The Art of Political Deception, Part 2 (a) – The Rational Objectivism of the Fed’s Debasement of Cash (and rebutting the Uncertainty vs Volatility conventionality)
The New Determinant of Market Volatility
It’s always worth starting with a bit of humor – I just love that cartoon. I used to have it pinned to my desk in Hong Kong to serve as a reminder of just how debased equity market volatility was from fundamentals and how sensitive price movement had become to top-down macro events, regulation and centralized (fiscal or monetary) policies.
Right, let’s start by defining the major challenges with a series of poignant questions which are concerning the market today (in no particular order).
More Questions than Answers
- Why is the Fed hesitant to even mention QE3?
- How could a handful of small economies, like Portugal, Greece and Ireland create such huge global systemic risk, not only to the break up of Europe but even to the demise of the US Economy?
- Why has the Dollar fallen so far and why might that trend be reversing at this point?
- Why have commodities risen so much and why might that trend be reversing at this point?
- Why is China experiencing the double-whammy headwind of rising inflation and slowing growth and why are they getting increasingly irritated with American Monetary policy?
- With all the uncertainty in the World, why has realized volatility been so low and still at a discount to implied volatilities (as measured by VIX, for example) which, incidentally, are also bizarrely low? Why might that trend, too, reverse in the near future?
Source: Bloomberg. The VIX implied volatility index.
The answers to all of these questions are not as challenging as they first seem. In fact, we can distill all these riddles into a conundrum:
- The key question: what is Money?
Identifying Some Important Observations
Let’s start with some simple bullet points.
A. Capital – I define very broadly as anything which has value to more than one person. If I have a watermelon, that is a form of capital. If I have knowledge on how to do a great foot massage, that is a form of capital. Of course knowledge on foot massage is not a great form of money because it has pretty poor “exchange qualities”.
B. Money – I define money the way most people do. It is a form of “capital” which can be used as a medium of exchange and a good store of value. So a watermelon is not a bad form of money but it’s not as good as, say, a piece of gold or silver or even coal.
C. Sterilization – This is the manipulation of a money or currency relative to other forms of money or currency. For example, to weaken its “exchange rate” in order to decrease the costs of export (often exporting deflation) or increase the costs of imports (often importing inflation).
D. “Inflation is always and everywhere a monetary phenomenon.” — Milton Friedman
E. One more point to make, which is opinion, based on observation. The effectiveness of Monetary Policy is not merely affected by the politics associated with Fiscal Policy – it is dependent on it.
Monetary Policy and Fiscal Politics go hand-in-hand
Let’s start with Observation E. The markets are concerned about the cohesion of the Eurozone for one primary reason: it is exceptionally difficult to manage monetary policy over an economy with incoherent fiscal (political) policies and objectives. Monetary policy is inherently linked to politics and fiscal policy – current fractures within the European system are clear evidence of this.
This circumstance is not limited to the Eurozone. In fact, on a more granular level, QE and Obamanomics (and even the timing of policy announcements) are unequivocally inter-twined. I have written extensively about the linkages and the politicization of the Fed. Indeed, the institution itself is openly partial to its own set of political objectives. While admittedly sounding a little stroppy, Peter Diamond’s rant in the NY Times, after not getting nominated as a Fed Governor, offered a fascinating expose of just how politically convoluted the Fed is – as was the analysis of Morgan Stanley Asia CEO and Chief Economist, Stephen Roach, when interviewed with Bloomberg’s Tom Keene:
ROACH: …I’m very disturbed to have read Peter
Diamond’s withdrawal from the –
KEENE: Well, I wanted to bring that up, yes.
ROACH: I mean here’s a guy who knows as much about the labor market as any living economist in the United States today and yet is a victim to a sort of political sabotage of his nomination to serve on the Board of Governors at the Fed.
KEENE: Have you seen this before? Is it – where the Republicans are pushing back because the Democrats pushed back before? Have you ever observed something like the challenges to the Noble Laureate Diamond?
ROACH: Look, I’ve been going around this track for a long time and the polarization, the disfunctionality of our political process in Washington right now is in a league of
its own right now. And I think it’s a real tragedy for the need to get talent into running the government at all levels. I don’t know anybody who wants to subject themselves to this
There is no sensational conspiracy theory here. It is obvious that, no matter how far you go to secure the independence of a Central Bank, monetary policy will always be effectively joined at the hip to the pantomime of partisan politics.
So that’s it!
