Traders work on the floor of the New York Stock Exchange (NYSE) on March 20, 2020 in New York City.
As stocks from New York to Tokyo stage monstrous rallies, it’s important that we don’t lose sight of the creatures behind them. And how they may ultimately turn on the global economy.
Wall Street’s boom is especially eerie. What else can one say about investors yelling “buy” when the U.S. is approaching 7 million Covid-19 cases, its economy is cratering at a nearly 33% rate and the president is so obsessed with hitting China that he’s targeting apps popular with teens? Yet stocks are on a tear.
Japan’s equity upsurge also seems plenty supernatural. The economy is contracting at a 28% rate, deflation is returning and the population is shrinking at a record clip while the national debt burden, the worst by far in the developed world, swells apace. And yet the Nikkei 225 Stock Average is soaring.
The creatures behind this bull market in cognitive dissonance are the Federal Reserve and the Bank of Japan. Both are fueling epic asset bubbles by way of their own in-house bubbles.
At the end of 2018, the BOJ’s balance sheet exceeded the size of Japan’s $5 trillion of annual gross domestic product. In March, the Fed’s balance sheet topped the $5 trillion mark, too. In one week alone that month, the Fed’s asset holdings jumped an unthinkable 12.4%, or roughly the annual GDP of Portugal.
This $10 trillion-plus of central bank stimulus, coupled with liquidity flowing out of Europe, is warping market forces beyond recognition. Along with propelling asset markets higher amid dreadful economic fundamentals, all that largess is wreaking havoc with credit markets.
In Japan’s government debt market, the BOJ has deadened trading. Entire days sometimes come and go without a single security changing hands. That has altered the price discovery role public debt often plays. It makes it harder for companies, municipalities and investors alike to know how to value bond sales. It means that the spreads between public and private debt that tend to let markets know when trouble is arising are virtually useless goalposts.
Michael Hartnett, chief investment strategist at Bank of America, speaks for many when he calls equity markets “divorced from reality.” He goes further, though, warning that central banks are essentially creating “fake markets.”
Politicians like U.S. President Donald Trump label any news they don’t like as “fake.” The real story, though, is how leaders have coopted central bank policies to the extent that the real fakery is the bullishness investors feel toward markets.
Those fake markets in New York, Tokyo and beyond have asset prices parting ways with underlying economic conditions in unprecedented ways. The question, though, is whether these frothy bourses have pivoted from too-big-to-fail territory to too-big-to-save status.
U.S. Treasury Secretary Steven Mnuchin and Federal Reserve Chair Jerome Powell share an elbow bump ... [+]
For years, investors proceeded with a “don’t fight the Fed” mindset. That’s become a self-fulfilling prophecy. First, the Fed’s trillions flushed out the bears. Now it has punters of all stripes ignoring the forces of financial gravity. And chasing the Fed’s liquidity higher and higher with share prices.
The upshot is that once reality returns, markets are in for a monstrous reckoning.
In a sense, Trump’s Fed has created the financial equivalent of Frankenstein’s monster. While fascinating at first, such beasts tend to get away from you. They tend to come back and do you grave harm.
One of the loudest warnings that central banks may be playing God comes from, ironically, former People’s Bank of China Governor Zhou Xiaochuan. He says monetary authorities need an exit strategy from the “swift and bold” steps taken to address coronavirus recessions. Effective delegating strategies must now be the priority.
“On the one hand, we firmly support central banks’ monetary policy response to the pandemic,” Zhou says. “On the other hand, we should not ignore or underestimate side effects of the current monetary policy.”
Japan demonstrates that effect better than any large economy. Since 1999, when the BOJ first cut rates to zero, officials in Tokyo have been in perpetual feed-the-beast mode. Japan is on its 11th government since then. What each share in common is pressing the BOJ to increase the frequency and the size of those feedings.
It’s early days for Prime Minister Yoshihide Suga’s government. Yet there’s every indication he wants the BOJ to keep Tokyo’s 21-year-old financial fiend from attacking Asia’s No. 2 economy.
Yet isn’t that the problem? Tokyo thinks it’s presiding over a giant financial system. In reality, it’s struggling to manage a menace of its own creation of which it risks losing control. Eventually, rating agencies and investors will figure out this power dynamic. Eventually they’ll glom on to the wildly divergent trends in Japanese demographics, debt and deflation and realize the math doesn’t work.
For now, though, the BOJ keeps feeding and feeding and the Nikkei keeps rising and rising against all odds.
This is a cautionary tale for Jerome Powell in Washington. Investors long ago lost track of the untold trillions of dollars the Fed chairman is churning into markets bafflingly divorced from reality. The idea that stock bourses undergirded by an economy losing tens of millions of jobs are skyrocketing is just bonkers.
Powell isn’t an economist, a first for a Fed leader. If he were, he might know how badly pyramid scenes tend to end. Odds are the BOJ and the Fed will keep feeding these monsters. But these power economic creatures, born out of unorthodox experiments, could go awry at any moment. Scary, indeed.
