Adventures in Quantitative Tightening

All remaining doubts concerning the place the U.S. economy, and its tangled web of international credits and debts, is headed were clarified this week.  On Monday, Mark Yusko, CIO of Morgan Creek Capital Management, told CNBC that:

“…we’re flowing toward the path of 1928-29 when Hoover was president.  Now Trump is president.  Both were presidents with no experience who come in with a Congress that is all Republican, lots of big promises, lots of things that don’t happen and the fall is when people realize, ‘Wait, it hasn’t played out the way we thought.’

“[By the fall], we’ll have a lot more evidence of declining growth.  Growth has been slipping.”

If you recall, autumn of 1929 is when the U.S. stock market commenced a multi-year swan dive and the economy commenced a decade long Great Depression.  This is the path Yusko believes we’re flowing toward.  To be clear, this is a path that can be extraordinarily hazardous to your investment wealth.

For example, from September 3, 1929 to November 13, 1929, the DOW lost 47.9 percent.  Then, as rarely noted, it rallied 48.1 percent through April 17, 1930.  This had the adverse effect of luring the buy the dip crowd back into the stock market just in time for their final massacre.

In the end, it turned out to be the ultimate suckers’ rally.  The stock market subsequently crashed 89.2 percent from its initial peak along with the hopes, dreams, and aspirations of a generation.  Such a colossal collapse could never, ever happen again, right?

Unknown Road

Indeed, the possibility of even a partial repeat of the 1929-32 stock market crash is something to be wary of.  Remember, if it happened before, by definition, it could happen again.

In addition to the political similarities Yusko mentioned, including a fiscal policy flop overseen by a Republican President and Republican Congress, the economy’s also traversing a path of tightening monetary policy as it was in 1929.  However, this time the path has several new twists and turns that are leading down an unknown road.

The Federal Reserve has quite a task ahead of them to achieve their goal of policy normalization.  Raising the federal funds rate is one thing.  But they also must pioneer a new path of quantitative tightening.  This is something the Fed has no experience with.

According to Jamie Dimon, CEO of JPMorgan Chase & Company, the effects of reversing QE are unknown.  Speaking at a conference in Paris on Tuesday, Dimon remarked that:

“We’ve never had QE like this before, we’ve never had unwinding like this before.  Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.

“When that [quantitative tightening] happens of size or substance, it could be a little more disruptive than people think.  We act like we know exactly how it’s going to happen and we don’t.”

Adventures in Quantitative Tightening

No doubt, Dimon is right.  No one, including the Fed, knows exactly how reducing the Fed’s balance sheet will play out.  This has never been attempted before.

But Dimon misses the mark.  You see, quantitative tightening won’t “be a little more disruptive than people think,” as Dimon suggests.  More accurately, it will be much, much more destructive than most people are capable of imagining.

Still, Dimon’s remarks caught the attention of Representative David Kustoff of Tennessee.  On Wednesday, during Fed Chair Janet Yellen’s semiannual Congressional testimony, Kustoff asked her if she shares Dimon’s concerns about moving assets off the Fed’s balance sheet.

Yellen didn’t provide an explicit yes or no to the question.  However, she did use her uncanny flair for reducing by logic all the disagreeable repercussions of the Fed’s prior actions:

“We’ve tried to be very methodical about informing the public and the markets about how we’re going to do this.  We’ve provided essentially complete information, we’ve not heard significant concerns or seen a significant market reaction”

Obviously, the reaction that comes from telegraphing your actions to the public via carefully scripted policy statements is a great deal different than the reaction that will come when central banks begin dumping mass quantities of sovereign debt in tandem. Here, in the spirit of modest contemplation, we offer several hunches, inklings, conjectures, and guesses as to what quantitative tightening will mean.  These aren’t predictions.  They’re merely a starting point from which you can extend out your own visions into the future…

Interest rates will rise.  Asset prices, including bonds, stocks, and real estate, will fall.  Credit will contract, yanking the thin rug the economy’s resting upon right out from under it.  GDP will decrease.  Unemployment will increase in the face of declining labor participation.

Cash in hand will be king (at first), as several too big to fail banks will, in fact, fail.  Numerous cities and several states will also go bankrupt.  Hartford and Illinois are leading the pack in their respective category.  More will follow.

The Fed will be forced to reverse course.  However, efforts to push interest rates below zero through massive balance sheet expansion will have a negligible effect on stemming the economy’s collapse.

Thus, the Fed will inject fiat money – not credit – directly into the economy via helicopter drops.  This will take the form of direct delivery of monthly electronic tax rebate cards to taxpayers and non-taxpayers alike.  This will trigger an earnest freefall of the dollar and of all paper currencies, as other central banks will be executing similar programs.  Simultaneously, grocery stores will be cleared out and the shelves will remain empty.

Gold and silver prices, in dollar terms, will launch into the upper stratosphere.  This will be met with direct government confiscation.  After that, things will really get ugly.

Alternatively, everything could all go off without a hitch.  For as Yellen told Kustoff, “I expect, and certainly hope, that this will go smoothly and it will be a gradual and orderly process.”

Don’t hold your breath.

Sincerely,

MN Gordon
for Economic Prism

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