Stimulant Bender

Coffee and I have a long history of booms and busts. I love its taste and smell, but unfortunately I’m highly sensitive to caffeine and need to be prudent on how much I consume (ironic that I currently work out of a coffee shop!). Despite my best efforts, there have been times when I’ve overindulged and paid the price. One of my most memorable coffee moments occurred while visiting Philadelphia for a day of client meetings and presentations.

I arrived at my hotel late the night before and was rushed to make my early morning meetings. To save time I decided to order room service. When breakfast arrived I immediately noticed it came with a large pot of coffee. It smelled incredible, but I was reluctant to pour a cup due to my sensitivity to caffeine. However, given I was tired, I thought I could handle and possibly benefit from a half cup.

Although I hadn’t had coffee in a long time, it went down smoothly – too smoothly. It was so good I couldn’t stop. A half cup turned into a full cup and a full cup turned into two cups. Before I knew it, I finished the entire pot, or five cups of coffee. Now that was a delicious breakfast! And even better, I apparently overcame my sensitivity to caffeine. Feeling full and refreshed, I looked at the clock and rushed to my presentation.

Fortunately my first meeting was right across the street from the hotel. I arrived just in time and sat in a boardroom with a group of consultants. As we enjoyed some small talk, I began to sense something was wrong. I started to feel warm and began to sweat. What was happening? The office was cold so it wasn’t the temperature. Was I nervous? I didn’t think so as it was a friendly crowd and it’s a presentation I’d given hundreds of times. And then it hit me – oh no, I may have drank too much coffee! Just as I made this realization a tidal wave of caffeine crashed over me and my presentation began.

After being introduced, I was asked to tell everyone about my absolute return strategy. “Tell you about my strategy?” I thought, “I don’t even know my name!” My heart was racing and I was having trouble concentrating. I wanted to, but was unable to say, “Excuse me, but I just drank a pot of coffee and I’m seriously considering running through that wall behind you.” Finally some words came out and I gave an hour presentation in 15 minutes. I concluded by asking, or yelling, “Questions, questions, questions?! Thank you!!!”

My sales rep rushed me out of the meeting like a shot president. Once safely in the elevator she asked, “What was that?” I replied, “That was a pot of Philadelphia’s finest coffee.” Needless to say, from that day forward, I was back on the coffee wagon and sentenced to a life of green tea.

Although I didn’t need to drink an entire pot of coffee make this point, overdosing on caffeine was a good reminder that there are limits and when those limits are exceeded there are consequences. Because I didn’t feel the effects after my first cup, I thought it was safe to drink another cup. And after my second cup I still felt okay, so I thought it was safe to have a third. And this line of thinking continued until the entire pot of coffee was gone. While the consequences were delayed, my sensitivity to caffeine did not miraculously disappear and this time would not be different.

Speaking of overdosing on stimulants, several Federal Reserve members spoke publicly this week. For the most part, central bankers continue to go about their business as if they didn’t serve investors five cups of monetary coffee. Fed members recently increased their hawkish tone, raised rates 25 bps, and continue to discuss plans to reduce the Fed’s balance sheet. In their eyes, and in the eyes of many market participants, central bankers are firmly in control of the financial markets and their exit strategy.

On Monday, San Francisco Fed President John Williams stated the U.S. economy is “about as close to” the Federal Reserve’s goal of maximum employment and 2% inflation “as it’s ever been.” This made me wonder, if the economy is as close to the Fed’s goal as it’s ever been, why does monetary policy remain so close to where it’s never been?

In his speech, Mr. Williams provided clues as to why monetary policy remains so accomodative. Specifically, he acknowledged concerns that the normalization process could cause “market turbulence”. He reassured investors by saying, “The last thing we want to do is fuel unnecessary or avoidable volatility or disruption—whether we’re talking about domestic markets or international markets.”

Based on recent comments from Fed members, it appears the Federal Reserve’s main tool to combat potential “volatility and disruption” in financial markets, is to normalize policy gradually and be transparent. Mr. Williams stated, “The more public understanding, the less chance that said actions will fuel unnecessary volatility in the markets.”

I can’t help but be reminded of 2004-2006 when Greenspan took a similar gradual and transparent path (I call it “pretty please” monetary policy). After raising rates in 2004, Greenspan communicated to the markets that increases in interest rates “are very likely to be measured over the quarters ahead.” Gradual and transparent is what Greenspan wanted and it’s exactly what he delivered. The Greenspan Fed raised rates at a measured pace for 14 consecutive quarters before passing the monetary baton to Bernanke in 2006.

Initially Greenspan’s transparent and measured approach was successful in promoting further asset inflation and credit growth, but in the end, it was unsuccessful in painlessly deflating the equity, mortgage, and housing bubbles. Eventually years of easy money and credit caught up with the Fed as its measured and transparent approach failed, while “unnecessary volatility” prevailed – overwhelming investors and policy makers.

Similar to 2004-2006, investors currently do not appear threatened by the Fed’s measured and transparent (predictable) normalization process. In fact, based on asset prices and valuations, investors appear to believe the normalization process is “transitory” and more, not less, stimulative policy is on the way.  And they may be right. Who doesn’t believe a pot of QE4 will be brewed during the next market correction?

As the Federal Reserve attempts to exit from years of record low interest rates and previously unimaginable asset purchases, I’m reminded of my experience with overdosing on caffeine. I have unfortunate news for the Fed. There is not a safe exit from a stimulant binge – even if you stop, the effects are already in the system. In the case of the Fed, their relentless doses of monetary caffeine have already significantly altered interest rates, asset prices, capital allocation decisions, and balance sheets. The only uncertainty, in my opinion, is how many more cups of monetary stimulus can be served before investors realize something is wrong, get jittery, and cause the central banks to lose control.

As I’ve been recently diagnosed with chronic central bank fatigue syndrome (CBFS), I’ll be back to writing about individual businesses next week. We’ll have more substantive news to discuss and analyze soon as earnings season is approaching — I’m really looking forward to it. Have a great weekend!