Nothing has Changed, but That's Not What the Markets Heard

Looking at the FOMC statement released on Wednesday, one can see that its contents have barely changed compared to the last one. Kremlinologists can take a look at the WSJ's trusty statement tracker and will see that only two half-sentences and two word were altered. The changes express a slight increase in optimism about the economy, which makes one wonder which data the Fed has been looking at, but so be it.

The most important change is actually the fact that there are now two dissenters among the four regional Fed presidents that have votes this year: Esther George of Kansas once again wanted 'QE' to end, which was no surprise. She is worried about future market instability and a possible 'unanchoring' of inflation expectations. The surprise was James Bullard's dissent – we quote:


“ Voting against the action was James Bullard, who believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings….


In other words, Bullard wanted the committee to send out an extra 'dovish signal' with respect to bringing 'inflation' (read: CPI's rate of change) back up to the 2% level.

However, Ben Bernanke's press conference was of course all about the dreaded 'tapering' and market participants didn't like at all what they heard there – in spite of the fact that they didn't really get to hear anything that wasn't already known. The only thing Bernanke did differently was to tell the assembled journalists his own best estimate as to when the pace of asset purchases might be wound down, while stressing that this did not amount to a fixed time table, but continued to be entirely 'data dependent'.

According to a Bloomberg report:


“Federal Reserve Chairman Ben S. Bernanke said the central bank may start dialing down its unprecedented bond-buying program this year and end it entirely in mid-2014 if the economy finally achieves the sustainable growth the Fed has sought since the recession ended in 2009.

The Federal Open Market Committee today left the monthly pace of bond purchases unchanged at $85 billion, while saying that “downside risks to the outlook for the economy and the labor market” have diminished. Policy makers raised their growth forecasts for next year to a range of 3 percent to 3.5 percent and reduced their outlook for unemployment to as low as 6.5 percent.

“If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year,” Bernanke said in a press conference in Washington. If later reports meet the Fed’s expectations, “we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”


Still, Bernanke tried to temper his message by saying that the Fed has “no deterministic or fixed plan” to end asset purchases.

“If you draw the conclusion that I just said that our policies — that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy,” he said. “If the economy does not improve along the lines that we expect, we will provide additional support.”


(emphasis added)

We have discussed the boomlet within the Great Depression that was fueled by extremely expansionary fiscal and monetary policy, similar to the boomlet of 2009 to the present, several times in the past (see this example and see also Robert Murphy's article on Christina Romer's views on 1937). It lasted from 1933 to 1937 and resulted in a huge rally in the stock market. By 1937, the Roosevelt administration felt that it should cut back on its deficit spending somewhat (apparently it got spooked by the growth rate of the deficit) and the Fed, led by the Chicago Fed, became greatly concerned with rising prices. As a result of this, it raised its minimum reserve requirements, which were at the time a quite influential monetary policy tool.


Thus was born what Keynesian and monetarist economists today regard as the 'mistake of 1937', or the 'depression within the depression'. From our point of view, the mistake was not pulling back on accommodation, but providing too much of it in the first place. The inflationary echo boom was simply unsustainable and at the point when the Fed decided to tighten policy a little, the choice was basically between risking an unstoppable inflationary conflagration down the road, or abandoning further credit expansion just in time.

Naturally, the decision to abandon further credit expansion then led to a liquidation of the malinvestments of the preceding 'echo' boom, hence there was a sharp economic downturn in 1938, with the stock market plunging by nearly 60% from its late 1937 high.


Shades of  1937

This year, the growth rate of the federal budget deficit is finally set to shrink on account of tax hikes, the 'sequester' and several one-off revenue increases. Earlier this week,Nomura's Bob Janjuah has published an interesting missive as to why he believes the Fed will begin 'tapering' QE eventually. Janjuah essentially argues that the Fed's predominant worry will be with the asset price bubble and the associated leverage its 'QE' programs have produced:


“The Fed is NOT going to taper because the economy is too strong or because we have sustained core (wage) inflation, or because we have full employment—none of these conditions will be seen for some years to come," Nomura's fixed income strategist said in a recent missive to clients.

"Rather, I feel that the Fed is going to taper because it is getting very fearful that it is creating a number of significant and dangerous leverage driven speculative bubbles that could threaten the financial stability of the U.S. In central bank speak, the Fed has likely come to the point where it feels the costs now outweigh the benefits of more policy."


"At least some members of the Fed may be worrying about the future of the Fed and the U.S. if they persist with treating emergency and highly experimental policy settings as the new normal," Janjuah said.

Amid a climate of "dangerously loose global central bank policy settings, increasing complacency towards risk and blind faith in central bank 'puts' amongst investors," Janjuah correctly forecast that the market would make a new high this year, though he expected it to happen in the third quarter. Now he sees the groundwork being laid for a correction in late 2013, or early 2014, that could knock the market down 25 percent to 50 percent.

He believes the new bear market will happen after stocks churn around a little and get some dip-buying action before having to confront low economic growth and a market that soared on speculation.

"It depends on who says what, and on the levels of extreme speculation and leverage. In other words, did we collectively learn our lesson from the events leading up to and including the global 07/08 crash?" Janjuah said. "My 25-plus years in financial markets lead me to believe, sadly, that the answer is almost certainly NO."


(emphasis added)

From the point of view of overlegeraged and overextended markets it doesn't matter why accommodation may be withdrawn. Whether it is the fear of inflation, such as in 1937, or the fear of igniting too big an asset bubble doesn't really matter. Similarly, all the bubble activities that have been set into motion in the real economy are definitely going to come under pressure once monetary pumping slows down.

