DRUCKENMILLER THE STATEMEN / PRUDENTBEAR.COM

Druckenmiller the Statesman

by Doug Noland

July 18, 2014


Geopolitical risk erupts and a hedge fund titan speaks candidly. Hedge fund manager Stanley Druckenmiller rightfully attained “legendary” stature after achieving a phenomenal 30-year track record. Throughout his career, he has successfully implemented a “top down” macro approach to investing/speculating across global markets, including a highly successful stint partnering with George Soros. Druckenmiller provided cogent remarks Wednesday at the Delivering Alpha conference covered live by CNBC:

Druckenmiller: “As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns - and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economic statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events. That is why I am personally experiencing a sense of Deja vu.”

“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”

I really appreciate Mr. Druckenmiller’s statesman-like comments. As a seasoned trader and hedge fund manager, his thought processes are conditioned to analyze things in terms of probabilities and a risk versus reward calculus. He has generated incredible investment returns and accumulated stunning wealth through a profound understanding of shifting macro backdrops, while implementing disciplined trading strategies. Basically, success depends upon intense objectivity and focus, pressing the winning bets and slashing the losers – the old “You gotta know when to hold ‘em, know when to fold ‘em, when to walk away and when to run.”

I agree completely with Druckenmiller’s comment: “The current policy makes no sense from a risk/reward perspective.” And the critical issue of risk vs. reward gets right to the heart of the failure of contemporary central banking. As a masterful professional speculator, it was imperative for Druckenmiller to move quickly to recognize mistakes and mitigate losses. Discretionary central banking, in contrast, ensures that policy errors are followed by only greater ones. You can toss accountability and objectivity right out the window. Poor performance will see hedge fund managers lose their investors and businesses. Poor policy has led to previously unthinkable policymaker discretion and power at the Federal Reserve (and why there’s an appropriate push for a more rules-based policy approach). And when it comes to pure analytical prowess, the academic central banker is no match for the well-schooled hedge fund titan.

Druckenmiller highlights the 2003-2004 period as an example of “puzzling” monetary policy. I remember my frustration with the Fed during that time. Fed funds were held at one percent until June 2004, despite an acceleration of already breakneck mortgage Credit expansion. In fact, 2004 saw annual mortgage Credit growth jump to 13.5%, marking the fourth straight year of double-digit mortgage Credit growth (and fifth of six).

Monetary policy was recklessly loose, though it was expounded in terms of an adroit “risk management” approach for minimizing the probability of a very bad economic outcome. Stated differently, the Greenspan/Bernanke Fed believed aggressive monetary policies reduced the likelihood of a highly undesirable deflationary spiral. The Fed explicitly adopted the Bernanke doctrine of ignoring Bubbles and instead placed emphasis on post-Bubble “mopping up” (reflationary) measures. As Druckenmiller noted, the Fed was oblivious to the risks its policies were fomenting.

I wasn’t particularly puzzled by Fed policy back in 2003/04; I simply believed our central bank was following terribly misguided doctrine. Clearly, there was a complete lack of understanding as to the myriad financial and economic risks associated with asset inflation and Bubbles. Moreover, there was overconfidence with respect to the Fed’s capacity to reflate system Credit in the event of a major securities market crisis of confidence.

With the Fed apparently having learned nothing from past experience, I find current policy somewhat more baffling. At this point, risks associated with loose monetary policy should be readily appreciated. It doesn’t make any sense that the Fed remains so dismissive of securities market excesses. And with Fed funds stuck at zero and the Fed’s balance sheet rapidly approaching $4.5 TN, our central bankers should recognize that the risks of stoking asset Bubbles are actually even greater today. After almost six years of post-crisis stimulus, Bernanke’s “mopping up” maxim has understandably disappeared from Fed discourse.

From Druckenmiller: “There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate.”

We’re inundated these days with rationalizations and justification for ongoing reckless monetary management. There are variations of this “new neutral” mantra that an extraordinary backdrop dictates that the Fed sticks with exceptionally low targeted rates for much longer. Apparently, it’s logical that the dire consequences from a period of loose monetary policy stipulate another period of ultra-aggressive monetary stimulus.

