The Fed’s tone deafness when it has come to the recent global economic slowdown has been perplexing. The FOMC committee has been strangely reluctant to acknowledge the role their hawkish rhetoric has played on the global economy. I had assumed this mis-calculation was due to their reliance on econometric models that rely too heavily on the Phillips Curve and NAIRU. However, yesterday hedge fund manager Paul Tudor Jones spoke to Bloomberg and offered an alternative theory that must be considered.
I have great respect for Paul Tudor Jones – if he talks, you should listen. He is not some CNBC blow hard that is easily dismissed. He might not always get it bang on correct, but who does?
Paul Tudor Jones made the following points (from Bloomberg):
The Federal Reserve board is managing for the balance sheet as opposed to local economic conditions. Every time we have had this sort of set of macro variables – a huge bear market in commodities, slowing global growth – you have typically seen the Fed respond with an easing. I think of ’98 particular. And normally it would be a great time to own stocks. Now, for the first time since Volcker probably, you see the Fed managing for the balance sheet to take out the tail risk associated with expanding debt globally, not to mention our Federal debt.
According to Tudor Jones, the Federal Reserve is worried about the growth in credit, both domestically and internationally. They are in essence looking at the consequences of QE1, QE2, Operation “Twist”, QE3 and not liking what they see.
Over the past seven years, the Federal Reserve’s balance sheet has grown at a rate never experienced.
The expansion of the Fed’s balance sheet has encouraged a period of borrowing that has expanded the total credit in the global financial system, but has produced little real growth.
Paul Tudor Jones’ point is that the Federal Reserve wants to withdraw that credit, or at the very least, curtail its expansion. If I understand him correctly, Paul believes the world’s Central Banks have reached a point where they are reluctant to do more balance sheet expansion, and in fact, would probably like to shrink the size of their balance sheet. Again from Tudor Jones’ Bloomberg interview:
The BOJ seems reluctant to ease – they are balance sheet constrained. The ECB, everyone expects them to go, but it will be an incremental step because they are to a certain extent balance sheet restrained, and uncomfortable with it.
So normally where you would be seeing a lot of interest rate relief, globally, it’s different this time. I think that’s one reason why the markets are going to be much choppier going forward.
It would be really easy to be super bullish on equities given what the response function should be, but it’s not going to happen.
Reading between the lines, Paul Tudor Jones agrees with my point the current Federal Reserve policy is causing an economic slowdown. The Federal Reserve is aware of the consequences of their actions, yet will not change their course.
If Paul is correct, then I can only surmise the Federal Reserve has concluded monetary policy will not fix what ails the economy, so they might as well withdraw the extremely accommodative stance and force a fiscal response from governments. This policy is all the more scary as few governments are willing to let loose the fiscal pursestrings. Since the 2008 credit crisis, the only thing keeping economies from slipping back into a deflationary morass has been the aggressive response from Central Banks.
I am not sure the FOMC committee members understand what they are dealing with. Regardless of the consequences, there can be no denying that some Fed Presidents believe the Federal Reserve has overstepped its mandate, and has taken too much responsibility for trying to fix the economy. If this camp has convinced the Fed doves, that when it comes to the real economy, QE barely worked anyway – then we could have situation where liquidity will continue to be withdrawn until something big breaks.
The difference between Paul Tudor Jones’ theory the Federal Reserve is managing the size of their balance sheet, and my idea the FOMC officials are placing too much faith in outdated models, is a subtle one of intent. If I am correct, then as the wage growth disappoints, the Federal Reserve will quickly change tact. However, if Paul Tudor Jones’ theory is right, then the Federal Reserve will err on the hawkish side and refuse to enlarge their balance sheet even in the midst of an economic downturn.
You might think to yourself, Paul Tudor Jones didn’t sound that bearish. He said the markets would be “choppy.” Don’t forget Paul is not some CNBC douche bag that will scream BUY! BUY! BUY! Or in this case SELL! SELL! SELL! Remember he was already worried about being a scapegoat decades ago when he was interviewed in Market Wizards:
Jones had suddenly adopted a very cautious tone regarding projections to the stock market and the economy. He was concerned that a second major selling wave in the stock market—the first being October 1987—could lead to a type of financial Mc-Carthyism. Indeed, there is historical precedence for such concern: During the Senate hearings held in the 1930s, committee members were so desperate to find villains responsible for the 1929 stock crash that they dragged up New York Stock Exchange officials who had held long positions during the price collapse.
Jones feared that, as a prominent speculator and forecaster of economic trends, he might make a convenient target for any future governmental witch-hunts. Jones had been particularly rattled by a call from a prominent government official regarding his trading. “You wouldn’t believe how high placed this person was,” he explained to me.
When Paul Tudor Jones says the markets are going to be “choppy” that is code for he thinks they are most likely headed lower. There is little upside for him to call for the next bear market on national TV. He doesn’t need anymore “street cred” and even if he is right, it only puts a spotlight on his activities if the decline spirals out of control. So that “choppy” comment was about as bearish as Paul will get.
And I agree with him. If the world’s Central Banks are balance sheet constrained, then the days of rising stock markets are over. I don’t believe there has been any real improvement in the economy, and I think the stock market rise of the past few years is the result of financial engineering at its worst.
The global economy needs credit growth to simply tread water. There is so much debt out there, any slowing of the expansion of that debt unleashes a contractionary credit destruction cycle that is extremely difficult to stop.
Once you slow down the credit growth, the vicious circle of deflation rears its ugly head.
Since the 2008 credit crisis, Central Banks have stepped in to provide that needed credit expansion. If they are now truly balance sheet constrained, then the deflation will return. And when I say deflation, it will be deflation in assets that have been inflated. What has been the biggest beneficiary of the Central Banks’ balance sheet expansion? Equities and other risk assets.
Paul Tudor Jones has highlighted a major change in Central Bank attitude. If he is correct, then equities will be the absolute worse place to be invested. I still contend we are dangerously close to a big financial accident…
Thanks for reading,
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