«If we get inflation it’s going to be a real big problem.»
The party on Wall Street is on. Since Donald Trump’s election victory the Dow Jones Industrial advanced more than 15%. This week, the famous stock market indicator traded for the first time over 21,000. Jim Bianco takes a cautious stance. The influential market strategist from Chicago thinks that inflation will soon become a main concern for investors. In his view, this will change the basic relationship between stocks and bonds and could set up the financial markets for severe turmoil, like in the late 1990s when the collapse of Long-Term Capital Management sent shock waves around the globe.
Mr. Bianco, the US stock market is in record mood. What’s your assessment of this rally?
This market has just been grinding higher and higher without any belief that there are any problems. Equities are at an all-time high and volatility measures for the stock market are way down. The S&P 500 (S&P 500 4'464.33 -0.22%) has now gone nearly a hundred days without a correction of 1% or more. That’s one of the longest such stretches ever. The last correction of more than 1% was in early November, right before the election. Also (ALSN 277.50 +1.09%), if you look at some of the economic data you’ll see that consumer confidence is at an 18-year high, business confidence is at a 30-year high and the NFIB Small Business Optimism Index is soaring as well. So if you look at all that you would come to the conclusion: «Wow, things are good!»
But then you turn on TV-stations like MSNBC, Fox News or CNN and they’re hyperventilating about Trump and what he said or didn’t say. This is not what you would expect given these all-time highs in confidence and in the stock market. So you’ve got two diametrically opposed things going on and I think to some extent it’s signal and noise: The market believes that Trump is very business friendly, a pro-growth president who is going to cut regulations and taxes. All the rest of this stuff doesn’t matter.
So are there more good times ahead?
The market is in the belief that we are going to get reflation and it’s trading on that belief. Basically, I agree with that. But the real question is what kind of reflation we are going to get. Are we going to get real growth which translates into earnings like the market believes? Or are we going to wind up getting mostly inflation? And that’s what I would argue for. I think that there is an incipient inflation coming and the market is not ready for that.
What does that mean for investors?
Inflation is not quite here yet, but it’s coming. Since the financial crisis we’ve talked about it from time to time. But it has never ever arrived. Now, you’ve got all of this optimism that Trump is going to do this and that and the economy is really going to grow. That’s why the markets are going ahead. But if we get inflation it’s going to be a real big problem. It’s going to be a game changer for the economy and for the markets.
The most basic relationship there is is the relationship between stocks and bonds: when bond prices go one-way how do stocks react and vice versa. This is not a stable relationship. It’s not something you can write into a textbook and teach everybody at business school. There are times when the movements of stock and bond prices are highly correlated to each other and then there are times when they are not correlated and move in the opposite direction. The premise here is that the stock bond relationship is not stable. It changes over time.
Why is this so important?
From the mid-1960s to the late 1990s stock and bond prices were highly correlated to each other: They moved up and down together. When rates went down stocks went up. During this period what you had was an inflation mindset. Everybody was worried about inflation and during the period of high inflation in the 70s stocks got crushed. Especially on an after inflation basis they did very poorly.
And what happened next?
Around 1997/98 you had a regime shift. Now, bond and stock prices started to move in the opposite direction of each other. When such a regime change happens you get a lot of stress in the financial markets. In the late 1990s we had Long Term Capital Management collapsing, we had the Asian financial crisis and we had the Russian debt moratorium. Markets got all stressed out.
So where’s the connection to the present situation?
Since around twenty years we mainly worry about deflation: When we are relieved that there is no deflation yields go up and stocks go up. When we are worried about deflation yields go down and stocks go down. So when we have a regime shift back to an inflation mindset this will put a lot of stress on the financial markets because the relationship of how bonds and stocks react to each other is not going to work anymore the way you think. It’s going to change.
Where would you see early signs for such a fundamental change?
To be clear, the stock bond relationship hasn’t changed yet. But you will know it’s happening when you see turmoil in the financial markets, especially when risk parity funds start to blow up. Risk parity funds, an investment concept pioneered by Bridgewater Associates, are basically an artifact of the deflationary mindset. They trade the stock-bond relationship based on how it’s been for the last twenty years. So if this relationship changes you could either look at all of these correlation charts, or you could just open up The Wall Street Journal or watch CNBC, and you’ll hear stories about risk parity funds blowing up because their models aren’t working anymore. Basically, the same thing that happened with Long-Term Capital Management could happen with risk parity funds in the next regime change.
How does the Federal Reserve fit into this picture?
