That Was The Weak That Worked: Part I

2013 saw the passing of many beloved celebrities, but one who perhaps seemed to receive less attention than merited was Sir David Paradine Frost, who died of a heart attack, aged 74, whilst aboard the MS Queen Elizabeth, where he had been due to give a speech the following day.

Those aboard the ship were deprived of a chance to hear the words of a journalist and broadcaster without peer in the modern world, whilst the rest of us woke to find ourselves being reminded of the high points of his remarkable life, particularly his famous interviews with Richard Nixon, which were immortalized a few short years ago in the stage play and subsequent movieFrost/Nixon.

But Frost’s star was set on its upward trajectory via a completely different type of vehicle when, after graduating from Cambridge University in 1962, he was selected to present a new weekly satirical review devised, produced, and directed by Ned Sherrin and entitled That Was The Week That Was or, as it became colloquially known, TW3.

The writing staff of TW3 was a who’s who of British comedy (John Cleese, Peter Cook, Eric Sykes, and Ronnie Barker were all amongst the contributors) but also included literary greats such as Dennis Potter, Roald Dahl, and Sir John Betjemin; and some of its sketches became the stuff of British comedy folklore.

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Wikipedia describes TW3 thus:

(Wikipedia): The programme is considered a significant element of the satire boom in the United Kingdom in the early 1960s. It broke ground in comedy through lampooning the establishment and political figures.

You can probably figure out why I’m a fan. TW3 liked to point out the absurdities of the political system and take pot-shots at political figures. If only they’d had some kind of financial crisis in the 1960s, the symmetry would have been perfect … but no. Instead, after a tumultuous four years between 1957 and 1961, the US, though saddled with high unemployment and huge excess capacity, embarked upon a mid-decade boom, which — hard though it is to believe — was actually helped by constructive government policy in the form of the Kennedy-Johnson tax cuts.

Of course, there was the little matter of a war police action in Vietnam which led to a sudden 3.5% surge in the PPI in 1965, but let’s not let anybody get any ideas as to how combat might be used to create a little desired (but controllable) inflation, shall we?

Let’s change the subject.

Slightly.

The end of the year is inevitably a time when even the most hard-bitten amongst us wax nostalgic and reflective, looking back on the previous 12 months as though the arbitrary break in the calendar should have some meaningful effect on fortune or fate. Of course, it doesn’t, except for the fact that enough people tend to subscribe to that line of reasoning that it feels as though it actually matters.

Human beings change their behaviour around the end of one year and the beginning of the next because over time they’ve been conditioned to believe that changes are justified. The appropriation of that mindset by various groups over the course of the past twelve months has been, for me, perhaps the most noticeable evolution in 2013.

The title of this week’s Things That Make You Go Hmmm… says it all:

“That Was The Weak That Worked”

Throughout 2013, the distortions created by intervention in once-free markets have left many (myself included) scratching their heads. The interventions have worked — almost faultlessly — but for them to do so has required the suspension of one belief system (economic reality) and the adoption of another — namely, that everything will be OK because … well, just because.

Can the fantasy persist into 2014? Yes. It most certainly can.

Will it continue into 2014? Most likely.

Will this new belief system become the new economic reality? Not a chance.

So we’re going to end 2013 by taking a three-part look at “The Weak That Worked” to try to get a sense of what could take place in 2014 if it happens to be the year that economic reality finally reasserts itself.

This week in Part I, I will focus largely on equities, and next week we’ll take a look at the bond and housing markets before heading to Europe and beyond.

So let’s get cracking, shall we?

2013 was another year brought to you by the letters Q and E.

Quantitative easing spanned the entirety of 2013 and, as was no doubt intended, the market, the public at large, and most certainly just about every single inhabitant of Capitol Hill became so inured to the creation of $85 billion each and every month that the enormity of that policy dissolved from the collective consciousness like early morning mist.

But amidst all the commentary and the debate surrounding QE, most people lost sight of what it actually is — even when we received the much-anticipated news in December that there would, in fact, be a Taper after all.

Before we get to the Taper that happened, though, it’s important to revisit the one that didn’t.

