Why The Fed Is Tilting At Windmills

This post first appeared on The Felder Report PREMIUM on September 23, 2016.
“My reason is now free and clear, rid of the dark shadows of ignorance that my unhappy constant study of those detestable books of chivalry cast over it. Now I see through their absurdities and deceptions, and it only grieves me that this destruction of my illusions has come so late that it leaves me no time to make some amends by reading other books that might be a light to my soul.” -Don Quixote

I grew up surfing in Southern California. Sure, I played baseball and basketball like most other boys along with a lot of soccer but these never really captured me like surfing did. I was eight years old when I first stood up on surfboard and rode a wave to the beach at Latigo Point and from that moment I was hooked. There was truly something magical about harnessing the power of Mother Nature for nothing other than the pure joy of essentially walking on water. Over the next decade I surfed as much as I could and I think those experiences taught me much of what makes up the foundation of my investment approach today.
The best surfers have a deep understanding of the ocean. They come to almost embody it in a way other athletes will never understand. It’s an internal rhythm that becomes tuned to the rhythm of ocean. Through a consistent daily routine of getting in the water surfers internally come to know when low tide will bottom out and when high tide will peak. They also know how dramatic those tides will be based on the phase of the moon. They know what the weather patterns far offshore look like and how they will create tomorrow’s surf. They also understand which beaches will best benefit due to the direction of the swell being created.

In other words, great surfers are highly attuned to natural cycles. It doesn’t take very long at all after sitting out in the water to see that waves come in to the beach in sets. The first wave comes in at a decent size followed by one slightly larger. Then a larger one comes in until the set peaks and the size of the waves begin to reverse the pattern and wane in size. Then there’s a lull in between sets before the next decent wave comes in. Over the course of the day, the overall size of the sets may grow or wane depending on the strength of the storm well offshore, out of sight. The more time you spend in the water the better attuned you become to all of these cycles and how they interact with each other to create the magic that happens when you finally catch a single wave.

A successful investor is much like a great surfer in that she studies the markets and their various dynamics to such a degree that she internalizes a great number of invisible cycles. Just because she cannot see all of them she knows that, just like the storm hundreds of miles away that creates a great day of surfing or a blown out stormy day, they are out there and they are real. Not only are they real, they are undeniable and unalterable. She may not consciously be able to enumerate every one of them in detail but she has a very good feel for them and for how they interact with each other. She believes that in order to be successful, she must align herself with them and to try to eliminate or ignore them is the height of foolishness.

Perhaps now you have an idea where I’m going with this. Unlike some Fed critics, I have a great deal of empathy for our central bankers here in the U.S. and those abroad. They have been tasked with precisely this sort of foolishness. They have been tasked with the impossible. It was the creation of the “dual mandate” in 1977 that is really at the root of many of the problems in the markets today. This was when Congress tasked the Fed with ‘promoting maximum employment and stable prices.’
There are many questions that should have been asked before any of this was implemented but the first question they should have asked is, ‘are these two things even compatible?’ In other words, is it possible to have maximum employment at all times while keeping prices reigned in? I think the obvious answer is no. The idea of maximizing employment at all times is essentially the same as eliminating the business cycle and ending recessions. If recessions are the natural mechanism of reigning in prices how would prices behave without them? Clearly, the Fed is dying to find out.

We can debate whether the Fed is even capable of accomplishing any of this, which I believe is very dubious, but my point is that the root of the problem comes back to the idea of trying to manipulate natural cycles. And there is all sorts of wonderful evidence of mankind attempting to do so in various other fields and failing spectacularly. My favorite metaphor here is the one Mark Spitznagel shares in The Dao of Capital, courtesy of Dr. John Hussman:

The spread of fire-suppression mentality can be linked to the establishment of forest management in the United States, such that by the early 1900s forests became viewed as resources that needed to be protected – in other words, burning was no longer allowed. The danger of this approach became tragically apparent in Yellowstone, which was recognized by the late 1980s as being overdue for fire; yet smaller blazes were not allowed to burn because of what were perceived to be risks that were too high given the dry conditions. And so smaller fires were put out, but in the end could not be controlled and converged into the largest conflagration in the history of Yellowstone. Not only did the fire wipe out more than 30 times the acreage of any previously recorded fire, it also destroyed summer and winter grazing grounds for elk and bison herds, further altering the ecosystem. Because of fire suppression, the trees had no opportunity or reason to ever replace each other, and the forest thus grew feeble and prone to destruction… In 1995, the Federal Wildland Fire Management policy recognized wildfire as a crucial natural process and called for it to be reintroduced into the ecosystem… Central bankers, too, could learn a thing or two from their forestry brethren.

The single most important thing they could learn from their forestry brethren is that which surfers are already well aware: cycles are natural; cycles are healthy; cycles are necessary; cycles are undeniable and unalterable and to try to eliminate or ignore them is the height of foolishness. In their attempt to do so, the Fed has turned the most powerful institution on the planet into a financial Don Quixote, attacking the windmill of the natural business cycle which it believes to be a monster.
Now I’m not expert in Fed history but I don’t believe it was created originally to address employment or the business cycle or even inflation, for that matter. It was created after the banking panic of 1907 to address the liquidity needs of banks amidst a bank run and, in this way, to improve overall financial stability. The greatest irony of this fact today is that in recent years they have managed to accomplish just the opposite of their original mandate.

Over the past 20 years, the Federal Reserve has created a series of asset bubbles that have threatened the financial stability of the country and the world. And each subsequent bubble has posed a greater threat to the world’s financial system. In the late 1990’s the dotcom mania didn’t pose much of a systemic threat to the system but Long Term Capital Management certainly did. Then, during the middle part of the last decade, the major banks made LTCM look like child’s play.
In recent years, debt has exploded at the corporate level all around the world enabled by the “reach for yield” resulting from the parabolic growth of central bank balance sheets via quantitative easing. I have no idea what the next post-bubble crisis will look like, what will trigger it or when. I am very certain, however, that this pattern of growing financial bubbles with growing consequences has not reversed; it has only grown stronger. Today’s unprecedented and extreme policies being implemented by central banks around the world will lead to unprecedented and extreme problems.

All of this has been done in the vain attempt to “dream the impossible dream.” Rather than see Janet Yellen and company as a “committee to destroy the world,” I see them as dreamers, just as pathetic (in the true sense of the word) as our Don Quixote. The trouble over the past two decades is that the Fed has taken the markets along on their academic misadventures. They have made investors their squire, their Sancho Panza.  They haven’t necessarily convinced him the windmill is a monster and that they have both the courage and the steel to destroy it but they have offered him enough of a reward to faithfully go along for the ride. Like Sancho Panza’s promised island, the Fed put is a very lucid and lucrative mirage.

While they are willing to play along for a time, once they get close enough to the windmill to see it for what it really is, investors will refuse to follow their master in plunging headlong into battle, lance tilting toward inevitable disaster. Just as they refused during the financial crisis and the dotcom bust before that. There comes a point when the game is up. When the dream clashes with reality, reality always wins. It could be a small pickup in volatility, further economic deterioration, a continuing shift in risk appetites or any number of other potential catalysts that could trigger such a clash. I don’t know how but I do know that it will happen and the current crescendo of Fed criticism, coming from both its peers and from the public, is a clear sign it’s getting closer.

12/15/2016
Jesse Felder