22.12.2017

The Fed risks a grave policy error

by Lantern Fund Forum 2017

We would like to share this article published last month on Finanz und Wirshaft: a very interesting interview with John Mauldin (by Philippe Béguelin) about our next future, a shocking vision on US politics, the forthcoming employment situation, the new expected business and financial models.

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John Mauldin, financial writer, is optimistic about the future, despite the danger of a recession, too much debt and a frustrated society.

The world will be a place of abundance, predicts John Mauldin. Before that, obstacles must be overcome. Mauldin warns that after the unconventional monetary policy has increased asset prices, the Federal Reserve now risks to trigger a crisis. Eventually, governments will have to monetize their debt, which means to clear it with freshly printed money. Mauldin gave a presentation at the seventh edition of the Lantern Fund Forum in Lugano, Switzerland.

Mr. Mauldin, will the Fed succeed with tightening monetary policy without derailing financial markets?
The Federal Reserve is in the process of making a big mistake. They should have raised interest rates four years ago. Now they are raising rates, but they are trying to reduce their balance sheet at the same time. The Fed is risking a grave policy error.

Fed Chair Janet Yellen is proceeding very carefully.
The central banks bought many assets – the Fed, the ECB and the Bank of Japan, and on top of this China by increasing bank debt. It would be ludicrous to argue that this quantitative easing didn’t drive up asset prices. In fact, the former Fed-President Ben Bernanke patted himself on the shoulder and said: «Look how successful our QE has been. We’ve raised home prices, we’ve raised stock prices.» And now they pretend that the reverse isn’t going to have an effect. Really? Can you please explain that economic model to me one more time?

Why then does Janet Yellen claim that the balance sheet reduction is as boring as watching paint dry?
That’s wishful thinking. It’s very dangerous to assume that this is not going to have an effect on the markets. If there was a serious bear market in the US, it would take everything down and cause a global recession. It would be one of the great ironies if the Fed caused such a downturn. They take a big risk and need to be extremely careful.

Shouldn’t the large balance sheet be reduced?
In the Great Depression in the 1930s, the Federal Reserve finally increased the balance sheet, which helped the economy. And you know what they did afterwards? Nothing. They just let it stay there. Eventually, the economy grew so much that the balance sheet became relatively small. Therefore I say: Just don’t do anything, just leave it there. In 20 years, the US economy will be twice as big as it is today in nominal terms, and the Fed’s balance sheet in terms of GDP will be half as big as now. That’s ok, nobody will care. So why the rush? Where’s the fire? I just don’t see it.

How can the Fed react when the next recession occurs?
In a recession, the Fed will lower interest rates. But they won’t have much room to maneuver, because for now, the most they can do is three more rate increases. They would also do more QE. The irony is that we could see a Fed under Donald Trump actually introducing negative interest rates. Trump might appoint Marvin Goodfriend as a Fed Governor, and he was the one that two years ago went to the annual central bank symposium in Jackson Hole arguing for negative rates. They may be willing to introduce negative rates for the world’s reserve currency.

The Swiss National Bank also has a large balance sheet. What are its prospects?
Their balance sheet is 800 billion dollars already. At what point do they stop? Norway owns almost one trillion dollars’ worth of assets, financed by oil revenue. The Swiss National Bank by contrast prints money. The SNB (SNBN 3910 -0.99%) is the world’s largest hedge fund – except that they can’t sell their bonds and shares. The minute they start selling, the markets would tumble. What on God’s green earth is the Swiss National Bank doing owning 3% of Apple (AAPL 175.01 0.38%)?

Should the SNB abstain from intervening to weaken the Swiss Franc?
I understand why they do it and in a really odd sense, I don’t know what else they should do. The currency is so strong that the SNB can’t sell their increasing assets. On the other hand, if they don’t intervene, then the Swiss Franc will be at 50 Cents to the Euro. People are willing to bring their money to Switzerland and pay 0,75% for the privilege. It’s a world turned upside down.

The SNB said repeatedly that they would consider to introduce capital controls.
You can’t have capital controls in a globalized world where everybody is trading.

What should central banks do?
What happens with central bankers is that if there is a crisis, they feel that they have to do something. We are in a strange new world. I don’t understand how the Bank of Japan can monetize debt to the extent they have and their currency hasn’t weakened more. This has never happened before. It’s really odd.

Is there a way out of this strange new world?
More and more, we are going to have to think the unthinkable. We really have to ask ourselves: What happens when we get ourselves backed into a corner? What are we willing to do?

You don’t seem to be very confident.
It may not sound like this, but I am very optimistic. The world will be a place of abundance. Food is getting more and more abundant and cheaper. We will soon be making sweet water from salty ocean water and distribute it everywhere. The cost of stuff is going down. Google (GOOGL 1070.85 -0.25%) and Facebook (FB 177.45 -0.25%)will cover the whole world with free wireless Wi-Fi communication, using high balloons and solar drones. The cost for this technology is a rounding error in their pocket change.

