'Follow the Money' Getting More Important in Markets

Pay attention to what central bankers are doing and not what they say they are doing.

Making money from nothing.

Photographer: Dan Kitwood

There is nothing more important in financial markets now than “following the money.” It is sort of like the Wall Street idiom, “The numbers don’t lie.” The amount, direction, and velocity of money don’t lie, either. Don’t get caught in the “bear trap” of listening to what politicians or central bankers effuse into the markets each day. Pay attention to what they are doing and not what they say they are doing. Those are very different paradigms.

In the U.S., we are confronted with President Donald Trump’s choice as to who will lead the Federal Reserve and who will be on its board. My bet is that it will not be current Fed Chair Janet Yellen. It is a fairly safe assumption that the Trump administration doesn’t want significantly higher interest rates. That would not be helpful for fostering a growing economy. The Fed of today will not be the Fed of tomorrow, and all of the dot plots and speeches, and all of the careful dissection of the Fed’s minutes, will be worthless a few months from now. Projections based upon the current Fed will have gone the way of the flappers of the 1920s.

Thursday’s European Central Bank meeting is in the spotlight. ECB President Mario Draghi says policy makers are “recalibrating” their approach to bond purchases and the markets are translating this into “tapering.” Bloomberg data show the yield on the 10-year German bund was 0.30 percent on Sept. 7. It now stands at 0.48 percent, a 37.5 percent rise in just seven weeks. I suspect it will be even higher in the weeks to come, and significant pressure may be in the cards for the peripheral euro-zone countries such as Spain, Portugal and Italy. A year from now we will look back at today’s yields and express surprise that they were actually this low.

Any rise in European yields will have consequences. Europe’s social programs will become more expensive to support and the budgets of many European countries will come under pressure. The ECB will also hold significant mark-to-market losses in its bond holdings, and the current $8 trillion in negative yielding debt will dwindle and cause some consternation for European investors.

It appears the Bank of Japan will continue on with its quantitative easing programs, and may be the proverbial last man standing unless there is some hitch. In that case, the Fed and the ECB may be right back on center stage with more monetary stimulus. The use of pixie dust, like opioids, is addictive.

Regardless of the continuing blather about monetary policy “normalcy,” there has been no “normal” for the past nine years as the central banks created $21.7 trillion out of pixie dust and sprinkled it out into the world. It has been equities up and bond yields down and a continuing compression of risk assets to their benchmarks. This arsenal of newly minted money has driven the markets since the 2008-2009 financial debacle. If you “followed the money” during all these years, then you should have done quite well, and if you didn’t, then probably not so much.

The Hill reported that Speaker Paul Ryan detailed the House’s timeline on tax reform Tuesday. He allegedly said Republicans will pass the Senate budget on Thursday, unveil their long-awaited tax reform legislation next week, and send the bill to the Senate before Thanksgiving. House Republican leaders have apparently decided to take up the fiscal 2018 budget resolution that the Senate passed last week. Approving that budget would allow Republicans to fast-track their tax-reform plan without needing to secure any Democratic votes in the Senate.

There is a massive amount of speculation here, and hoped-for delivery does not always lead to execution, but it does appear that something may happen. If all of this does come to pass, then it would be a further boon for equities. It is still “follow the money,” as investors would have more cash to put into the markets as a result of this legislation. The world’s “free cash flow” would once again be increased.

To be sure, reports are that lawmakers from New York and other high-tax states are resisting a proposal to reduce the state and local tax deduction for individuals, which could raise tax bills for some. This has implications for municipal bonds. The loss of this deduction could impact valuations of bonds issued in high-tax states. This is something to consider now, before any legislation is passed, when evaluating your holdings or any new purchases. It could also have a significant impact on some exchange-traded funds as well as some closed-end bond funds that primarily invest in these states.

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