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No One Wants to Pop the Asset Bubble

On July 31, the Federal Reserve will announce its latest update to interest rates. While Chairman Jerome Powell used to be a serious monetary policy hawk, his outlook has softened significantly in the first half of 2019.

No longer is anyone worrying about an interest rate hike. Instead, the investing public anticipates more dovishness. Amazingly, the Fed may even opt for a rate cut this time around.

By bowing to political pressure, as well as fear of blame for sparking a downturn, the Fed appears to be committed to keeping the bull market and economic expansion moving for as long as possible. Sadly, that is fundamentally unsustainable in the long run. The Fed is playing a very dangerous game with monetary policy, a game that might well end with everyone losing.

From hawk to dove

During her years as chair of the Fed, Janet Yellen proved reticent to raise interest rates, even as the U.S. economic expansion continued to hum along. It seemed that no amount of good economic data could sway her from the dovish, easy money policies that had underpinned the recovery following the Great Recession. When Jerome Powell assumed Yellen's mantle in February 2018, things began to change swiftly. A longtime monetary policy hawk, Powell made it clear rate hikes were back on the menu, and wasted no time enacting his vision.

Then, as the the market outlook darkened toward the end of 2018, Powell seemed to lose confidence in his hawkish position. Indeed, he ended up doing a veritable about-face, promising much more caution and guiding for fewer hikes going forward. With rate cuts back on the menu, Powell looks like a very different kind of Fed boss these days. He has decided that he likes the economy running hot after all. That sentiment is understandable to a degree. No one wants to be blamed for crimping economic growth or -- worse still -- a recession. As a result, he seems to be happy to keep the music running as long as possible.

Beware of pricking the asset bubble

Consider a party balloon. As a balloon inflates, the tensile strength of the rubber diminishes. Thus, the bigger the balloon, the easier it is to pop.

Today, the stock market looks an awful lot like an overstretched bubble. This fact has not escaped many of the shrewdest minds in the investment community. As we discussed in a recent research note, hedge fund guru Ray Dalio (Trades, Portfolio) is increasingly worried about central banks' diminishing firepower. The Fed's decision to expend further ammunition to keep the economy running hot, rather than conserving it for the next downturn, only adds to this worry. Sergio Ermotti, CEO of UBS (NYSE:UBS), recently added his voice to the mounting chorus of concern by pointing out the strange disconnect between economic sentiment and asset prices:


"Asset prices went up, but it's not really correlated with investor sentiment, which is, in my point of view, of course, a very dangerous development."



Only thinking about tomorrow

The top brass at the Fed are apparently willing to do whatever it takes to keep this expansion going without concern for long-term consequences. That short-term approach may help them maintain their approval ratings and public goodwill for the time being. But a high price must eventually be paid for kicking the can down the road.

Alas, the music cannot go on forever, as longtime Wall Street commentator George Goodman observed many years ago:


"We are at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know at some moment the black horsemen will come shattering through the terrace doors wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time. So everybody keeps asking -- what time is it? But none of the clocks have hands."



No one wants to be in the hot seat when the downturn starts, so the only solution is to delay the inevitable and, more often than not, indulge in some magical thinking that maybe this time will somehow be different. Unfortunately, reality always wins out in the end.

Verdict

Investors must watch the Fed closely since its actions may have profound -- and perhaps unexpected -- impacts on capital markets, as well as the broader economy. Caution is key as it will be the only safeguard against losing the current game of capital market hot potato.

Disclosure: No positions.

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This article first appeared on GuruFocus.