In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.  Chairman Ben Bernanke at the 49th Annual Conference on Bank Structure and Competition

With junk bond yields piercing the 5% barrier to the downside, stocks making new highs, residential real estate prices bubbling higher by double digits and farm land fetching prices never before seen, one can’t help but wonder when Ben and his fellow central bankers last had an eye exam. Junk bond issuance is not exactly punk with volumes up 12% over the same period last year which wasn’t exactly a bad year to be a low rated bond issuer. Commercial real estate lending is reviving and cap rates are basically back to where they were pre-crisis. So too, the dividend yield on the S&P 500 which currently nets a yield reacher a whopping 2.13%, almost but not quite a full 1/4% pick up over the 10 Year Treasury Note. Hedge funds are buying residential real estate to rent and capture yields that a few years ago would have been considered rich for a muni bond. If this isn’t yield reaching by the Fed’s definition, then what exactly is?

Elsewhere in Bernanke’s speech he mentions “the apparent tendency for financial market participants to take greater risks when macro conditions are relatively stable” and laments that “prolonged economic stability is a double-edged sword.” Well, yes it is and thanks for finally recognizing that the Great Moderation engineered by the Fed during the 90s and 00s was a mistake. Unfortunately, it appears that Bernanke learned nothing from his apparent recent reading of Hyman Minsky since current Fed policy is intended to provide the exact same type of artificial stability that produced the last crisis. Maybe Ben could add Leon Festinger to his reading list to supplement the Minsky.

The degree to which this market is dependent on continued Fed easing was demonstrated just last week when rumors of a Jon Hilsenrath article on the Fed’s exit strategy knocked the market down nearly 100 points in a matter of minutes Thursday afternoon. Hilsenrath is known – or at least believed – to be the Fed’s unofficial mouth piece at the Wall Street Journal so when he writes, Wall Street listens. When the article failed to materialize Friday morning, traders apparently took that as the all clear and the market recovered back to near its weekly high. Hilsenrath’s article did finally appear after the market close Friday and it will be interesting to see how it is interpreted tomorrow morning.

A market that can move so quickly based on nothing more than a rumor about a reporter maybe writing an article that might possibly signal something about Fed policy is not one that I would call healthy. The article itself doesn’t give us much detail about the Fed’s exit strategy other than to say that they will eventually, someday dial back the bond buying, something that isn’t exactly a scoop. If anything the article only makes clear that the Fed has no idea what it is doing or how it might exit from its extraordinary policies. The article states that the Fed wants to clarify the policy so “markets don’t overreact” but also says that they don’t want to create expectations that their exit will be a steady, uniform process like the “measured pace” of rate hikes it engineered from 2003 to 2006. So the Fed apparently wants to clarify but also wants to keep the market guessing as to their next move? I’m sure that made sense to Hilsenrath’s Fed source but it is hard to clarify and obscure at the same time.

Charles Plosser, President of the Philly Fed, was quoted in the article as saying the Fed’s recent change to its statement was meant “to remind everybody” that the Fed “has a dial that can move either way” which sounds a lot like a warning to the stock market bulls. What I find most interesting about Plosser’s statement though is that he seems to believe, as Bernanke and a lot of others do, that economic growth is merely a matter of rotating the dial of monetary policy like a thermostat. If economic growth and over indebtedness could be cured by purely monetary means, France would still be celebrating the genius of John Law.

On a day when we celebrate Motherhood, I find myself longing for a Fed that would act more like a good mother. Good mothers know that a little adversity is a good teacher and that giving the kids everything they want is a recipe for disaster. Good mothers provide a firm hand but know that the best discipline is that provided by life itself. Failure is something to be learned from and parental intervention is a double edged sword. Good mothers provide support but also force their progeny to stand on their own. Bernanke seems more like the kind of mother you see in the grocery store sometimes who buys the sugary cereal just so her brat will stop throwing a fit in aisle 3. Based on the Bernanke speech and Hilsenrath’s article I am tempted to say the end of QE is nigh, but if the market throws a fit when Uncle Ben takes away the Sugar Smacks, will he act like a good mother and walk out of the store? Or will he act like the bad mother and offer up a box of Cocoa Puffs as consolation?

In the quote at the top, Bernanke notes that asset prices that are far from historically normal levels are susceptible to destabilizing moves. Are markets currently priced far from historical norms? Wall Street bulls say no but their case rests mostly on the ability of analysts and economists to predict the future, a dubious prospect at best. Economists expect a brief slowdown in the current quarter and an acceleration in the second half of the year. Analysts expect earnings to resume double digit growth in the second half. These soothsayers are telling us to ignore all the current clouds because the sun will shine later this year. What exactly they base this optimism on is a mystery but it could be true and if so, my current insistence on carrying an umbrella will look foolish. If I’m right and asset prices are as high as they appear, we may need hip waders. Or maybe we’ll just need a spoon to enjoy another bowl of sugary cereal served up by the bad mothers running the Federal Reserve.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.