Abstract Art and Monetary Policy

Marcel Duchamp was a French artist living in Manhattan in the early part of the 20th Century. On a walk with fellow artists, Duchamp stopped at a plumbing supply store on 5th ave and purchased a porcelain urinal. A few weeks later, he flipped this bathroom object upside down, inscribed “R. Mutt 1917” on it, and displayed it in an art exhibit under the title, Fountain.

Voila! Modern art was born! Art, which had previously only existed in forms such as sculpture and painting, was now represented in the abstract: an idea in the artist’s head. Anything could be art as long as it evoked a reaction from the dilettantes. Even an object as seemingly innocuous as an upside-down urinal.

In December 2004, 500 British art world professionals voted Duchamp’s Fountain the most influential artwork of the 20th century. Duchamp had invented conceptual art and “severed forever the traditional link between the artist’s labour and the merit of the work”.

An appreciation for modern art is an appreciation for modern monetary policy. Central banks, through a series of crafted policy speeches and actions, attempt to evoke a response in the hearts and minds of investors. This response is what matters most- not the speeches, nor the programs.

So in this regard…

ZIRP doesn’t matter.

Operation Twist doesn’t matter.

QE doesn’t matter.

None of it matters!

Here’s what matters: the Fed attempts to change investors’ expectations of the future. Their goal is to make investors and businesses believe that things are getting better and will be better 1 year, 3 years, 5 years from now. If the Fed could just tell you that the economy is improving, they would. However, that message wouldn’t be believable without some evidence that the Fed is working some type of voodoo behind the scenes.

The effectiveness of monetary policy (and the future of our economy) now lies in the Fed’s credibility as an artist. Much like art collectors paid an absurdly arbitrary price of $58.4 million for Jeff Koons’ Balloon Dog (Orange), investors that believe in the Fed are now willing to pay absurdly arbitrary prices for a claim on future growth. (And in either scenario, you are not allowed to wonder why prices are out of control.)

The Schiller CAPE ratio is now into warning territory:

And junk bond spreads are historically tight:

This gauge measures how much risk investors are willing to take to own bonds that have a lousy history of defaults. When spreads are wider, investors are demanding more yield for the risk (and vice versa). The current spread of 3.5% to the current yield of 2.5% on the 10 year US Treasury indicates that junk bond investors are only getting about 6% for the risk.

Frighteningly, these higher valuations of stocks and junk bonds arrive at the same time global growth is slowing, as 2014 global GDP estimates have declined from expectations of 3% in January to 2.5% today.

Thus, these lofty valuations constitute a wariness by investors to fight the Fed, as newer converts have trampled non-believing bears for the past 2 years. If we reject the dogma of Duchamp’s Fountain or Koons’Balloon Dog, we are societal outcasts that have no appreciation for the arts. Rather than be the odd-man out, we conform along with everyone else. In order for both modern art and the Fed’s art to be successful, there always needs to be converts waiting on the margin to buy at increasingly higher valuations. You should be fearful when it looks like they’ve all joined the party.