Wednesday, August 05, 2015

Lancing The Financial Market Bubbles Of 2015

I blogged yesterday about the Fed's information operations campaign for an interest rate increase.  Gold is the obvious first victim of any move to strengthen an already strong dollar.  It is worth asking ourselves whether other assets will suffer as much.

Bubble economies happen all the time.  They tend to happen in isolation, when investors in one country or sector gets overly excited about a single, big story.  It is very unusual to see them happen in tandem across multiple asset classes in many countries.  The Bank of International Settlements and other disinterested international observers have noted the bubble conditions of the developed world's stocks, bonds, and real estate since at least 2013.  The march to new heights has gone uninterrupted without a major correction.

Low interest rates have transformed conservative savers into bold risk takers.  Venture capitalists throw every last penny they have into unicorn startups solving problems of convenience for the wealthy.  The Economist compares today's Silicon Valley unicorns to kitesurfers.  It's a valid comparison because engaging in either "sport" requires a lot of free time and money.  Higher interest rates mean money will no longer be free.

Paying something other than zero for capital means companies that have been throwing money away will reconsider their ways.  Borrowing to buy back stock and pay a rising dividend will no longer be a CFO's Plan A in the weekly C-suite conference.  The effect of a rate change on the stock and bond markets may not be immediate.  Federal Reserve policy changes normally have a six-month lag before they affect the larger economy, but the markets are not the economy.  Traders' reactions will be firmer if subsequent FOMC meetings keep interest rates moving up, in regular basis point increments, at regular intervals.

The Fed's messaging since the end of QE has been a gamble that predictability matters in market psychology.  The gamble presumes that messaging is more powerful than economic reality.  I do not believe the Fed can sustain regular interest rate increases from the ZIRP baseline without harming both its own balance sheet and the US economy.  It may not matter if an unsustainable interest rate increase becomes an uncontrollable one, should a panic selloff in the bond market cause the Fed to lose control of the yield curve.  September will be a test for the markets.