Last week I received a call from Adam Shell at USA Today. Adam was working on a story about the Brexit referendum. His thesis was that this week’s vote could not have come at a worse time due to several risk factors that are also weighing on the financial markets. Among these risk factors, Adam said, are the uncertain trajectory and efficacy of Fed monetary policy, negative interest rates in certain areas across the globe, terrorism, the US presidential elections, and cautious commentary from the likes of George Soros. Adding the Brexit vote to the mix, he said, could be too much for the markets to withstand.
My first inclination was to agree with Adam. The threats do indeed seem numerous, and therefore caution seems justified. Upon further reflection, though, I realized that: 1) the capital markets don’t appear to be reflecting any undue concern about Brexit or anything else as stock prices are close to all-time highs, credit spreads are reasonable and volatility is subdued; and 2) we have been in a near-constant state of vulnerability since the financial crisis, according to the Fed. For today’s market commentary, I am including the thoughts I provided to Adam for his story, which appeared in yesterday’s USA Today and can be found here.
I’m not sure I agree with your assertion that now is the worst time possible for Brexit. The Fed has kept the Fed Funds rate near zero for many years precisely because of its perception that the financial markets (and economy) have been in a near-constant state of fragility and uncertainty since the Financial Crisis. Therefore, at least from the Fed’s perspective, there hasn’t been any period of time over the past 7+ years during which the economy and financial markets have been strong enough to withstand a Brexit-like shock. Think about all the potential land mines we’ve had to navigate since the financial crisis: the European debt crisis; the rise of ISIS; Russia’s annexation of Crimea; a collapse in energy and other commodity prices; the debt ceiling crises and federal government shutdown; the Occupy Wall Street movement; China’s economic deceleration; the Syrian war, etc, etc. Each time it appeared as though the Fed could take its foot off the pedal in earnest, either the capital markets threw a fit or there was some exogenous factor to justify caution. The Brexit is another one of these exogenous factors. The repercussions could be worse, but some of the aforementioned “crises” seemed pretty dire at the time.
My point is not to say that these risk factors have provided justification for the Fed keeping interest rates near zero for 7 years. Quite the opposite. I’m trying to say that there will always be exogenous risk factors to navigate, landmines to avoid, and the Fed (and other central banks) cannot try to carry the entire weight of global economic and political stability on its shoulders. I think it is fairly indisputable that ultra-loose monetary policy for protracted periods of time has proven to cause major problems that can grow to be bigger than the problems it’s meant to solve. Not only does it create moral hazard and the risk of asset bubbles, but the entire economy resets to a lower level of interest rates and effectively becomes heavily dependent on low rates. Ultra-loose monetary policy pulls forward future demand and dramatically reduces the strength of an eventual economic recovery. The longer the maintenance of low rates, the greater the damage. Ultimately, it becomes exceedingly difficult for the Fed to extricate itself. This is where we are now.
Interest-rate hikes are never popular. Politicians don’t want them, corporations don’t want them, and individuals don’t want them. As a result, the Fed has a heavy bias (and political pressure) toward keeping the program humming far longer than originally intended. Central bankers can always find reasons for caution. But the longer the bar remains open, the worse the hangover in the morning. And this says nothing of the fact that the Fed is now left with very little fodder with which to fight future crises, including a potential Brexit or indeed the complete disintegration of the EU.
US stocks are very close to all-time highs. US housing prices have rebounded nicely and sales activity has accelerated. Credit spreads are reasonable, and the economy is chugging along with weaker sectors like corporate investment, manufacturing and exports offset by relatively strong consumer spending. At this point, it doesn’t appear as though investors are overly anxious about the Brexit vote. This could change, but so could a lot of things. Having said that, I also believe the Fed’s largesse is responsible for a reasonably large portion of our current (relatively) good fortune. But at what ultimate price? At some point, the Fed has to get off this treadmill of trying to help the world avoid every potential crisis. Every time stocks pull back more than a couple percent we start to hear warnings that the sky is falling and the Fed needs to tread lightly. In my view, the time is long overdue for the Fed to get out of the picture so we can revert back to a market economy.
I expressed some of these sentiments on PBS’s Nightly Business Report last night. Please see below.