crack on dam 

One never knows when they will be fatal.


You should not believe studies showing what happened to stock returns when the Fed raised rates in the past: they are missing something big. We may not be in historically “uncharted” territory (I hate the expression; makes me feel like running for pencil and paper), but we are in the middle of little explored waters. The fact is there are no historical instances when rates were raised after being kept artificially low for so long. Hence, we really don’t have a clue of what will happen. My guess: investors have piled into every “earning” asset available for 6+ years, so it’s easy to envisage troubling scenarios when cash will be above 0%. Especially given where valuations are.

But the zero-rate environment has had other consequences in addition to stimulating the indiscriminate purchase of riskier assets. Borrowers have jumped at the opportunity to access money at limited cost. Corporate entities, governments and other participants (university endowments and foundations) have chosen to take advantage of this. The individual borrower’s logic is fair (the “micro” view) but the end result is what economists call an unbalanced or distorted allocation of capital (the “macro” view). What suffers in this environment is the capacity or willingness to invest and innovate; what flourishes are dividends and share repurchases (in the corporate world) and procrastination in taking the inevitable tough decisions (in the sovereign world). It is no wonder productivity has been so atypically complacent during this cyclical upswing.

There is also the issue of declining commodity prices, which is impacting a number of unsuspecting rich producers and delaying positive economic developments in other countries. I would wager the structure of world bond markets will look different in a few years.

We are witnessing deflationary pressure, the ones not linked to productivity gains but to lackluster global demand – or excess capacity. This is a problem because it ties the hands of central bankers in their efforts to normalize monetary policy while forcing other countries to engage in survival tactics. The Yuan’s recent devaluations have to be seen in this context, and while these actions maybe good for abstractions such as “reserve currency” status or the broadening of international payment means, it leaves all of us mortals with uneasy feelings. The way events are shaping up is not pretty, and I suspect one of the last drops might be the “discovery” in Washington of just how much the Dollar has appreciated in the last four years (+39%).

If you are younger than me (a good chance) you may not know that the October 1987 crash was preceded, among other events, by:

  1. a 66% oil price decline from November 1985 to July 1986;
  2. a 36% decline of the trade-weighted Dollar from February 1985 to October 1987;
  3. war-like events between Iran and the US in the days just before the crash.

As Mark Twain taught us, “History doesn’t repeat itself, but it does rhyme.”

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