Although Europe is now mired deep in negative interest rate territory, not that long ago the ECB was one of the relatively tightest Central Banks. With Jean-Claude Trichet at the helm, the ECB pursued a policy whose overarching concern was controlling the supposedly budding inflation pressures.
In June of 2008, even though the world’s largest economy had just entered what was obviously a monster credit crisis, good ‘ole J.C. Trichet raised the ECB’s main financing rate from 4% to 4.25%. It had been sitting at 4% for a full year, so there was no rush. Yet Trichet was “worried” about inflation. From the ECB’s statement:
On the basis of our regular economic and monetary analyses, we decided at today’s meeting to increase the key ECB interest rates by 25 basis points. This decision was taken to prevent broadly based second-round effects and to counteract the increasing upside risks to price stability over the medium term. HICP inflation rates have continued to rise significantly since the autumn of last year. They are expected to remain well above the level consistent with price stability for a more protracted period than previously thought.
We all know how much of a concern inflation was during the ensuing period. By the end of January 2009, a little more than six months after Trichet had tightened, the ECB’s main financing rate had been slashed to 2%. By the start of the summer it had been further halved to 1%.
Maybe I shouldn’t be so hard on J.C. After all, the 2008/9 credit crisis was a wake up call for many Central Bankers throughout the globe. Few of them were out ahead of the curve. At that time the Japanification of the global financial system was something only doomsdayers spoke about.
But Trichet’s next bonehead stunt is the not something I am nearly as forgiving. In April of 2011, even though the problems with the European Monetary Union were obvious even to high school economic students, Trichet raised rates from 1.00% to 1.25%. And then came the real egregious error. As if to prove the first raise was not a mistake, Trichet hiked rates again in June.
Since Trichet’s 2011 blunder, Europe has been battling a vicious self reinforcing deflationary feedback loop.
Balance sheet recession
Trichet failed to realize the European economy (along with most of the developed world) had entered a balance sheet recession. He was still busy fighting the last battle (inflation), not realizing the deflation was the real enemy. He had failed to read Nomura strategist Richard Koo’s terrific book:
The Fed is making the same mistake
I have consistently argued the Federal Reserve was making a mistake in their relatively aggressive monetary policy. Their December tightening was bad enough, but until the market swooned in January, they also seemed determined to set expectations on a crazy path higher regardless of the consequences.
Even now their communicated expected path for interest rates differs greatly from the market. From Martin Enlund at Nordea:
Ray Dalio from the world’s largest hedge fund Bridgewater, along with many other smart guys have warned the Federal Reserve was making a “1937 style mistake” with their December tightening. Their tight policy has created more stress on an already precariously balanced global financial system.
What if they are not done?
Although the financial market turmoil in the first couple months of the year has caused many FOMC members to back off their hawkish rhetoric, they have yet to commit to changing their policy. There has been some acknowledgement financial conditions have tightened reducing the need for tightening, there has been no withdrawal of a commitment to higher rates.
Over the past couple of weeks the market has become giddy with Chinese stimulation, but this reduces the need for the Federal Reserve to change their hawkish policy. In fact, the face ripping rally in risk assets increases the chance the Federal will mistakenly assume they can resume their tightening path.
Although as risk assets have stabilized, markets have priced in an increasing chance the Federal Reserve will resume their tightening policy, expectations are still signficantly more easy than the turn of the year.
Here’s my trade
The rabid rally in risk assets over the past couple of weeks, along with the market’s reluctance to return the short end of the yield curve to December 2015 levels offers a great opportunity. The market is over estimating the Federal Reserve’s willingness to abandon their tighter monetary path.
It’s a little bit of a Texas hedge, but on Friday I started aggressively shorting US equities. Over the next couple of days I will add to the position, but I am also going to short the front end of the yield curve.
I expect the Federal Reserve to resume their hawkish rhetoric at any moment. Just like Trichet made the second rate rise in the summer of 2011 just to prove the first one was not a mistake, I expect Yellen’s Federal Reserve to make the exact same error.
This Federal Reserve has shown zero understanding they are dealing with a balance sheet recession. Until they acknowledge that reality, it is foolish to assume the policy will change.
It is obviously made more complicated by the fact other Central Banks and governments are aggressively trying to counter act the Federal Reserve’s hawkishness. Yet at the heart of the matter, the Fed’s reluctance to set policy for a balance sheet constrained economy (just like Trichet did in 2008 and 2011) will over ride the short term good news from the rest of the world.
It won’t be long until we return to an overly aggressive Federal Reserve that pushes risk assets back down. They will keep tightening until they break something. And even if I am wrong, risk assets have gotten so far ahead of themselves, they are probably bound to disappoint over the short run.
Thanks for reading,