Interestingly, leading “Keynesian” (inflationist) Paul Krugman has focused a bit recently on the “Wicksellian natural rate” (esteemed Swedish economist Knut Wicksell, 1851-1926):

Krugman (NYT, July 7, 2014): “The Keynesian view of monetary policy is that the central bank should, if it can, set interest rates at a level that produces full employment. Sometimes it can’t: even at a zero rate the economy remains depressed, so you need fiscal policy. But in normal times the Fed and its counterparts should be aiming at the full-employment interest rate. Wicksellian analysis is an older tradition; it argues that there is at any given time a ‘natural’ rate of interest in the sense that keeping rates below that level leads to inflation, keeping them above it leads to deflation. I have always considered these approaches essentially equivalent: the Wicksellian natural rate is the rate that would lead to full employment in a Keynesian model. I have, in fact, treated them as equivalent on a number of occasions, e.g. here. Now, what about the BIS [Bank of International Settlements]? It is arguing that central banks have consistently kept rates too low for the past couple of decades. But this is not a statement about the Wicksellian natural rate. After all, inflation is lower now than it was 20 years ago.”

Similar to so many traditional metrics, axioms and concepts, Wicksell’s “natural rate” is not so easily applied to the current environment. I have always been fascinated by Wicksell’s notion of a hypothetical (“natural”) rate that equates with general price and economic stability. The “Austrian” school has argued persuasively that central banks have for years fostered precarious boom and bust dynamics by pushing market yields below the “natural rate.” It makes for a provocative discussion.

From my perspective, Wicksell’s conceptual “natural rate” was derived from the interplay between the supply of and demand for a limited quantity of capital. And this gets right to the major problem I have with both contemporary finance and monetary management: There is today, on a globalized basis, no limits to either the quantity or quality of Credit. To that end, I avoid using the word “capital.” Capital connotes something of real value – or a financial claim backed by real economic wealth. Yet too much of today’s (debit and Credit entry electronic) finance is backed by nothing. So then, what does a global regime of unfettered electronic finance imply for a “natural” or “neutral” interest rate?

Brief thoughts on Wicksell’s “natural rate”: I completely disagree with Krugman’s contention that modest consumer price inflation is evidence that current central bank-dictated market rates have been consistent with a Wicksellian equilibrium rate (which Krugman states appropriately supports today’s asset prices). One should instead think more in terms of general stability in various price levels throughout the system, certainly including real and financial asset prices. And one would have to be delusional to believe that asset prices have been in anyway consistent with a stable “equilibrium”. Moreover, it is disingenuous to claim that asset prices have not been profoundly impacted by the almost six-year $3.5 TN increase in Federal Reserve securities holdings (Fed Credit). Simply overlay a five-year chart of Federal Reserve holdings with a chart of the U.S. stock market.

And while on the subject of a “natural rate,” I think it’s worth pondering this concept in terms of today’s extraordinarily low Treasury and corporate yields. I believe central bank policies – especially “open-ended” QE3 – have comprehensively distorted asset markets. First, the unprecedented purchases of Treasuries and MBS created liquidity/purchasing power that inflated securities prices generally. Secondly, this liquidity onslaught incited dangerous self-reinforcing excess throughout corporate debt and equities markets. And a runaway corporate securities Bubble has of late boosted the safe haven appeal of Treasuries, with sinking yields further stoking the historic Bubble throughout virtually all asset markets.

Importantly, the willingness to adopt an open-ended approach to the third round of QE has been viewed throughout the marketplace as the Fed (in concert with the global central bank community) having adopted a regime of boundless securities market support. This has profoundly affected market perceptions, hence securities pricing, with the greatest impact upon the traditionally higher-risk segments of the corporate and “structured finance” securities markets.

Stated somewhat differently, the collapse in risk premiums – risk asset price inflation – is this inflationary cycle’s greatest market distortion. Indeed, I would strongly argue that unprecedented liquidity injections coupled with implied (ok, explicit) central bank market backstops has inflated the biggest Bubble yet. Any semblance of a “neutral rate” – or a stable securities market “equilibrium” – would require that central banks extricate themselves from the securities market liquidity and backstopping business. Good luck with that.