The Fed is very accommodative right now. They’re way too easy but it’s okay because we don’t have inflation. So some people may say: «Hey, a little inflation wouldn’t be a bad thing because if it reverberates it would get the economy moving». That might be true if you get a little inflation. But once inflation gets going it’s usually hard to stop at that point.
The Fed says that if we get inflation they’ve got the tools to respond, namely raising interest rates. That’s 100% right except the question is where you are starting from. Right now, the nominal Fed Funds Rate is only at 0.75%. But they’ve got this giant, bloated balance sheet. So what if you factor that into the equation? Former Fed chairman Bernanke and Bill Dudley at the New York Fed said that every six to ten billion dollars of excess reserves equates to one basis point of Funds Rate reduction. So you’re actually talking about a Fed Fund Rate at around -1.75%. That means if we are going to get inflation the Fed has a long way to go and it has to start jacking up interest rates really hard – and that’s where it could be very disruptive for the markets.
The next FOMC decision is on March 15. Will Fed chief Janet Yellen raise interest for the second time in only three months?
According to the futures markets, we started this week at a 40% probability of a rate hike. Now, we’re all of a sudden at 70 to 80%. So there has been a dramatic shift in the market’s thinking which is highly unusual. A lot of that move is due to Dudley saying that the argument for a rate hike is compelling. The minutes after he said that the odds for a rate hike went up dramatically. Interestingly, in the last ten years there have been only two FOMC meetings where inside of twenty days to the meeting the market has changed its opinion on what the Fed is going to do. One of them was on September 16. 2008, the day after Lehman went belly up. Also, in such close calls the Fed always tipped to the dovish option to either not raise rates or ease because they’re concerned that if they upset the market it’s going to be all their fault. Now, we’ve got debate and confusion: Will they break with tradition and hike rates? If they do it is significant because they’re actually changing their approach.
What will Trump do with respect to upcoming appointments to the Fed?
There’s a total of seven governors at the Federal Reserve and today there are two vacancies. Soon there will be another vacancy since governor Daniel Tarullo announced that he wants to leave the Fed by April. Additionally, governor Lael Brainard might want to leave, too. And then Yellen’s term is up for renewal next February. Trump has already said that he will replace her. Now here’s the question: If you want to bring people back to work and create all these manufacturing jobs wouldn’t an easier Fed be to your advantage? Probably yes, but I take Trump on his word. He made it very clear. He said he’s going to get rid of Yellen so I’m going to operate under this assumption. That’s why I suspect that in one year to eighteen months we are going to have a new Fed chairman and we’re going to have three or four of the seven Fed governors appointed by Trump.
Who do you think Trump will pick as next Fed chair?
For the first eighty years after the creation of the Federal Reserve the governors and chairmen were mostly bankers, lawyers and other business people. But since 25 years that has changed. Now, they are mostly economists. So that’s a fairly new phenomenon and I think Trump will go back to bankers, lawyers and business people. He will choose people that have been successful in the private sector and not in writing papers at the economics departments of Harvard, MIT or Princeton. With this in mind, a possible candidate could be a guy like John Allison of BB&T or David Nason of GE Capital. Another name we hear is Kevin Warsh who has worked at Morgan Stanley (MS 101.80 +1.52%) and was a Fed governor and is now at the Hoover Institute at Stanford University.
What does that mean for monetary policy?
All of these guys have in common that they think extreme monetary policies like QE and negative interest rates are counterproductive: They’re distorting the markets and don’t help the economy. They don’t create jobs. So what Trump’s picks will be doing is raising interest rates and reducing balance sheets. Based on their private sector experience they think that when we stop distorting the markets things will return to normal and we will have faster growth. That will be their argument. They won’t care about all those models with all those math equations which the Fed is operating on now. So you are going to have a very different Fed with a whole different mindset to it.
So how should investors position themselves in today’s markets?
As mentioned, I believe in the reflation trade and that we’re going to see inflation. That’s why I think that the ten year treasury note could move from 2.5% to north of 3% by the spring of next year. But that’s also the most consensus thing somebody could say right now. Everybody believes that interest rates are going to go up and everybody is betting on that. So when I look at it from my perspective as a former technical analyst I see such an overcrowded trade and I see so many people being short the bond market that I’m going to say that at first, we are going down to 2% by the middle of the year. And then, when inflation kicks in, we are going to 3%.
And what’s your outlook for stocks?
I think the stock market will continue to advance from here through the summer because we don’t have inflation and we have this hope about Trump getting the economy going. But then, as interest rates start going up, we are going to see the stock market struggle and these are going to be the early signs that the deflation-inflation mindset is starting to shift.