OK perhaps that’s a bit cryptic, so let’s identify some dots for us to connect. As I said in my last comment, I was pleasantly surprised by Charlie Rose’s interview with Greenspan – I actually agreed with more than 50% of what Greenspan said!
On inflation, Greenspan said he did not know of a
…single economist or member of government who isn’t worried about this issue…
So what is inflation? Is it the rise of food and energy etc, asks Charlie Rose?
…no, it comes from basically the issue of a very large amount of liquidity in the system…
Greenspan then quoted his good friend, the late Milton Friedman (Observation D) in his interview. This is not insightful to you, dear reader, I’ve written most extensively about the perils of inflation in many comments and how we can perceive it from a simplistic monetary standpoint.
Hmmm… but wait a minute. The dots are not connecting here at all, are they? Almost all commodities are denominated in the World’s Reserve Currency, the US Dollar, and Bernanke is the guy who controls the supply of US Dollars. But, wait, didn’t Bernanke say, only a few days ago in Atlanta, his policies were not really attributable to the rise in commodity prices? The Milton Friedman/Greenspan thesis of inflation appears to be in direct contradiction to Bernanke’s defense.
But let’s move on…
Revisiting the key question: what is money?
This is the question which holds the answer to everything. To keep it simple (and save me re-writing it!) let me highlight a reply-comment I made to a blog article on the issue of inflation and the definition of money (Definition B and Observation D):
I tend not to look at the shorter term moves but briefly, Gold is up almost 300% over 10 years and the dollar fiat-to-fiat index is unchanged. That puts a line through Bernanke’s story.
By far the most economically important trading commodities to the World, though, are oil, Nat Gas (and, increasingly the most common food products) partly because of their political relevance and partly because the trading supply are very good proxies for the actual supply available (just my opinion).
Why the Dollar collapse directly affects commodity prices is firstly because it is the denomination, the World’s reserve currency. The second reason harks back to how we define capital (my definition is simply anything which is of more utility to more than one person) and how we define money. In my opinion a form of capital which:
a) acts as a good exchange medium, and
b) a good store of capital value.
Which means almost everything is a form of money. The Dollar has been a very efficient money compared to say a lump of coal because it is unmatched in (a). However, by exploding its Monetary Base it is losing value relative to the lump of coal (b) due to uncertainty over the sheer supply supply.
I find it useful to ask not how many dollars I can use to buy a lump of coal but rather how many lumps of coal I can use to buy a dollar. If I know that the dollar supply is exploding, it is quite logical to deduce that the dollar (and indeed other inflated fiats) is trash so I’d like many more of them for my lump of coal – hence the dollar drops in value compared to commodities. I believe it is that fundamentally simple. to Bernanke;s quip last week:
“…implying that the dollar’s decline can explain, at most, only a small part of the rise in oil and other commodity”,
I say: “The dollar’s decline does not explain the risk in commodities – the dollar’s decline IS the rise in commodities.”
This is why we see strategic decisions by China, Russia, India and many other large growing economies to diversify out of pseudo fiat trash and into Gold and Silver, why they are using massive surpluses to aggressively massive pursue resource related projects and pander diplomatically to resource-based governments in Australia, South East Asia, Brazil… even as politically risky as Africa, Mongolia, Iraq, Iran and Russia. This is why the timing of China’s latest introverted infrastructure-specific boom is poignant. This is why capital continues to flow into this sector despite the state of the global economy. It also helps to understand the meteoric rise in “collaborative consumption”.
There is a move towards resource investment directly related to the uncertainty and sheer size of ensuing dollar supply dynamic. Fiat cash is still an asset, but who would want any asset class whose supply is being overtly exploded beyond any comprehension? I wouldn’t, I’d look to get out in any way I could and if that meant exchanging it for a farm or a coal field, I’d do it.
A Lesson from Japan
During Japan’s “Lost Generation”, they tried everything to fight deflation, but they could not find the monetary escape velocity from, the gravitational pull of what economist Richard Koo coined, a Balance Sheet Recession.
You see, simplistically, there are three types of debtors in an economy: corporations (including banks), individuals/consumers and governments. In Japan, the banks, government and even large corporations piled on huge amounts of debt which foundered the subsequent debt-deflation death spiral. Only Mrs Watanabe, the Japanese consumer, kept herself well capitalized, she saved a heap of cash and so could weather the deflation storm for decades (remember cash alone appreciates in a deflationary environment). No matter how low interest rates got, because, in part, monetary uncertainty was so high, dear old Mrs Watanabe could not be shaken out of her consumption coma. She was a risk-hater. As all debtor types are linked in an economy, it mattered not how well capitalized the banks and companies were to become, their consumers (and therefore customers) were simply not driving the top line, so the inflation transmission system stalled. Japanese corporations reverted to simply using liquidity to repair their balance sheets – in some cases, ultimately to near impeccable credit standards.