On May 22nd, 2013, Ben Bernanke, in a question and answer session, said the following:

We’re trying to make an assessment of whether or not we have seen real and sustainable progress in the labor market outlook. If we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.

Boom!

The consequences of that statement — and in particular, the last 20 words — reverberated around the financial world and wrought havoc in all sorts of weird and wonderful places.

(In a presentation entitled “A Confederacy of Dunces” that I gave to a small group in Spain in late June, after Bernanke’s comments, I pointed out the effects of the Taper threat and pinpointed some of those weird and wonderful places.)

The effect Ben’s pronouncement on both the S&P 500 and the US 10-year yield were immediately obvious:

Source: Bloomberg

The S&P dropped a quick 6%, and 10-year rates (seen inverted in the chart above) spiked from below 2% to 2.6% — a big move.

But some of the other instruments affected by Bernanke’s carefully floated idea weren’t quite so readily apparent. Nonetheless, they demonstrated just how pernicious and far-reaching the tendrils of QE had grown.

Like all the way to Indonesian bond yields, for example:

Source: Bloomberg / Grant Williams, “A Confederacy of Dunces”

Or those here in Singapore:

Source: Bloomberg / Grant Williams, “A Confederacy of Dunces”

And even those who held Brazilian bonds saw something meaningful shaved off:

Source: Bloomberg / Grant Williams “A Confederacy of Dunces”

Bernanke also committed the cardinal error of announcing that QE would END once unemployment fell to 7% — a statement he had to back away from, rather embarrassingly, as the slump in the participation rate brought 7% unemployment closer, rather faster than expected:

(WSJ, Dec 6, 2013 ): Back in June, when Fed Chairman Ben Bernanke laid out a tentative timeline for winding down the bond-buying program, he said 7% is where the Fed expected the unemployment rate to be when it ended the purchases. He said central bank officials expected that to occur around mid-2014. Friday’s jobs report showed the jobless rate hit that level in November, and the Fed hasn’t even started scaling back the program.

The jobless rate for May, the latest data Mr. Bernanke had when he laid out that guidepost, stood at 7.6%. Then it fell much more quickly than Fed officials expected, dropping to 7.4% in July and 7.3% in August.

In September, the Fed surprised many market participants and held the quantitative-easing program steady. At his press conference after that meeting, Mr. Bernanke made no mention of the 7% guidepost he’d set out a mere three months earlier. When asked about it, he downplayed the importance.

“There is not any magic number that we are shooting for,” he said. “We’re looking for overall improvement in the labor market.”

In short, the trial balloon floated to gauge potential reaction to a $20 bn per month Taper was a disaster, and that meant that when the September FOMC meeting came around, the governors in the voting seats just couldn’t bring themselves to pull the trigger.

Oopsies!

When the minutes of the October meeting were released in November, it became clear that the FOMC, lessons duly learned, were going to try out the Taper again — perhaps in December:

(Fox Business): Federal Reserve policy makers are still struggling to find the right message for conveying to investors their plans for scaling back their easy-money policies, notes from the Fed’s October meeting reveal.

The minutes, released Wednesday, also said members of the policy-setting Federal Open Markets Committee could see the central bank trimming its $85-billion-a-month bond-buying program at “one of its next few meetings.”

If at first you don’t succeed…

But they had clearly realized that even a $20 bn Taper was going to be taken poorly by the markets, and so the FOMC (and in particular its soon-to-be-retired chairman) needed to pull off a delicate balancing act.

On the one hand, Bernanke would want to leave the Fed with the wind-down of his expansionist policy underway so that he would have the kind of plausible deniability that history has gradually been stripping away from Alan Greenspan. (“Hey, don’t blame ME. We were exiting QE when I left office!”) On the other hand, though, he wouldn’t want to hand Janet Yellen an impossible situation.

The solution?

Taper Lite!

“All the goodness of the Taper with no bitter aftertaste!”

… and the markets, after the scares in May and June, LOVED it!!

(CNBC): U.S. stocks surged on Wednesday, with the S&P 500 and Dow industrials closing at records, after the Federal Reserve moved to cut stimulus, saying it expects the labor market will continue to improve and vowing to keep interest rates low.

“Investors are looking past the

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