But what happens in the current world turned upside down?
We have to figure out how we get through a few bumps in the road like politics, government debt and pensions that can’t be paid. The first real severe bump will happen with a recession. Wherever it starts, it will go global really quickly. When the US go into recession, we will go from 20 trillion dollars  of debt to 30 trillion dollars overnight.

Is so much debt affordable?
We simply have too much debt in the world. The major countries will have to figure out how to monetize their debt together and in such a way that it doesn’t create a currency war. If we start currency wars, it gets a lot more that bumpy, it gets nasty. The great depression was brought about largely by two things. Number one: The US Federal Reserve acted stupidly. Number two: One country after another devalued against gold. If they had all devalued together, rather than trying to devalue their currency so that they would have an advantage against their competitors, the depression would have been over much quicker. We’re going to need a new Bretton Woods, an international monetary agreement. There is no way around it.

You mentioned politics being a bump in the road ahead.
People are becoming more and more frustrated. Donald Trump is not the end result, he’s the harbinger, the beginning of where we are going. In the US, we have an epidemic. For the first time in the history of America, we are seeing people dying earlier rather than living longer. And it is all 45 to 55 year old white men, who are taking drugs, alcohol and commit suicide, because they don’t have jobs, and they feel hopeless, and they give up. Interestingly, in Europe that is not the case.

How do you assess the political sentiment in Europe?
I have not seen any study as to why Europeans appear to be better dealing with the situation than Americans. But do you think the French are happy, with the way they are voting? And in Italy, you don’t support Beppe Grillo if you are happy, even if he is funny. We have a society that is increasingly frustrated.

What do you see as the main reasons for the frustration?
There will be self-driving cars, and the roads will be safer. But that’s also, in the US alone, the jobs of 6 million truck drivers and taxi cab drivers. There will be fewer car wrecks, so we will need fewer mechanics, and fewer people in the emergency rooms in hospitals, fewer insurance  salesmen, and on and on. Where will these people go to work? Being a truck driver does not exactly train you for a technology job.

Structural change has happened before.
Artificial intelligence is going to take one job after another. Also (ALSN 132.7 -0.67%), lots of new jobs will appear, because that’s what has always happened with technology. But today, it’s going to happen in the blink of an eye. We’re not prepared for the speed, the rapidity of change.

Politicians have a recipe: They want to curb immigration.
I’m in the republican team, I was in the executive committee of the Republican Party of Texas for twenty years. But I no longer understand what’s going on. I truly don’t get it. We have what supposedly passes for sane republicans, calling for reduced immigration. What are they thinking? There are only two ways you can grow the economy: you increase productivity, which has not been increasing. And you increase the number of workers. In the United States, immigration has been the way we have been increasing the number of workers. That has been allowing our economy to grow. If we reduce the number of workers, we are not going to grow as fast. That’s just the rules. It is legendary, in Silicon Valley, how many immigrants have created new businesses and new jobs.

What can be done about the frustration?
Eventually, we will need basic guaranteed employment. I hope we won’t have a basic guaranteed income. People need to be able to work, to have a purpose, to contribute to society. In the Great Depression, Franklin Roosevelt introduced a work program for roads, dams, parks. People went to work and got a salary. That worked out quite well, and it could be similar today.

What should investors do in this world to manage savings?
Investors should not diversify asset classes. It’s all one big pocket, one big pool of risk. Instead, you diversify trading strategies. I use quantifiable systems, algorithms, that tell you when to be in and out of the market. You also need hedging strategies.

Could you give a specific example?
There is an ETF for automation and robotics – which I don’t own – that has outperformed the S&P 500 (SP500 2684.57 0.2%) by six times, because that’s the area where the growth is. This ETF is also market beta on steroids: When the market goes down 40% it will go down 60%. Now, if you put a hedging strategy with that ETF, you need to take a little bit from the upside. Then you have an investment that doesn’t have the volatility but still the potential for growth. There’s almost nothing that you can’t figure out how to hedge, and that is what you’ve got to do. You’re trading, you’re not long biased. A long bias is going to be dangerous over the next years because of the bumps in the road as we go through the coming transition.

 

About John Mauldin
John Mauldin is one of the best known financial writers. His comments «Thoughts from the Frontline» and «Outside the Box» reach well over a million readers all over the world. John is a New York Times best-selling author. He wrote several books, among them «Code Red: How to Protect Your Savings from the Coming Crisis» with Jonathan Tepper, and «Endgame: The End of the Debt Supercycle». He is founder and chief of the research company Mauldin Economics. He has served on the executive committee of the Republican Party of Texas. John lives in Dallas and is the father of seven children, five of whom are adopted.






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