“What more can I do?”
In 1990, this mere question asked by to David Evans (aka “The Edge”) to Larry Mullen Jr almost led to the split of U2, one the most famous rock bands of the past forty years. At that time, after one decade of exponential commercial success, the band decided to reinvent itself and try something different after the massive impact of The Joshua Tree and the long tour that followed.
While the band was struggling to write something meaningful, despite the presence of British producer Brian Eno, Mullen asked The Edge “what more can I do?”, and the guitarist’s reply was a stunning “what less can you do?” question.
While this is just an anecdote, the band almost split after this conversation, but finally they found inspiration from new instruments and electronic sounds, releasing Achtung Baby in 1991, which is now regarded by many fans or critics as the second masterpiece of U2.
“What more can you do?”
This question has been implicitly asked by capital markets to central bankers for more than ten years. Today, stock investors are not concerned about traditional metrics like economic growth or earnings perspective, but by the dynamic of money supply. Thus, markets have reached zoo station, meaning that they are more and more driven by pure animal spirit, displaying Pavlovian reactions to any speech or announcement from the Fed or the ECB, and reaching absurd valuation levels whatever the asset class.
The problem is that after a crazy year 2020, the two biggest central banks of the West are now trapped into an endless spiral of dovishness. Given the massive distortions created by zero interest rates policies and infinite quantitative easing (see There Ain’t No Such Thing as a Free Lunch – Part 1 and Part 2), the good question to ask Jerome Powell and Richard Clarida in America, or Christine Lagarde in the Eurozone, should be: “what less can you do?”
Love is Blindness
As already explained in previous posts, in economics everything comes at a cost, including QE. People love to state that “there is no limit to balance sheet expansion”, as an excuse to continue to buy stocks or cryptocurrencies at all-time highs. But there is a limit to money printing.
Speculative bubbles are pure endogenous phenomena, and this time is not different. However, one participant has played a significant role to fuel the mania, the Federal Reserve. Indeed, they have been feeding a narrative for years, i.e. that yields will continue to fall, and that inflation will remain very low thanks to the central bank’s action. “The Fed has our backs”, investors say.
In other words, there are two things that could lead to a giant squeeze: the dollar and/or inflation.
I already talked about the dollar in recent posts (see New Year Is Coming: The Biggest Disconnect Ever), so today the emphasis is put on the message sent by commodity markets, as many people might be frontrunning massive public spending in the US after the victories of the Democrats candidates in Georgia.
As inflation expectations have grown, bond yields have begun to quickly move higher. Thus, everyone should be aware that if this trend continues, then it may signal the end of the TINA narrative.
Until the End of the World
Does it matter? Is the Fed going to save us? Well, Powell and Clarida have spent the past weeks claiming that they are not concerned about asset valuations (including stocks). And you can be sure that the plunge protection team will keep doing “whatever it takes” to offset yield curve steepening.
However, some people at the Fed have begun to offer alternative views. For instance, Raphael Bostic, who might become the new Chair during Biden’s term, surprisingly suggested that bond tapering could begin in 2021.
More interestingly, the St. Louis Fed research team recently published a short note on their website, discussing the problem of excessive stocks valuation, reminding that “when stock prices get very high compared to fundamentals, such as earnings, central bankers become concerned.” Do those people disagree with the board of governors?
Unfortunately, the Fed is trapped. Even if governors might be concerned about parabolic moves everywhere, they cannot communicate on that, and they are forced to sticks to an ultra-dovish stance on monetary easing.
Who’s Gonna Ride Your Wild Horses
However, if bond yields continue to rise, or if there is a spike of commodity prices, or if the dollar falls further, then markets will reach a critical point and the threat of the biggest equity sell-off ever.
The 1987 crash might a good proxy for that situation. And that should be a concern for every “trend follower” that claims that you can just buy the ongoing bull market as long as you use stop-loss strategies…