The Federal Reserve is no longer markets’ best friend
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The writer is president of Queens’ College, Cambridge university and adviser to Allianz and Gramercy
I vividly remember a meeting in late 2007 with the head of a major US bank. The executive drew an inverted U in response to me asking where financial markets stood. When told that we were near the top, I immediately asked about the bank’s risk positioning. “Max risk on” was the rather surprising answer.
Surely, it was prudent to reduce risk ahead of an expected turning point? No, I was told. The bank needed “unambiguous evidence” that the markets were turning before altering its strategy. After all, it is hard to time inflection points, competitors also had lots of risk on, the bank feared short-term underperformance and the authorities were not ringing any alarm bells. In the event, the bank had to be rescued in the 2008 financial crisis.
Today, this institution (with a different chief executive) is better capitalised and more constrained in the risk-taking it takes. But the mindset and risk behaviour in play have not disappeared. They have morphed, migrated to, and grown in non-banks. Moreover, until very recently, central banks and other regulatory agencies have stood on the sidelines, acting as inadvertent enablers.
While the systemic threats in play are smaller, the financial system is vulnerable to market accidents that expose the economy to unnecessary risks. Already, the system has navigated three near-accidents this year: the sudden January surge in yields; the February retail investor uprising focused on retailer GameStop; and the March demise of a little-known family office Archegos that inflicted some $10bn in known losses on banks.
In all three cases, the disruptive spillovers on the financial system were contained by luck rather than crisis prevention measures. Lacking evidence of anything beyond a temporary disruption, the enormous risk-taking encouraged by the provision of liquidity by central banks resumed.
This was accompanied by a big slice of opportunistic positioning by some investors — an approach well captured by hedge fund manager Leon Cooperman’s cleverly-worded observation that he is a “fully invested bear”.
Yet the drivers of these near accidents should not be ignored. They are part of dry tinder that, if ignited, could risk a consequential financial accident. Fortunately, the central banking community is waking up, jolted by the spectre of inflation as well as financial instability.
As usual, the Bank of England is among those leading the pack with its recent statement that “continuing purchases” of assets under its quantitative easing programme could now slow somewhat. This lays down a marker for hiking interest rates down the road.
For its part, the European Central Bank warned last week of “remarkable exuberance” in markets, adding to earlier small signs of something many deemed unthinkable: The possibility of the ECB tapering QE before the Federal Reserve.
Fed officials had adopted a virtually universal adherence to a common set of speaking points dismissing inflation concerns and reiterating that the central bank was “not thinking about thinking” about tapering. However, the Fed policy meeting minutes released last week indicated that some officials would like to talk about the possibility “in upcoming meetings”.
The good news is that the Fed may now consider embarking on a policy correction that would help reduce the probability of a policy mishap similar to the mistake banks made back in 2007-08.
Less good is that the minutes suggested that only a few members of the Fed’s policy-setting committee are there; and that does not seem to include the chair. The timeline is vague and open ended. No wonder markets have paid little attention.
Having already waited for too long, the Fed faces a tricky policy pivot — especially as it is now hostage to a “new monetary framework” that is ill-suited for the pandemic-related structural changes to the economy.
As such, the pivot involves the twin risks of market volatility and loss of Fed credibility. Yet the alternative of dogmatically holding on to a backward-looking policy stance would threaten far greater damage.
For their part, investors should be encouraging the Fed to pivot rather than just focus on the continued joy of surfing the liquidity wave. Learning from the experience of banks in the financial crisis, it is better to risk some short-term discomfort than the durable larger damage that a bigger policy mistake would inflict on asset values, the functioning of markets, and economic and social wellbeing.
Unhedged — Markets, finance and strong opinion
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