This weak link in the transmission mechanism of inflation, however, meant that monetary base was not manifesting into broad-based money supply and velocity – money was just being stored “somewhere in the system” – to paraphrase Greenspan.
History never repeats itself, they say, but it often rhymes. America faces an uncannily similar predicament today although a couple of the the cast of debtors have swapped roles. Once again the banks are in trouble and government “stimuli” are racking up huge deficits, but here, in the US, the large corporations are in great health and it is the consumers who are riddled with debt. Never-the-less, the broad effect is remarkably similar to the situation in Japan. The boardrooms of American corporations face the same level of apprehension about leveraging their balance sheets as Mrs Watanabe did 20 years ago. El-Erian and the PIMCO boys refer to this, symptom of Balance Sheet Recessions, eloquently as: having “the wallet but not the will”.
The Paradoxical Effect of Uncertainty on Underlying Volatility
In this interview, Greenspan concurrently implied that corporations were hoarding cash and cash-equivalents because they were disinclined to invest in longer term projects due to the uncertain unintended consequences of centralized policy and interventions into the market place (otherwise known, sometimes incorrectly, as economic “stimulus”).
In normal times, debt can be good. In normal times hoarding cash can be dangerous, as it limits an organisation’s ability to innovate and grow ahead of its competitors. But these are not normal times. Generally speaking, corporate executives are interested in two things: exploiting highly specific growth areas of the business (e.g. emerging market demand) and, more importantly, survival. Companies with more cash on the balance sheets are in a better position to weather downturns, they have better credit ratings and so can borrow cheaply even during times of great uncertainty. As a direct consequence of this focus of the business and lower leverage, their profitability is more predictable and their earnings (and therefore stock prices) become less volatile.
I admit, I have been wrong on the issue myself up until this point. Instead, I now challenge the conventional wisdom that uncertainty causes volatility. Every action deserves a reaction, perhaps even an over-reaction. In extremely uncertain times, large corporations, which are highly sensitive to market sentiment, regulation and macro policy, react by hunkering down to core business and swamping their balance sheets with cash. In doing so they counteract external volatility with internal shock-absorbers on their balance sheet. Consequently. the volatility of their share prices get suppressed and can significantly underperform the volatility of other asset classes (say commodities) and other facets of the economy. For example, small businesses (which actually account for 60% of the US economy) may experience a very different environment and may have extremely high levels of volatility – just look at the unemployment numbers! But of course this environmental volatility may at times fly under the radar of the market for a simple reason – we can only trade the volatility of the extremely big companies. Indices like the VIX only relate to the biggest (most conservatively positioned) multinational businesses.
We are starting to see the effects of the Fed’s extreme monetary policy and it does not always directly lead to increased Money Supply on Main Street. Rather, one may observe the effects of an explosive monetary base in commodity prices, in stock prices, on the balance sheets of banks and on the balance sheets of corporations.
The macro-economic uncertainty is directly correlated to the uncertainty level inside the boardroom of a company. But the correlation between this and the volatility of stock prices is very inconsistent and, at times, completely uncorrelated. Paradoxically, more certainty over the economic, fiscal and monetary outlook may lead to more, not less, volatility in the markets. As Mrs Watanabe starts to splash the cash and Western Corporations see the opportunity to compete by taking more longer term risk onto their respective balance sheets.
The inherent flaws of applying rational objectivism to the markets
Greenspan also said something in his interview which struck a chord with me. He made a concession which I think most people missed. That was that large groups of people (including the markets) did not always make rational decisions, but rather they made “systematic” ones. After all rationality is in the perception of the beholder. Remember this admission came from an ardent disciple of the philosophy of Rational Objectivism.
Thus, in a time-constrained environment, it is at times more important to understand the pattern of human behavior than to attempt to justify it. We can neither rationalize nor claim to understand everything the market does at any point in time. There is a healthy helping of humility in this acceptance. I can’t believe I’m saying this, but: well put, Alan, the market is wiser than us both and today you and I must eat our humble pie.
Next comment we’ll summarize and, in one fell swoop, put a nail through each one of those questions which are troubling the market today.