start QE back up.

Richard goes on to say:

Mr. Fisher made it clear he believed bubbles had developed in a number of financial markets, mentioning emerging markets and real estate investment trusts. He also noted that companies issuing bonds with a triple C rating, which is junk status, could now borrow for less than 7 per cent.

Clearly Richard is comfortable with some asset classes falling in price. It is just a matter of degree I guess. At what point would Richard say: “they have fallen enough to not be in a bubble.”

Each investor will have to assign their own probabilities to the three different outcomes. Yoda’s opinion might be 100% wrong, but he assigns the highest probability to option 2, Ben draws a line in the sand. You likely will assign different probabilities to each of the scenarios. Maybe you are a long term, buy and hold investor and will not take any action, regardless of which scenario plays out. That is fine.

If you are NOT a buy and hold investor, you might think through the different scenarios. Clearly the best portfolio management strategy since 2009 was to remain 100%+ invested in equities. How lucky are you feeling today?



[1] Richard Fisher interview in Financial Times

[2] 1992 British Pound Currency Crisis

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