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THIS MATERIAL HAS BEEN PREPARED BY A MEMBER OF SCOTIABANKS US RATES TEAM AND DOES NOT

CONSTITUTE INVESTMENT RESEARCH



THIS PAPER CONTAINS THE PERSONAL OPINIONS OF GUY HASELMANN
AND NOT NECESSARILY THE VIEWS OF SCOTIABANK


Undermining the Integrity of Financial Markets
Introduction
Financial markets are broken. Fundamental analysis and Modern Portfolio Theory are
relics of the past. Investors used to care about maximizing a portfolios expected
return for a given amount of targeted risk. The goal used to be that prudent
diversification through the analysis of security correlations could move the Efficient
Frontier Line up and to the left. In other words, improve returns per unit of risk.
Today, Fed policies have commandeered investor thinking and altered investor
behavior. The powerful driver of moral hazard has fueled greed, and imbued more fear
of underperforming peers and benchmarks, than fear of downside risks. Some
investors are buying the riskiest assets simply because prices have been rising. Some
investors say they are buying equities instead of Treasuries because equities have
upside, while bonds yields are puny and their prices are capped at par.
Fed policies have led to (investor) herd behavior that has plunged market volatilities
and manipulated asset prices and correlations to lofty levels. The rallying cry has
simply become dont fight the Fed. Relative return - without regard for risk - is all that
matters. As a result, future return expectations have fallen with ever-rising prices;
correspondingly, risk levels have risen in parallel. The allure of the Feds magic spell
has lapsed investors into a soporific state of cognitive dissonance, with them focusing
more on trying to justify valuations, rather than on the Upside Downside Capture Ratio.
Markets have thus mutated into one of two possible combustible states. Either
financial assets have all transcended into prodigious bubbles, or stocks and bonds are
signifying two completely separate outcomes. Either possibility will have dangerous
repercussions for the economy, and for portfolios and investors. At the moment, I
believe that the Treasury market has it right, signifying concerns about disinflation and
future growth.
Using Financial Asset Prices as a Policy Tool
Uber-accommodation and aggressive promises by the Fed have been successful at
chasing money into equities and the lowest part of the capital structure - as was its
intent - but the stellar performance of equities have been divorced from the underlying
economy for the last few years. (Note: better earnings from improved margins are
unsustainable without revenue growth.)
Fed policies have also laid the foundation for debt issuance to fund private sector
share buybacks and mergers, creating the self-reinforcing illusion that all is well.
Super-subsidizing the cost of debt destabilizes the basic tenets of investment. By
Capital Market Comment
Undermining the Integrity of Financial Markets
Guy Haselmann
(212) 225-6686
Director, Capital Market Strategy

