Authored by Eric Peters, CIO of One River Asset Management
Consequences: “The Taylor Rule with its neutral 2% r-star interest rate may have worked better than the global monetary policy we implemented over the last few decades,” said the CIO. “But it didn’t allow for financial rescues or policy choices – maybe stocks fell and the Fed wanted them to rally, or the ECB wanted to rescue the Eurozone, so they deviated from Taylor and slashed rates.” With each cycle, leverage increased and this lowered r-star either consciously or unconsciously. “We ended up with a system where monetary policy is now one-size-fits-none.”
“Policy is too tight for those who don’t get the full pass-through of lower rates; much of rural America, small businesses, emerging markets,” continued the same CIO. “But policy is too loose for urban housing and large cap growth companies.”
This creates a self-perpetuating dynamic.: “Investors see that the ability to normalize monetary policy declines as leverage rises, which suppresses interest rates, which lowers the cost of capital for growth companies, and this subsidizes their rising market share without requiring profits, which reduces inflation expectations, which reduces r-star and gives investors confidence to increase leverage.”
“So what’s an investor to do in this world?” asked the CIO. “Be a true believer or an extreme cynic?”
A believer expects r-star to decline in perpetuity and central banks to always have tools to rescue markets. Cynics acknowledge it’s unsustainable but jump aboard anyway, believing they can sell before markets fall.
“But if you’re in between and believe in a world of consequences, you can understand why the Nasdaq can continue higher in the current market/policy construct while not believing its sustainable in any real way,” he said, frustrated, waiting around for consequences, with no position.