Already interest rates are no longer under the Fed's control, something Bernanke declared himself 'puzzled' by in his press conference, but that is only because he hasn't read Mises. If he had, he would know that interest rates that have been artificially suppressed will eventually always return to their natural level due to the market process.

This process may be delayed by throwing even more fiduciary media on the loan market, but it cannot be averted forever. Moreover, if the central bank were to simply continue inflating without limit, it would eventually end up destroying the currency system completely. So the Fed is in a bit of a box – and eventually it may find out, just as the BoJ has found out, that 'QE' actually doesn't work as advertised.

One thing that argues in favor of Bob Janjuah's view is the speech delivered by Fed governor Jeremy Stein earlier this year, in which he decried growing speculation in credit markets.

Lastly, every time a new Fed chairman takes over, a market convulsion is never far away – and Ben Bernanke's term ends in January next year. This is probably because it takes a while for the markets to trust that a new Fed chairman is willing to provide them with enough monetary fuel.

Overnight markets plunged around the world – virtually all of them. Stocks, bonds, gold, commodities – it was an equal opportunity slaughter. We thought it may therefore be a good idea to take a look at what the market did in 1937 and compare it to today's action. Unfortunately there are only selected technical data available from the time (although all the price data are certainly available), so we decided to look at one indicator specifically, namely the cumulative NYSE advance/decline line.




The NYSE Index (NYA) and the cumulative a/d line. Note that there was  no warning from the a/d line in 1937 – it did not diverge from price! – click to enlarge.



It was quite surprising to us that the advance/decline line, one of the most consistent 'early warning' type technical indicators, did not give a warning of the impending decline in 1937. Not only that, it turns out that the shape of the final rally into the 1937 high was very similar in terms of both prices and the a/d line to the recent rally:





$NYAThe NYA over the past year. Consider that the time scale (x-axis) in this chart is a bit different from the more compressed one in the chart above. However, if one compares the shape of this rally to that of the 1937 advance, it certainly looks eerily similar – click to enlarge.





Even more eerie, the shape of the cumulative a/d line is also very similar to that of 1937. It has the same ups and downs (essentially following prices) and it has also 'confirmed' the recent new price highs – click to enlarge.




Every slice of economic history is of course unique. However, history does often 'rhyme' in important aspects, and human greed and fear as expressed in the financial markets is never different.

Given the dependence of current market prices on extremely loose monetary policy, even a slight pullback in monetary pumping may be sufficient to lead to a serious upset. We have talked at length about the many 'warning shots' the markets have received in recent weeks, such as the plunge in emerging market bonds and currencies, and the recent plethora of bearish technical divergences.

The action in various financial markets overnight following what appeared to be a fairly inconsequential FOMC decision shows how brittle the situation really is. 

Just as happened in 1937, or in the several instances when the BoJ dialed its 'QE' programs back down, the 'tapering' of the Fed's monetary pumping program could easily lead to a major decline in 'risk assets'. Caveat emptor.


Addendum: Gold

We wrote today's gold and gold stock update last night, before the most recent plunge in the gold price began. It seems now that our worries were well-founded: gold is indeed breaking down from its descending triangle in the near term. Initial technical support is in the $1250 region, while the 2008 high at $1030 provides major support (at the level, the decline from the high would be almost exactly similar to that of 1974-1976 in size).



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7 Responses to “The FOMC and the Ghost of 1937”

  • Specterx:

    What are the implications of stocks being sold, but bond yields rising? This seems like a major regime change from past years/dips.

  • SavvyGuy:

    >> Lastly, every time a new Fed chairman takes over, a market convulsion is never far away – and Ben Bernanke’s term ends in January next year. This is probably because it takes a while for the markets to trust that a new Fed chairman is willing to provide them with enough monetary fuel.

    Another reason could be that Fed chairmen time their exits before the “fit” they created starts hitting the “shan”!

  • The question is, when does 1937 come? My own opinion is the only purpose for QE is to cover up massive insolvency in the system. If not for this insolvency, history has shown the banking system can get along with a fraction of the money already created and the entire act is useless and senseless. Bernanke might have to withdraw more than $1 trillion to move short term rates up. Then we have risk premiums the insolvents would have to pay.

    If Bernanke thought he had control of the bond market longer term, he probably missed something in his education, indicating they have an incompetent at the head of the Fed. They are going to find the same thing in Japan and they may have already been shocked to find the truth that the 10 yr. JGB has a mind of its own. Then again, rates might be moving up on insolvency concerns.

  • zerobs:

    At least some members of the Fed may be worrying about the future of the Fed and the U.S.

    This is laughable. While some members of the Fed (without votes) may be somewhat worried about Fed-induced bubbles, the arrogance of all Fed members does not allow them to worry about the future of the Fed itself. Central-planners all.

    • Well, that’s Janjuah’s assessment, not mine. However, some of the regional Fed presidents like Richard Fisher or Jeffrey Lacker have a more differentiated view/approach w.r.t. what the central bank can or should do than the board of governors in Washington. Of course, not even the best intentions can alter the basic difficulty, namely that the central bank essentially represents a special case of the socialist calculation problem. It is not POSSIBLE to centrally plan money and create outcomes that are better than market-based outcomes would be. That central conceit is one ALL Fed members must perforce subscribe to.

      • No6:

        “That central conceit is one ALL Fed members must perforce subscribe to”

        Only if you assume that they are honest people. There are more nefarious reasons for wanting control of money.

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