By Brendan Brown*
According to the mainstream narratives, a state of inflation alert was the catalyst to the US stock market mini-crash of February 2 and February 5, 2018. This explanation echoes the run-up to the October 1987 stock market crash. On other occasions in history, inflation alerts have not had such an immediate effect, with the pull-back of asset price inflation (which typically leads reported goods and services inflation) waiting for a substantial tightening of monetary policy.
Now everyone and his dog realizes that an inflation “break-out” (from inertia under the 2 per cent standard) would mean a bigger take for Uncle Sam and an eventual crash and recession. Some investors who have been riding the “hunt for yield” train decide it is time to get off, but on approaching the exit they encounter a stampede of like-minded people. Asset prices have gapped down or, worse, the market has seized up. Aggravating the stampede is the arrival of fellow-investors who have suddenly discovered the state-of-the-art products and services they — during the hunt for yield — have blown up.
Many decide to postpone their exit hoping for a quieter time in the future. The history of the stampede and the realization that many of its one-time participants still “want out” weigh on markets and the economy going forward.
In autumn 1987, the trigger to the inflation alert had been the new Fed Chief (Alan Greenspan) hinting that he would no longer steer monetary policy towards bolstering the dollar in line with the Louvre Accord of early that year. Paul Volcker (the previous Fed Chief) had had late remorse for having pursued a policy of monetary inflation since the Plaza Accord of summer 1985 (where he had signed up for Treasury Secretary Baker’s dollar devaluation policy). In the first half of 1987, Volcker had been tightening policy, annoying the Treasury Secretary and thereby failing to gain a nomination for a further term. The Bundesbank quickly indicated that Germany (unlike Japan at the time) would not follow the US on this further journey into monetary inflation. The US-German policy divergence (underlined by Secretary Baker criticizing a Bundesbank rate hike) and the related dollar setback, triggered a US inflation alarm in the stock markets.
The late Jude Wanniski, a well-known contemporary economist close to anti-Baker conservatives, saw this alarm as the crucial catalyst to Black Monday (October 19). Adding to the drama of the market quake was the failure of a newly popular strategy of portfolio insurance during the post-Plaza asset price inflation; many investors had become convinced that they could carry larger equity risk positions than in the past due to the hedging potential of the new equity future markets; but when prices suddenly gapped down they found this tool of “hedging on demand” froze.
Today Germany is out of the picture in terms of sounding an inflation alert. The new “grand” coalition deal concluded this week in Berlin seals German abdication as hard money sovereign in Europe, a role in practice abandoned in stages since the launch of European Monetary Union. At every point where Germany could have called a halt to the softening of the European monetary regime Chancellor Merkel has fallen back on the default position “there is no way back.”
Pundits suggest the Merkel coalition deal will culminate in an electoral disaster for her CDU/CSU alliance and its SPD partner, meaning an overall majority next time for the anti-euro and euro-sceptic parties (AfD, FDP, and Left). Perhaps that would make possible a German hard money restoration, especially if in a post-Merkel era the CDU/CSU move to the right, but that is too uncertain and too far ahead to become a matter of present market speculation.
Despite German abdication, the inflation alert this time did nonetheless come in part from a weakening of the dollar, which responded to the Davos chatter of Treasury Secretary Mnuchin (expressing fondness for a cheap greenback). But it was due more fundamentally to a US federal budget deficit in a late boom phase of the cycle projected now at as much as 6% of GDP next year. Another factor is the appointment of a Yellen loyalist who gets on well with the Treasury Secretary (and presumably President Trump) as Fed Chief, with only four Republican senators voting against. Actual wage and price data was a factor as well. The approach of 10-year Treasury bond yields to 3% helped to precipitate the alert.
Asset managers following the popular risk parity portfolio strategies using innovatory financial products based on trading so-called “market volatility” (the VIX) found themselves blindsided when the alert caused equity prices to gap down. Underlying the strategies had been the notion that asset managers could combine high leverage with assets of perceived low volatility to manufacture synthetic portfolios of a stipulated overall higher volatility and returns to match; they could also take advantage of an alleged overpricing of volatility in the markets to create arbitrage profit (taking short positions in volatility against long positions in risk). As the price for volatility and actual volatility gapped up at the start of this month, these strategies blew up.
Central bank officials, whether from the Fed, ECB, or Bundesbank have been quick to say that there is no macro-economic significance or even serious financial consequence from the blow up and the related mini-crash. But how could it be that a jump in perceived asset risks (volatility) across the board and related jump in the price of put and call options can be so inconsequential?
In Finance 101 we learn that the price of credit, especially high-risk credit, is tied by formula to the price of options on the underlying equity, and volatility is a key input to pricing (according to Black-Scholes). The spread on corporate bond yields (above Treasuries), for example, should now rise meaningfully, especially for high-risk categories. That is a potential big drag on overall risk markets and economic activity. Alongside we may well find a greater reticence of many households and businesses to spend now that the recent market tremor has heightened anxiety about the end game all know is coming for the monetary inflation created by our central bankers.
No doubt the Fed, ECB and BoJ would exercise their “Greenspan puts” in response to an economic slowdown and continued market pullback this year by delaying still further policy normalization. That put was successful in 1987/8 in producing an eighteen-month respite before the final stage of asset price inflation set in (featuring then global real estate market downturn and eventually recession) while goods-inflation meanwhile did indeed spike upwards. This time a hypothetical Powell put may not even have that success given that so much of the speculative narrative that has accompanied asset market temperature rises to the sky in this cycle is already so aged and problematic sustained by market momentum which has faded away and even gone into reverse.
About the author:
*Brendan Brown is the Head of Economic Research at Mitsubishi UFJ Securities International.
This article was published by the MISES Institute