I have written repeatedly in recent months about the contrast between strong stock market performance and deteriorating economic fundamentals. It’s the most important story. The market has obviously been celebrating the willingness of central bankers throughout the world to print money and resort to other non-traditional methods of rescuing both economies and markets. The past two weeks demonstrate how seriously concerned central bankers must be. Following earlier pledges of substantial easing from the Bank of England and the European Central Bank, our Federal Reserve and, most recently, the Bank of Japan have committed to potentially giant expansions of quantitative easing (QE), the popular euphemism for money printing.
These most recent rescue efforts are eloquent testimony to how dangerous central bankers consider current conditions to be. In the U.S., the Fed began the use of non-traditional methods (such as QE) only after they had dropped short interest rates essentially to zero. The extremely aggressive interest rate policy failed to prevent a major recession and a stock market collapse from 2007 to early 2009. The first iteration of QE in 2009 followed TARP and TALF as part of a coordinated government effort to prevent worldwide financial collapse. It halted the downward economic spiral and stimulated a powerful stock market rally.
When the economy began to slow and stocks slipped perceptibly in 2010, Fed Chairman Bernanke hinted at and soon followed with QE2. Another year later stocks again fell and the economy threatened to fall back into recession. The Fed once more stepped into the breach with Operation Twist. Again the economy picked up, though less aggressively than in 2010, and stocks again rallied.
All three of those non-traditional stimulus efforts were timed to rescue a slowing economy and to reenergize declining stock prices. This month’s worldwide rescue efforts similarly are designed to prop up a flagging economy. Unlike the past, however, they have been initiated when stocks were near a high, not a trough, following the earlier rescue effort.
To more carefully identify the Fed’s primary intentions, we need only listen to their language. Fed Chairman Bernanke and other Fed members have admitted that additional QE will probably do little to improve the employment picture, which is one of their dual mandates, the other being maintenance of a stable currency. They went to great pains to suggest that, despite their pledge of unlimited newly printed money, there was little imminent risk of inflation. Should significant inflation eventually rear its ugly head, they were well equipped to withdraw all this stimulus. Since no prior Fed has ever created such an outsized balance sheet, no prior Fed has ever had to withdraw such excesses. Knowledgeable analysts have grave doubts that the Fed will be able to mop up the excesses without creating severe economic dislocations, especially because debt levels remain excessive throughout the world economy. The risks of serious unintended consequences are extremely high.
Mario Draghi, head of the ECB, when asked: “What’s the first statistic you look at in the morning?” replied: “Stock markets.” Ben Bernanke has pointed with pride to the Fed’s success in raising stock prices and justifies his most recent QE as a force that should continue to lift stock prices and create a feeling of greater wealth. Chinese leaders appealed to their regional offices earlier this month to support the stock markets. It appears that stock market support has become an additional central bank mandate.
Longtime readers know that I have long suspected the Fed of directly attempting to support stocks with purchases when it served their purposes. Just this week, two well-respected analyst/commentators have voiced similar suspicions. Bert Dohmen speculated that the NY Fed uses S&P 500 futures to support markets. My old friend from La Jolla, California, Richard Russell, who has written Dow Theory Letters since the 1950s, similarly suggested that the Fed appears to be providing direct stock support.
Obviously, we can’t know how markets will proceed from here. It is potentially noteworthy, however, that the positive response to the recent central bank stimulus efforts has been tepid after a day or two of rally. Whatever the short-term response, investors run the risk that artificially inflated prices could adjust very quickly if confidence in central bank power disappears, as it has many times in the past.