What happens when you keep pushing on a string? After a while you end up with a tangled pile, not an orderly ball that you can easily unravel. And the longer you push the more difficult unraveling becomes. For the past several years, central banks have enacted policies that, in hindsight, have begun to appear no more effective at driving sustainable growth than “pushing on a string.”
The policies of quantitative easing and negative interest rates have supported risk-asset prices but have failed to materially increase capital investment and consumer spending. Current global central bank policies are perhaps delaying a day of financial reckoning in the hopes that economic growth eventually justifies asset valuations. However, these policies have done little to create sustainable longer-term growth.
The risk of long periods of QE and low interest rates is forcing institutional investors into riskier assets. Are investors buying riskier assets because of good investment value or because they have no other choice in the search for positive returns. In fact, absent improved economic growth, QE arguably fuels the latter and thus creates mispricing and risks the formation of asset bubbles. The credit and equity markets' sell-offs in January and February could be viewed as letting some air out of a bubble. The sell-offs only reversed course when it became apparent that the Federal Open Market Committee was rethinking the pace at which it intended to hike rates, slowing them.
The latest move to negative interest rates by some central banks is unlikely to provide a sustainable solution. In fact, the long period of low interest rates in the U.S. and the more recent period of negative rates adopted by the European Central Bank and Bank of Japan are not encouraging people to spend, but instead focused consumers on saving as they became concerned about their future. With borrowing costs at or near zero, the fact that businesses and people do not want to borrow money to purchase goods or invest in new opportunities portends quite a dire outlook.
Volatility should continue to remain high as the unsettled economic outlook remains and the markets will be searching for leadership and solutions to its problems. Markets often look for unspoken leadership generically. That said, this is most likely to come from either the Obama administration or Congress at this stage not the Fed, which has been trying to do it solo for too long.
It is likely that we have reached the outer limits of central bank policies absent commensurate fiscal policy and that it is time to question the effectiveness of the transmission mechanism of QE to create widespread economic benefit. QE more likely benefits those who hold financial assets rather than those with limited savings. One could even reasonably speculate that this imbalance might be a significant contributing factor to growing income inequality, which has manifested into populist political movements globally.
For the near term, economic growth will remain constrained as corporations and individuals lack an appetite for cheap money. Absent demand, purely making the cost of capital cheaper has failed to stimulate new borrowing. In addition, once rates go negative, it creates problems in the banking system that has difficulty passing negative rates on to their depositors. Central banks are now starting to confront the limitation of such policies. Central banks have also started to beat the drums more loudly for fiscal reform, infrastructure and educational spending and are questioning the soundness of limiting deficit spending.
The thought is this type of spending, infrastructure specifically and other fiscal policy spending more generally, in both the short and long run can create millions of jobs and puts the money directly into the hands of the working class, who are the likely beneficiaries of such job creation. Whether this trend of monetary easing absent any fiscal policy stimulus continues and the decibel level grows in support of new fiscal policy remains to be seen. Perhaps in time central bankers might consider even more unorthodox options, such as so-called helicopter money, or the issuance of mon-ey without a commensurate issuance of bonds.
The correction in the credit markets over the past nine months has widened spreads above their long-term averages. In addition, market liquidity has been significantly reduced forcing one to rethink how to optimally allocate investment capital. The removal of secondary market liquidity will create opportunity in the government bond market. Additionally, active trading strategies are able to capture the short-term dislocations created by the absence of proprietary trading activity at the global investment banks.
There are some encouraging signs on the horizon. One of the major impediments to gross domestic product growth has been the lack of productivity growth. There are very real possibilities that productivity has the potential to re-emerge as an economic growth engine as new technology advancements continue to appear, such as what we're seeing in the “shared economy” successes like Uber Technologies Inc., Lyft Inc. and Airbnb Inc.
Until these developments take hold, it is unlikely that central bank policies will be more effective in changing course than pushing on a ball of string, and active trading strategies will continue to be a refuge for the institutional investor hunting returns.
