Global Macro Commentary

Fronkensteen Re-visited
Wednesday, January 07, 2015

Guy Haselmann
(212) 225-6686
Director, Capital Markets Strategy
John Zawada
Director, US Rate Sales

Fronkensteen Re-visited
The brilliant Mel Brooks 1974 parody Young Frankenstein ranks No. 28 on Total Film magazines list of
all-time funniest movies. When QE-infinity was first announced, I drew analogous similarities between the
monstrous experiments of Dr. Frankenstein (Dr. F) and the Fed (See note: Sep 23 2013).
In the movie, it was only after the monster went berserk that Dr. F (Gene Wilder) learned that Igor had
snatched the Abby Normal brain. Clearly, even the most well-intentioned experiments can have
unintended consequences. In this vein, the Fed created a financial market monster via six years of pedal to
the metal Fed stimulus designed to encourage risk-taking and speculation, and like Dr. F, the Fed was
confident it had the tools to control it. Unfortunately, history will likely view QE- infinity as the AbbyNormal brain that sent its grand experiment awry. The full argument follows.
There are two important and distinct reasons why QE-infinity was materially different and more hazardous
to financial markets than QE1 and QE2: 1) it originated subsequent to earlier action that had already
changed investor behavior; and 2) its open-ended time frame hijacked the markets typical price discovery
mechanisms.
At first, misallocation of resources resulted when money became (basically) free after the Fed lowered its
interest rate to zero. Next, the markets normal functioning was altered, and price discovery distorted,
when the Fed decided to embark on QE1 and QE2. Finally, when QE-infinity was introduced, price
discovery was completely demolished. It even triggered talk of an equity market melt-up.
QE1 and QE2 changed investor behavior because the Fed was implicitly providing a market put by
suggesting that any dissatisfaction with the pace of the recovery would always be met with more action. In
general, investor behavior moved away from determining whether adequate compensation was being
received for risks, and towards fear of missing out on the upside of easy Fed-driven market profits. This was
particularly true for asset managers who were now even more incentivized to seek out-sized risks to ensure
they beat peers and benchmarks. They were convinced because the Fed appeared resolute in its
determination, and investors had been overwhelmingly programmed over the years not to fight the Fed.
QE-infinity turbo-charged the equity markets myopic focus on its upside potential. Basic finance teaches
that asset valuation entails discounting all future cash flows to todays present value. Yet, when the last QE
program was (initially) not given an end date, the market had to accept zero rates (ZIRP) as extending
infinitely into the future. In other words, the discounted rate used to value those cash flows was assumed to
be zero in perpetuity. Dividing a number by zero equals the empty-set; thus, triggering talk of an equity
market melt-up.
Furthermore, by forcing interest rates to such artificially low levels, the Fed flipped the foundations of the
Capital Asset Pricing Model upside-down. Equities became the preferred asset class simply because they
provided uncapped upside, while bonds technically were capped at par. Asset managers even moved into
dividend paying stocks as a substituted for their fixed income exposures. This shift in perception had a
material impact on asset allocation models and increased systemic risk.
With QE terminated and expectations of a near-term rate hike looming, the Fed put is now much further
out-of-the-money. More importantly, the discounting function for future cash flows is moving away from
zero. In addition, as the Feds policy pivot is tightening the spigot of easy money, share buyback programs
that have enhanced the illusion of the power of the equity market will wane.
Going forward, prices will have to be supported by fundamental values rather than easy money and
speculation. The upside vs. downside distribution now looks skewed to the left-tail. The Junk bond
market started declining last June. A move that was not solely due to the decline in oil, since WTI did not
fall below $90 until October. The divergence with the equity market is large and worrisome.
The bottom line is that I expect a large equity price adjustment (down) to occur imminently. Portfolios
need to adjust from blindly accepting the Feds sugar high toward realistically assessing valuations based
on fundamentals. After six years of fuel, there is quite a bit of speculation to work off. Risk-assets will not
like a hike in rates, while a pause would probably be attributable to bad news that is not good for risk assets.
During the (volatile) adjustment process, the Fed will likely vacillate between over-confidence and fear.
Investors should not be fooled, but rather, should stay focused solely on re-calibrating exposures based on
the new market risk vs. reward distribution under a paradigm of declining accommodation. With
compromised market liquidity, first movers will have the advantage, especially since market liquidity is
dreadful. Risk paring is currently unfolding. Capital will flow to Treasuries. I remain a bond bull.
Maybe you had too much too fast, or just over played your part. Nothin shakin on shakedown street.
Grateful Dead

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