Easy’s Getting Harder Every Day

The job of the investor is to answer that impossible question, ‘ What is the correct valuation for this financial instrument?’ There is almost never a right answer to this question, but there are, of course, many wrong ones. Eliminating wrong answers, especially when valuing an investment which already discounts the future, is an important strategy in coming up with better answers than the competition.

So there is really good news for investors: the current, prevalent answer to the question, ‘What is the correct valuation for this financial instrument?’ is clearly wrong. It is demonstrably wrong because the answer is ‘Whatever the central bankers say is the correct value’. It is clearly wrong because it has never been true in the past. It was recognised as clearly the wrong answer as early as 1810 in the words of the so-called ‘ Bullion Committee’-

‘The most detailed knowledge of the actual trade of a country, combined with the profound Science in all the principles of Money and circulation, would not enable any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.’

      Report of the Select Committee of the House of Commons 1810

The ‘Bullion Committee’ of 1810 realised the virtual impossibility of the United Kingdom remaining off the gold standard when the war with the French had concluded. It realised a simple truth: that no ‘man or set of men’ could provide the appropriate amount of money for an economy. And thus it has been true ever since that central bankers, when freed from any form of monetary anchor, have created the wrong amount of money. All we have to decide is which side of wrong are they on — too much or too little? Market movements now clearly indicate that the answer is too little.

The world is beginning to see that central bank action is insufficient to overwhelm the forces of deflation. The reported deflation of 2009 lasted only briefly. The consensus view is that it was defeated by developed world central bankers flooding the world with money.

The consensus view is wrong. Since 2009 almost 80% of the increase in the world’s money has come from Emerging Markets in general, and China in particular. It is the rapid slowdown in EM, exacerbated by the strong US$ discussed in the previous Fortnightly Solid Ground, that is bringing deflation to the world. The developed world will feel that deflationary wind and it will raise real rates of interest at a time when the central bankers cannot reduce nominal rates of interest. The chart below shows how, even in the USA, inflation expectations are declining and real rates of interest rising.

US 5 Year Treasury Inflation Protected Securities- Inflation Breakevens

Since July the markets expected average annual inflation rate, over the next five years, has declined from 2.1% to just 1.6%. After five years of QE inflation expectations are right back where they were in the final quarter of 2009. With no ability to reduce nominal rates further, the efficacy of monetary policy rests almost entirely upon its ability to generate inflation and depress real rates of interest. Monetary policy is failing to create inflation and if the central bankers don’t control this variable they certainly don’t control the price of financial instruments.

This is the third time that inflation expectations have dived in the post QE world and, on each occasion when expected inflation has neared 1.5%, the S&P500 has fallen sharply. It falls sharply because, in a land of near-zero nominal rates, the success or failure of the Fed is gauged solely on its ability to produce inflation. On both previous occasions when inflation expectations got this low the Fed responded with even easier monetary policy, causing inflation expectations to rise; but crucially inflation did not.

The bell has rung for Pavlov’s dogs twice before, but the meat of higher inflation has not been delivered. Now the bell is ringing for the third time. With the key driver of inflation events well beyond US shores, the inability of the Fed to generate the meat of inflation will be much more apparent on this occasion. After five and a half years of QE there is still no meat for the dogs: real rates of interest are rising rapidly and almost all financial market instruments are overvalued. If you believe that the correct price for financial market instruments is the price decreed by the Federal Reserve, you need to look at the chart above and ask yourself a simple question, ‘With inflation expectations back at 4Q 2009 levels, what evidence is there that QE works?’

Financial markets continue to price in the God-like omnipotence of central bankers, while the evidence mounts of their all-too-human mortality. When it comes to central bankers, do not forget the words of the Wonderful Wizard of Oz from the great monetary allegory of the same name. Unmasked and accused by Dorothy of lying about his great powers, he could only remark-

Oh, no, my dear… I’m… I’m a very good man. I’m just… a very bad Wizard.

The current Chair of The Governors of The Federal Reserve system may not be a man, but she is also no wizard.


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