Things are happening swiftly and prompt me to write more frequently.
An economist who always produces thoughtful and important input is Stephen Williamson at the St Louis Fed. Williamson has been one of the main voices for "NeoFisherism" ideas on monetary policy. Best to let him explain as it can be complex and his best work is on his blog: http://newmonetarism.blogspot.com/
I have always suspected he is the source of Bullard's material for several years now, just Bullard is a wee bit wily and does not go down the straight road on Williamson's stuff, so it comes out somewhat bizarre at times. The first notice I had of Williamson was Bullard's "Seven Faces of the Peril" paper in 2010 which had this iconic eye opening graph:
Now I have crudely drawn a dotted line which I feel is the US Fisher Rate, with the US higher productivity and our dynamic immigration policy (no matter the "Wall"), and this graph in 2010 has shown to have great prescience if not almost perfect foresight.
The original paper is here: https://research.stlouisfed.org/publications/review/13/11/bullard.pdf
I think Seven Faces is a must read now to try and figure out how a 2 1/8% long bond (!!!!!!!) can co-exist with a 2050 to 2110 SP500. It wont for long as it is an explosive unstable relationship. The graph shows that while the Fisher Rate is linear being a an additive of real GDP plus inflation [ FR = GDP + i ], the Taylor Rule has two coefficients which make it geometric. Once the Taylor Rule gets past the 2% area or so - the base rate - it flattens out so our habit is to see it as linear as well. That is why Yellen is set to go to negative rates as she sees her Taylor Rule version as linear and feels there is a Wicksell "natural rate" which is dropping a la Larry Summers but is still positive so all she has to do is drop rates and stimulus is provided.
However if the Taylor Rule rate is not linear but geometric as Bullard depicts in the slide above, and if the Taylor Rate maximum convexity is near or at the zero rate, then there are two equilibriums, one depicted by Bullard at or slightly less than 0 %and the other at or slightly above 2% . The lower equilibria, further more, acts like a "strange attractor" - ok ok, not "strange attractor" just an "attractor" (just from time to time it is fun to say stuff to suggest you were "3rd at Poly Technique" and lay on the French accent), that induces extreme stickiness. Or this can be seen as the standard Keynesian "Liquidity Trap" just with more nuance and more power to describe market behavior.
The end results is the central bank becomes a self fulfilling prophet. It is worried about disinflation and the inability to induce a targeted inflation rate so it drops rates seeking a standard Wicksell like response, but instead the short rates get sucked into the lower of the two Fisher-Taylor equilibria. To reach self fulfilling prophecy as a college student is not usually a big problem - you just get kicked out. But if your self fulfilling prophecy is that you think the US economy is and will be a lack luster here on - especially clear by Larry Summers - then that is a very serious issue if you actually have the largest book in the world to act upon your prophecy. Some kids of Munchhausen-by-Proxy moms do die. Then when every important word central bank is doing the same thing you have a world class crisis. Which is what is going on now. A central bank "gone wild"
This is a crisis of the first order. But first we must take the kid - the global economy and especially the US economy kid away from the Munchhausen by Proxy mom.
But this is not new, this ZLB two equilibria and chances are we would be able to break free as the 18 trillion economy gives up on the Fed and simply gets rid of the Fed as the Road Runner dispatches the Coyote.
As John Taylor quipped last year when discussing the reluctance of the Fed to follow the Taylor Rule as "this time it's different" ; "last time I checked US corporates still seek profit". Minsky with his Kalecki-Levy input would agree.
But there is another major factor going on which might make the world's central banks coordinated drop in rates even more of a Bullard "Peril" and that is the binding of the "safe assets" from their scarcity via the repo markets. Most roads in trying to figure out what is going on in US Treasurys end up on the repo desk. "Repo" guys are really the Titans of the US treasury market, followed by the layering of optionality onto risk free - the mortgage guys - and then finally the usual pricing of yield based on the future prospects of the US economy via a spot Fisher Rate and it forward values. Now the optionality guys are off the market given the core source of the 2008 crisis were mortgages. But the repo inventory is greatly depleted, mostly in the USA but it is a world problem.
This is where Williamson comes back with his critical paper: "Scarcity of Safe Assets, Inflation, and the Liquidity Trap" (2015) https://research.stlouisfed.org/wp/2015/2015-002.pdf which is where I have the pic at the top from.
As the NeoFisher two equilibria and the suction to the lower equilibria occurs, becoming ever more powerful trap that is hard to escape the lower the rates go, is then combined with the scarcity of "safe assets", the lower equilbria then creeps down the yield curve like a contagion making all maturities stubbornly sticky the lower they get. Then the "Peril" of what was a monetary policy issue becomes a national economic crisis for the Fisher Rate will "prevail" and in the end, after it is all said and done - the long bond rate will break down to GDP plus inflation. At a 2 1/8% long bond that is a very grim forecast, a massive "Peril". It explains easily Japan's two now going on three "lost decades". It is simply untenable for the USA, and it is untenable for the world to to have the USA enter into a lost decade, which at this rate is only 5 more years to go for decade One.
The conclusion to Williamson's "binding" paper.
Whats to be done?
First Yellen must go, as quickly as possible. She is more dangerous given the thesis of the "Perils" than a Miller or the 1936 Eccles Fed Chair. She is a world danger now. [That is if the NeoFisher ideas are right - otherwise we just stomach the secular stagnation to come. Isn't there sorta a macro Pascal Wager here when NeoFisher is equated to the concept of heaven?] Then we pick up where Bernanke ended, we get rid of the binding which means reducing long duration Federal Reserve assets bought during QE. An end of the reinvestment program and mortgage prepayment rolls would be a good start. Then a small amount, say, of about $500 billion QE is sold until the repo market frees up and we have a range of about 1% between specials and general collateral. Once that is digested I think the underlying economy is strong and has several years to go prior to peak of this cycle, so a shock raise of 2% in Fed Funds is in order. This of course would kick off pandemonium but no more so since the last time the Fed Reserve had a massive policy error which was during the 1970s stagflation ending with the Miller Fed who was replaced by Volcker. We survived the needed remedy then to Federal Reserve error and for a trader or arb it was a terrific time.
But I am afraid Yellen is having early morning calls with her gang of fellow traveler central banks, all of them - BOJ, BOE, ECB and even secret patch-in of remaining Bundesbank fellows. As they become more and more emboldened by their mutual adulation society, they will become more intractable and will not be the first group of economists to lead the world into ruin given their supreme shared confidence.
So that is why I think Yellen has to go.
Now to bring this down to day to day - what is the portfolio manager to do?
We do not think that there has been any "alpha" in the market for some time now, and it is especially important to recognize that now given this central banks gone wild world we are in now. A keystone for our approach is to use long duration US Treasurys as an offset to adverse movements in the risky assets, but we cannot use them now considering the unique richness in their price from binding. It is crucial to take bets off the table and keep the portfolio simple and seek negative correlation, or as low a correlation as one can find or anticipate, Correlation dynamics is far easier and reasonable bet to place than to predict what is going to happen to consumer cyclical. Now is not the time to have any opinion on single names. Dropping the portfolio's co-variance is the name of the game now. And while correlation is a reasonable place where a manager can place a bet, volatility still has the unique value to the portfolio manager of being prescient, or rather "persistent". If your portfolio manager or traders are not deeply concerned with what the current yield in the 20 year US Treasury means or are scaring the heck out of you talking about post-Brexit trades or similar foolishness, seek me out. What you read above is what I do.