Thursday, August 11, 2022

The 'Most Important Price in the World' Is Broken

By Dan Ferris (View Archive)

Editor's note: Our colleague Dan Ferris from our corporate affiliate Stansberry Research is back...

Continuing yesterday's discussion about the wordplay from the Fed and government officials in the midst of another quarter of GDP contraction, Dan explains in today's essay how this is a symptom of a far bigger issue...


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Politically motivated, recession-focused word salad is symptomatic of a greater problem...

The government and the Fed don't understand (or care?) that it's impossible to manage, tweak, and otherwise control a hopelessly complex, $24 trillion economy from the top down through a set of crude price manipulations that would get anybody else thrown in jail.

And we as Americans have no choice. We're forced to live with the often painful consequences of their management, tweaks, and control.

I've previously asserted this point about the Fed and U.S. government. But now, I've found a new way of thinking about it...

I recently started rereading economist Thomas Sowell's book, A Conflict of Visions.

The book compares what Sowell calls the "constrained" and "unconstrained" visions of human wisdom and morality. It takes the whole book to make his point. But for the purpose of today's essay, the following passage will suffice...

The two visions differ fundamentally as to the sources of human survival and progress. According to the unconstrained vision, the patterned behavior of society is successful, just and progressive insofar as it reflects the articulated rationality of man in general and of the most intellectually and morally advanced people in particular. Order – and especially a just and progressive order – is the result of design, backed by the commitment of people dedicated to the general welfare...

In the constrained vision, where man – individually and collectively – lacks both the intellectual and moral prerequisites for such deliberate, comprehensive planning, order evolves historically without design, and more effectively than when it is designed.

The constrained vision sees man's wisdom and morality as limited...

On the other hand, the unconstrained vision sees no limits. And it emphasizes experts' ability to take control of others and generate optimal (or perhaps "utopian") outcomes.

Those folks with unconstrained vision believe deeply in their (and no one else's) ability to manage society from the top down due to their moral and technical superiority.

It seems like Sowell could be talking about the Fed and the government when he says...

Given the constrained vision of man's wisdom and morality, he cannot successfully prescribe results but can only initiate processes, whose consequences are often the direct opposite of his intentions.

Unconstrained visionaries believe they can control financial markets and whole economies. And they think they can achieve better results than if those markets and economies were left alone.

The constrained folks – whose 18th-century forebears, the physiocrats, invented the term "laissez faire" – know that nobody can design or control a $24 trillion economy. And they know that all attempts to do so will backfire badly.

Humans don't build markets and economies. Markets and economies emerge out of other intentions. When humans purport to design and control them, we become hubris-addled idiots and generally fail.

The unconstrained visionaries find problems everywhere. And they believe they're the only ones with solutions. Constrained visionaries accept the limits of humanity. They understand there are no solutions, only trade-offs with different costs.


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These two visions are coming to a head on many fronts in our society today...

The Fed kept saying it wanted higher inflation, never acknowledging that higher inflation would mean untold suffering for millions of families. The government, aided by the Fed, pursued the insane policies that generated inflation near 9%.

Now, the Fed claims to want less inflation... not acknowledging that it will likely add insult to injury if it's effective. And it will likely crush the twin sources of wealth that sit at the heart of much economic activity – home equity and stocks.

The problem isn't rising or falling interest rates – or even rising and falling inflation. It's that some humans insist on seizing the levers of power so they can play God. They distort market signals, making it harder for businesspeople and investors to allocate capital.

As billionaire investor Stanley Druckenmiller recently said at the Sohn Investment Conference...

Unfortunately, the last 10 [or] 11 years, the bond market has not signaled anything because the central banks took it upon themselves to manipulate bond prices...

The 10-year Treasury is the most important price in the world and they took that price out of the equation as a signal. I remember last summer, when certain forecasters who had a different forecast than my own, kept talking about, "Well the bond market is saying this, the bond market is saying that," when the 10-year [yield] dropped all the way from [1.7%] to [1.15%]...

But the bond market wasn't saying anything. What was going on is central banks were buying trillions of dollars [worth of bonds] and manipulating the price of bonds, so there was no signal.

In other words... the "most important price in the world" is broken. And therefore, it can no longer be used as a reliable signal by capital allocators.

It's easy to see the extent of the Fed's bond market manipulation...

The Fed currently holds about $8.4 trillion in U.S. Treasury securities, mortgage-backed securities, and debt of various agencies (including Fannie Mae and Freddie Mac). The combined outstanding total of all three of those markets is about $37 trillion, according to the Securities Industry and Financial Markets Association.

That means the Fed owns about 23% of a $37 trillion U.S. bond market.

I promise if you buy 23% of a company, market, or anything else... you could push the prices around quite a bit. You couldn't do it forever because nobody can get permanent control of a $37 trillion market. But you could wreak plenty of havoc in a short period.

Maybe you think I'm contradicting myself...

On one hand, I'm saying the Fed doesn't control markets the way everyone thinks. Then, I'm saying it manipulates bond prices so much that you can't rely on bonds as an economically meaningful signal anymore.

It can't be both, can it? Well, let me ask you...

If someone poisons you, would you say they were in control of your health?

Do you gain control of a car's engine if you pour sugar in the gas tank?

Let's not confuse control with the ability to vandalize...

All too often, the Fed and government officials are arsonists posing as firemen.

People praise the Fed when it shows up after the fire is raging. But they seem to forget that the Fed has been there all along – and in fact, it lit the match that started the blaze.

This idea helps market participants maintain the delusion that the Fed and the government make asset prices and economic activity do what they want.

But it's not in control. I hope that is painfully obvious by now.

The self-directed creation and growth of whole markets and economies over time is unfathomably greater than that of destruction. Never infer that anyone can manage, tweak, or otherwise control something just because they can manipulate, distort, or destroy it.

Investors today show no signs of getting any of this, though. They've responded to the Fed's latest announcement with a panicky round of buying. They believe the Fed knows what it's doing, will soon have inflation in hand, and will save them once again.

I believe the opposite... The more it looks like the Fed knows what it's doing, the more vulnerable investors are to its ultimately distorting and destructive effects.

The many 'peak inflation' calls seem especially wrongheaded...

Inflation is a far stickier phenomenon than the stock and bond markets currently reflect.

It's a dragon. And dragons aren't slayed with baby steps (hat tip to macro investor Alf Peccatiello for the imagery).

Many investors like to talk about not fighting the Fed. But I say...

Beware the Fed.

More important, it's critical to prepare your portfolio for a wide range of outcomes. That includes much more volatility over the next decade than we've had over the previous one.

Stay cautious.

Don't get confused with worrying whether we're in a recession or not. The government's word salad and spin cycle are meant to misdirect reality. But don't fall for it...

Keep holding a diversified portfolio. That includes plenty of cash, gold and silver, and the equities of the best businesses. They're more likely to fare well (or at least not too much worse) during difficult times like what we're in today – official recession or not.

No matter how wonderful the recent rally feels, we're not out of trouble yet.

Regards,

Dan Ferris
August 11, 2022

Editor's note: "This is it. This is the moment when you must act. Now," Dan said recently. "This is when you take action that saves you from having to feel the way you did in 2008."

If you delay, you could be making a huge mistake for your finances and retirement. Learn the details about this time-sensitive situation, free of charge, right here.