BIS V The Federal Reserve – who will prevail?

So, after another brief dip last week down to 1955 on the S&P – a shocking (irony!) 2% drop, it seems that it’s back to business – buy the dip, new highs imminent, bad news is good, good news is even moar good and stocks are the best thing since sliced bread…

Indeed, last week the FED seemed once more to save the day with the release of its minutes from the June FOMC meeting. These minutes reinforced the view that the central bank is in no rush to raise interest rates. Although that was widely expected by investors, it helped to reassure the bulls that equity valuations can be justified at the elevated plane for quite some time more. Reason being that the discount rate at which future cash flows are discounted remains low and so a higher current value results.

For now, the minutes were enough to assuage investors’ fears once more and so keep them distracted from reality and enable the rally to continue, putting pressure on bears like us to hold our line.

But, while the FED pretends everything is going to be fine and dandy, the BIS (Bank of International Settlements) is of a rather different opinion. Some refer to the BIS as the central bank of central banks. Indeed, the BIS has come out on the tape and stated that they now believe it is time to revert the accommodative monetary policy that has dominated the financial landscape for the last 6 years. They were in fact pretty clear in their language in that they see even bigger risks if the return to a more “normalised” monetary policy framework is delayed for much longer. Perhaps less charitably, the BIS seem to be saying that in avoiding a generational Bust”, the globe’s major central banks have created a new bubble bigger than the last one and it is now time to pop it.

Uber Dove – Ms Yellen

So, we have the “hawk” BIS contrasting with the “dove” FED. Janet Yellen publicly opposes any quick reversion in policy and prefers to continue to massage investors first rather than risk an uncontrolled crash. The BIS meanwhile is ignoring what happened when Yellen’s predecessor “Helicopter” Ben Bernanke attempted last year to revert the monetary direction and which of course triggered a modest downdraft in the markets. The BIS do believe that it is better to have a “manageable” crash now rather than a bigger one in the future.

While it is remarkable to see the “central bank of central banks” admitting that things have gone too far and created a new bubble, it remains to be seen just what Janet Yellen and Shinzo Abe will orchestrate for the future. After printing so much money with relatively mild “real” economic results, they will no doubt be reticent to turn back now. At the same time, I am not sure on how much further margin for error Yellen does have. If I recall, the US government still has a huge debt pile, a situation that has benefitted more than most from near zero interest rates. If rates start increasing, from where will they get the dollars to service the debt? Of course! They could purchase every single new bond issue or by cutting interest rates to near zero, again. The Neverending story returns!

In the end, what seems to me as the most likely course of events is that rates will remain low. Before allowing interest rates to rise back to a more “normalised” level, the Federal government will have to cut into its enormous debt burden, something which is very unlikely, unless of course the dollar is really replaced by any other international currency, at that point they will have a proper motivation to get their house in order.

Filipe R Costa