THURSDAY, AUGUST 28, 2014
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creating an environment, whereby investor decisions are enticed into the junkiest
credits and equities (the junkier the better), and whereby financial market manipulation
is being used as a policy tool, the Fed is undermining the integrity and foundation of
financial markets.
Investors have also been led to believe, that should pressures build on those risky
securities, more subsidies will be offered. This dangerous feedback loop is
unsustainable. At some point - probably in the very near future - investors will lose
faith in the central banks ability to support the economy through higher financial asset
prices.
It is far too early for history to judge the success (or lack thereof) of QE policy. The
smug references of claiming victory by some FOMC members likely derives not from
comprehensive faith in their success, but rather from attempts at maintaining
confidence in the institution. After all, Fed policies are experimental, have had
questionable success, and the unintended consequences of the actions have yet to be
felt.
On balance, markets have too much faith in the FOMC, which is over-promising on
what can reasonably be delivered with such limited powers. Bigger than the bubble in
financial asset prices is probably the bubble in Fed-confidence.
Big Objectives, Limited Tools
As far as economic management is concerned, the Fed really only has one basic
instrument: managing liquidity through managing the supply of money. How does it
make sense that the Fed can achieve its dual mandate objectives of price stability and
full employment with this one blunt tool? When all you have is a hammer, than
everything looks like a nail. With this one tool in mind, it seems silly to think that
heated debates arise after each new piece of economic data, on how much to tweak
money supply. A $17 trillion economy cannot be micro-managed.
Debate even shifts between the focus on the price mandate and the employment
mandate and whether there is a trade-off between them. It does not require much
thought to realize that the dual mandates of the Fed are bewildering and illusory and
in need of a face-lift.
Even more problematic is the prospect that FOMC analysis could be faulty. In 2012, I
wrote that the Fed should not confuse good deflation with bad deflation in that good
deflation is a drop in prices caused by technology-enhanced declines in the costs of
production. Trying to fight such imagined deflation would lead to asset bubbles and
problems elsewhere. Bad deflation is when the consumers stop spending because
they believe prices will be lower in the future. Globalization and technological
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advancements result in the good type of deflation. Zero interest rate policy expedites
the process, rather than reversing or easing price pressures.
Dubious Economic Ideology
The group-think FOMC has perpetuated this state of being, because Fed leadership
believes in the same outdated economic theories popularized over a half-century ago.
Bernanke and Yellen, among others, were influenced by a few Noble Laureates during
their studies in the 1970s; those such as, J ames Tobin, Paul Samuelson, and Bob
Solow. Samuelson was credited with creating Neoclassical Synthesis, which all
policymakers use as their basic approach (they also use faulty neoclassical full-
employment optimization models).
The Samuelson synthesis basically says that with skillful monetary and fiscal policy,
the economy can be kept close to full employment and will behave as the models of
long-run growth suggest it will. However, every now and then (like the present), the
emphasis will have to be on the short run. Few would argue that the Fed has taken
this path, and in doing so, has created a time-inconsistency problem whereby it is
trying to bring demand forward at the expense of the future.
In past speeches, Yellen has blamed the Feds extraordinary measures on the
underutilization of labor resources (slack). It was interesting, however, that when
Yellen presented at J ackson Hole in front of the foremost academic experts on labor
markets, she did not reveal any biases regarding the amount of labor slack. Had she
regurgitate any of her earlier assumptions (that were used to justify current policy), she
would have likely opened herself up to criticism; especially given the complex
relationship between employment, wages, inflation, and growth.
By showing more ambivalence and lacking the confidence to share those assumptions
with this group of academic experts, she exposed the dubious and experimental
nature of FOMC policies. It can therefore be argued that the FOMC is basing the
greatest experiment in Fed history on low-confidence assumptions about labor market
slack and Phillips Curve trade-offs.
Solow, Samuelson and Tobin explicitly acknowledged the non-static nature of the
Phillips Curve due to shifts in expectations and to hysteresis. Yellen seemingly ignored
this aspect of their work, because it did not jive with the Feds policy actions.
(For review and emphasis) Hysteresis, according to Investopedia, is: the delayed
effects of unemployment. As unemployment increases, more people adjust to a lower
standard of living. As they become accustomed to the lower standard of living, people
may not be as determined to achieve the previously desired higher living standard. In
addition, as more people become unemployed, it becomes more socially acceptable to
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be or remain unemployed. After the labor market returns to normal, some unemployed
people may be disinterested in returning to the work force.
Counter-productive Policy
The Fed cannot do anything about hysteresis and has had little, if any, help from the
fiscal tools that could help. Using monetary tools where a fiscal solution is required
has consequences, and further enables fiscal stalemate. Furthermore, it could be
argued that holding interest rates at zero for a prolonged period of time is actually
counter-productive.
As mentioned earlier, corporations have been incentivized to issue cheap debt, but
those who are not buying back shares or increasing dividends are using the proceeds
to modernize plant and equipment. Improved productivity has resulted, but those gains
have not spilled into wage improvement; hence, feeding the Feds argument of slack.
As a matter of fact, gains in productivity through modernization have exposed
production redundancies, allowing firms to lay-off workers and cut prices. Certainly
capitalist societies always strive for advancement in this manner, but Fed policy has
turbo-charged the process. Without new and modernized job training, old jobs become
outdated, unemployment swells, and hysteresis results.
Conclusion
The FOMC has backed itself into a predicament where there is no easy escape. Its
policies might be counter-productive for the economy and harmful to financial markets,
which will likely to lead to tarnished credibility in the near future.
If the economy muddles along or stalls, the effectiveness of QE will be questioned. In
the unlikely possibility that the economy grows satisfactorily, the Fed will be accused of
being behind the curve.
Investors betting on Fed promises, and its hopes of navigating economic lift-off, will
likely have a difficult path going forward. Investors smart enough to have believed in
the implicit information embedded in (unloved) long dated Treasuries (+25% YTD)
should continue to reap the best reward per unit of risk.
Since February, I have predicted that 30-year Treasury yields would drop below 3%
before the end of year. The yield reached 3.05% today; earlier than anticipated. I
expect 30-year yields to outperform for a while longer, and continue the march to lower
yields. Those expecting much higher (back end) yields will likely be waiting quite a
long time; possibly even a year or more. Waiting for inflation in recent years has been
like waiting for Godot (he never shows up).
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Investors are advised to distinguish between interest rate risk and credit risk.
Unwinding of Fed policies is likely to trigger an expansion of the collapsed capital
structure. Better credits should outperform and liquid assets will command higher
premiums.
Fed policy normalization could have the opposite market impact that uber-
accommodation had; i.e., a meaningful negative impact on the prices of the riskiest
assets. Market volatilities will likely rise from suppressed levels.
Portfolio managers should ask themselves today if they are being adequately being
compensated for the risks of trying to capture the upside from current prices.
Historically, participating in downside corrections has typically meant a 7 to 10 year
period before portfolios are able to return to prior high water marks. In the meantime,
during this period of capital preservation, parking funds into long-dated Treasuries,
offers optionality, liquidity, upside potential, and opportunistic flexibility.



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