“Imperial Finance: A History of Empires”
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Two high quality courses that feature 15 hours of world class lectures from teachers like Jim Chanos, Marc Andreessen, Niall Ferguson and many more.
Bubbles, Manias & Fraud
Imperial Finance: A History of Empires
This week we learned that the money printer will still go “brrr”, but will be “brrr-ing” a little bit slower.
Of course, I am referring to the news out of Washington that rattled markets on Wednesday… Specifically, the Federal Reserve announced that it would “double the pace at which it’s scaling back purchases of Treasuries and mortgage-backed securities to $30 billion a month, putting it on track to conclude the program in early 2022, rather than mid-year as initially planned (Bloomberg).”
Oh, and in addition, the central bank is now projecting three rate hikes in 2022. (For those needing a quick refresher on what “tapering” is, and why it’s important, watch this great WSJ video below)
As you can imagine, the market reacted swiftly. There is truth in the maxim that “the market hates uncertainty”, which was evidenced by the fact that all major US indices rallied on Wednesday following Powell’s announcement (Nasdaq +2.15%, S&P 500 +1.63%, Russell 2000 +1.08%). Despite the Fed’s significant shift in policy and hawkish pivot on rate hikes, at least investors knew how hawkish it would be and could adjust accordingly.
What’s interesting, however, is how rapidly this sentiment changed. Investor’s confidence fell from “Three rate hikes? We got this.” to “Three rate hikes? Uh oh.” After notching gains on Wednesday’s announcement, the following day major indices all finished lower (Nasdaq -2.47%, S&P 500 -0.87%, Russell 2000 -1.95%).
The events of this week reminded me of a Spectator article from 1896 (nerd alert) that discussed “panic in the city” after investors that were accustomed to “cheap money” experienced a minor rate hike. The author alarmingly considers how investors may react to a real crisis if there was such consternation over a simple 50 bps rate hike that was widely anticipated. Yet, the article points out how quickly investors grow used to the low “artificial” rates and forget the “lifetime” of higher rates they’d experienced prior. Thus, “an upward movement in the bank-rate came upon them like a thunderbolt”.
While the small highlighted text below may seem daunting, I promise you this excerpt is worth taking the time to read through:
While there are many great quotes one can take from this article, I find the last lines most damning:
“The effects on markets of a trifling rise in the bank-rate were severe enough to make one tremble at the thought of what might happen if the Stock Exchange, in the inflated and flabby condition caused by a diet of cheap money, were called upon to face a really dangerous crisis. There are plenty of materials about for a genuine explosion, and it is evident that our credit system owes hearty thanks to the Bank of England for clearing away a great deal of very awkward top-hamper in preparation for any real gales that may be brewing.”
This market diagnosis from 1896 is quite fitting for investor’s reaction this week as the initial confidence on Wednesday gave way to caution and anxieties on Thursday. After the market bottomed in March of 2020 and the Fed started firing up the money printer, many investors have quickly grown used to this COVID-19 investing paradigm where markets feel more swayed by memes and narratives than earnings and balance sheets. The announcement from Jay Powell served as a message like the one from 1896 described above: “an effective warning that they could not count on the reality of their dream of perpetual cheap money.” In other words, this won’t last forever.
Now, let’s dive into some historical context on how markets perform under different monetary regimes, and periods of inflation!
Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms
Why This is Relevant:
Following Chairman Powell’s comments on Wednesday there is perhaps no better time to look back at the historical relationship between monetary policy and asset prices.
“This paper examines the economic environments in which past U.S. stock market booms occurred as a first step toward understanding how asset price booms come about and whether monetary policy should be used to defuse booms. We identify several episodes of sustained rapid rise in equity prices in the 19th and 20th Centuries, and then assess the growth of real output, productivity, the price level, money and credit stocks during each episode. Two booms stand out in terms of their length and rate of increase in market prices n the booms of 1923-29 and 1994-2000. In general, we find that booms occurred in periods of rapid real growth and productivity advance, suggesting that booms are driven at least partly by fundamentals. We find no consistent relationship between inflation and stock market booms, though booms have typically occurred when money and credit growth were above average.”
“Across some two hundred years, we find that two U.S. stock market booms stand out in terms of their length and rate of increase in market prices – the booms of 1923-29 and 1994-2000. In general, we find that booms occurred in periods of rapid real growth and productivity advance. We find, however, no consistent relationship between inflation and stock market booms, though booms have typically occurred when money and credit growth were above average. Finally, contrary to conventional wisdom, we find that wars have not always been good for the market.”
The Great Inflation, Factors, and Stock Returns
Why This is Relevant:
In addition to monetary policy, inflation is still increasingly top of mind for all investors as even Jay Powell admitted the word “transitory” is no longer useful in thinking about inflation moving forward.
“Inflation is an amorphous concept that generally refers to the sustained increase in the general level of prices. Inflation has been much maligned due to the deleterious impact of the ‘Great Inflation’ era of the 1960’s and 1970’s. That period conjures images of long gas lines, commodity shortages, paltry real investment returns, and price spikes.
