Yes, Worry About the Stock Market
Stanley Druckenmiller, the man who broke the Bank of England and made $1 billion in 1992 by selling the British pound with his colleague George Soros, is worried about today's economy. For Druckenmiller, it feels like 2004, just before the financial crisis, just before the global economy slid into recession. "There is nothing more deflationary than creating a phony asset bubble, having a bunch of investors plow into it and then having it pop," the investor told the Lost Tree Club in Florida on Jan. 18.
On Friday, a transcript of that talk started circulating (you can read it here). The same day, the total value of the world's equity market surpassed $70 trillion for the first time ever, extending a rally that's seen it expand by 175 percent since its 2009 nadir of less than $26 trillion:
Druckenmiller's message is that the economic backdrop doesn't justify the Federal Reserve keeping borrowing costs near zero, and that its policies are forcing investors to take on extra risk to boost returns. Half a decade ago, there was a risk that Japan-style deflation would trash the U.S. economy, justifying emergency measures; in recent years, Druckenmiller said, those concerns have turned out to be "dead wrong," but the Fed hasn't changed course:
"I feel more like it was in '04 when every bone in my body said this is a bad risk/reward, but I can't figure out how it's going to end. I just know it's going to end badly, and a year and a half later we figure out it was housing and subprime. I feel the same way now."
Druckenmiller cited a thought experiment from a decade ago, when the Fed held its interest rate at 1 percent for most of 2003 and 2004 even though the quarterly growth rate for those two years averaged 3.8 percent and had surged to 6.9 percent in the third quarter of 2003. By keeping borrowing costs so low for so long, the Fed helped finance a buying spree that saw investors loading up on toxic assets ranging from debt backed by mortgage that house buyers couldn't afford to collateralized debt obligations that even the rating agencies couldn't assay:
With monetary policy conditions now at their loosest since the Fed was founded in 1913, "I'm experiencing a very strong sense of déjà vu," Druckenmiller said. For today's policy environment to be justified, Druckenmiller said the central bank would have to believe the economy is in its worst shape in more than a century:
When you have zero money for so long, the marginal benefits you get through consumption greatly diminish, but there's one thing that doesn't diminish, which is unintended consequences.
In his speech, he cited the rally in U.S. household net worth from the 2007 dip as compelling evidence for the health of the economy. As this chart shows, it didn't take long for wealth to be recovered and the previous high to be topped:
Druckenmiller didn't claim to know what might trigger a market panic, or when one might arrive. But he did see compelling parallels with the central bank policy backdrop of a decade ago, when cheap money stoked the risk-taking that caused the crisis, and said he had a clear message to deliver:
When this thing ends, because we've had speculation, we've had money building up for four to six years, in terms of a risk pattern, I think it could end very badly.
In 2005, as an adviser to Tim Geithner -- who was head of the New York Fed at the time -- Druckenmiller warned U.S. authorities that a credit boom was starting to look dangerous. He was ringing an alarm bell that most officials were content to ignore. Let's hope policy makers are paying more attention this time around.
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