Since then, however, we have lived through the ‘Great Moderation’—four decades of low and decreasing inflation. Memories of the inflationary periods of the past, however, remain so visceral that signs of rising prices have recently plagued investor sentiment. Our analysis suggests that while investors are right to pay attention to inflation, comparisons with the 1970s may be overblown. Equities, as a whole, may not welcome high rates of inflation, but certain stock selection factors have shown more resilience than others in periods of rising prices.“
“We review excess returns in a U.S. Large Stocks universe for the cheapest, highest-yielding, and highest-ranked deciles of our Value, Shareholder Yield, and Momentum themes from 1926 to 2021, respectively.4 Note that Shareholder Yield consistently outperforms across all regimes, particularly in higher inflation environments. The disparity between factors in the lowest inflation regime is similarly interesting. The -3.9% average inflation rate captures deflationary environments. While Shareholder Yield and Momentum hold up quite well, Value struggles. This is likely due to the observations in that regime from the 1920s and 1930s, when cheap Utility stocks performed particularly poorly and value’s recent struggles since the GFC.
Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises (1870–2008)
Why This is Relevant:
With low rates and the Fed printer going brrr, markets are awash with “cheap money”. This paper looks at the history of what’s happened when the music stopped playing.
“The crisis of 2008–09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 14 developed countries over the years 1870–2008, utilizing the data to study rare events associated with financial crisis episodes. We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks’ balance sheets. We show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large. Importantly, we demonstrate that credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong” and that policymakers ignore credit at their peril. It is only with the long-run comparative data assembled for this paper that these patterns can be seen clearly.”
“We have shown how the stable relationship between money and credit broke down after the Great Depression and World War 2, as a new secular trend took hold that carried on until today’s crisis. We conjecture that these changes conditioned, and were conditioned by, the broader environment of macroeconomic and financial policies: after the 1930s the ascent of fiat money plus Lenders of Last Resort—and a slow shift back toward financial laissez faire—encouraged the expansion of credit to occur. The policy backstop also, to some degree, insulated the real economy from a scaling up of the damaging effects that prior crises had wrought in days when the financial system played a less pivotal role.”
The Quest for Financial Stability and the Monetary Policy Regime
Why This is Relevant:
While the market rarely appreciates changes in monetary policy that involve rate hikes, this paper looks at the long history of central banks and monetary policy authorities’ attempts to stabilize financial markets.
“This paper surveys the co-evolution of monetary policy and financial stability for a number of countries across four exchange rate regimes from 1880 to the present. I present historical evidence on the incidence, costs and determinants of financial crises, combined with narratives on some famous financial crises. I then focus on some empirical historical evidence on the relationship between credit booms, asset price booms and serious financial crises. My exploration suggests that financial crises have many causes, including credit driven asset price booms, which have become more prevalent in recent decades, but that in general financial crises are very heterogeneous and hard to categorize. Two key historical examples stand out in the record of serious financial crises which were linked to credit driven asset price booms and busts: the 1920s and 30s and the Global Financial Crisis of 2007-2008. The question that arises is whether these two ‘perfect storms’ should be grounds for permanent changes in the monetary and financial environment.”
“The current obsession with financial stability risks recreating some of the policies of the 1930s, 40s ,50s and 60s. In addition to financial repression, the adoption of many of the tools of macro prudential regulation that have been proposed may recreate many of the problems with the use of the tools in the past. Many of these macro prudential policies were actually credit or fiscal policies which greatly involved the monetary authorities in inefficiently picking winners and losers and influencing the allocation of resources. They also impinged on central bank independence because these policies strayed from their mandates and opened them up to scrutiny and criticism by the legislature. The pursuit of such an enhanced financial stability strategy may head off a few minor crises in the next few decades but much later precipitate an even bigger crisis than we saw a decade ago.”
Central Bank Liquidity & The Spanish Flu
Why This is Relevant:
A look back at how central bank liquidity impacted markets during the last global pandemic in 1918.
“The coronavirus outbreak raises the question of how central bank liquidity support affects financial stability and promotes economic recovery. Using newly assembled data on cross-county flu mortality rates and state-charter bank balance sheets in New York State, we investigate the effects of the 1918 influenza pandemic on the banking system and the role of the Federal Reserve during the pandemic. We find that banks located in more severely affected areas experienced deposit withdrawals. Banks that were members of the Federal Reserve System were able to access central bank liquidity, enabling them to continue or even expand lending. Banks that were not System members, however, did not borrow on the interbank market, but rather curtailed lending, suggesting that there was little-to-no pass-through of central bank liquidity. Further, in the counties most affected by the 1918 pandemic, even banks with direct access to the discount window did not borrow enough to offset large deposit withdrawals and so liquidated assets, suggesting limits to the effectiveness of liquidity provision by the Federal Reserve. Finally, we show that the pandemic caused only a short-term disruption in the financial sector.”
“We find that the banking system experienced deposit withdrawals during pandemic. While member banks were able to meet these deposit withdrawals by accessing the discount window and increase lending, nonmember banks had to reduce borrowing and decrease lending. However, member banks in the most affected areas could not borrow enough to fully offset their deposit outflows and so reduced their lending and liquidated certain assets. Given that member banks responded to deposit outflows aggressively by selling off their securities and reduction of cash, we interpret the result that member banks could not borrow enough to offset deposit outflows as due to a shortage of collateral that they could pledge to the discount window.”
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