Patrick Watson probes Janet Yellen’s bold statement on financial crises and makes a suggestion about what she might have really meant

By Patrick Watson*

Top central bankers choose their words carefully. They know sending the wrong signals can unleash havoc, and they’ll get blamed for it. More important, as masters in acrobatic flip-flopping and backpedaling, they rarely promise a specific outcome. 

So when a Fed official does say anything definitive, I pay attention - because it’s almost never an accident. 

Last week, I did a double take when I saw this Reuters headline: 

Fed's Yellen expects no new financial crisis in 'our lifetimes' 

That’s an unusually bold statement for any Fed leader, much less the chair. 

It sure would be nice if Yellen were right. We’d all go to our graves (hopefully not too soon) without ever having seen another financial crisis. 

Not so fast, though. Let’s see exactly what Yellen meant, and what it means for your investment strategy.

'We’re much safer'

Here is the Reuters lead: 

U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe that there will be another financial crisis for at least as long as she lives, thanks largely to reforms of the banking system since the 2007-09 crash.

"Would I say there will never, ever be another financial crisis?" Yellen said at a question-and-answer event in London.  

"You know probably that would be going too far, but I do think we're much safer, and I hope that it will not be in our lifetimes and I don't believe it will be," she said. 

This was a head-scratcher to me. While it wasn’t a prepared text, Yellen would still never say anything like this by accident.

It seemed as if she wanted to say it and was looking for an opportunity to do so. We found out why the next day.

Banks pass the test 

Last Wednesday, the Fed released the second half of the results of its annual bank stress tests. All 34 top US banks passed - for the first time since the post-2008 crisis reforms took effect. 

In practical terms, that means the banks can distribute more capital to shareholders as dividends and stock buybacks. 

Which is weird when you think about it. The Fed says the banks are safe, so now they are free to make themselves less safe by reducing their capital buffers. The six largest banks got permission to distribute about $100 billion.

Naturally, bank shareholders had a ball, but whether it’s good for the system is another question. It means the next crisis bailout of those banks, if one happens, will be $100 billion larger. 

Oh, but wait. 

There won’t be another bailout! Because, remember, the Fed chief herself said there won’t be another crisis in our lifetimes.

It looks like Yellen’s answer to that question was a planned signal to the banks: Go ahead and pay those dividends. We’re off your backs now.

Spring cleaning 

As I said, it would be great if Yellen were right and we could avoid another financial crisis - but I’m not going to bet on it. 

In fact, her predecessor, Ben Bernanke, was becoming a laughing stock among professional investors during his time in office, because everyone agreed that he made the best contrarian indicator they’d ever seen.

If Bernanke said there was no housing bubble, better take your money out of mortgage-backed securities immediately. If Bernanke said the economy was stable, better watch out below for falling rocks. 

If Yellen is anything like Bernanke, her uncommonly daring statement could mean that we are getting closer to another stock market crash and recession. 

US markets already look shaky. Even if the banks are okay, many other things could trigger a crisis. 

One thing that scares me is the increasing concentration of gains in a handful of technology stocks. Some of those companies are legitimate champions, but they can’t carry the whole market higher. Problems in any of them could easily make it drop, though. 

Then there’s the Fed with its fixation on raising rates despite slow growth, which could easily set off a deflationary recession. Not good for growth stocks or real estate. 

To reduce our exposure to this particular house of cards, I’ve been looking outside the US for new investment opportunities. 

In my Yield Shark income investing service, subscribers are holding… 

A European transport stock that should benefit from changing trade flows and pays close to 6% in dividends.

An emerging-markets fund that filters out the high-risk, high-volatility players and holds only stable stocks poised for steady growth.

A global natural resources fund that generates option income from commodity-producing stocks around the world. 

I also look for ways to stay in the US with reduced risk. You can do this by moving up the capital structure to own preferred stocks, as well as quality-screened dividend payers from defensive sectors.

Watch those dollars 

In an ideal world, we wouldn’t have to worry about unstable banks. We wouldn’t have to deconstruct central bankers’ statements. We might not even have central banks.

Instead, to paraphrase Don Rumsfeld, we must trade the markets we have, not the ones we wish we had. 

Hiding in cash, or gold, or whatever you think is a safe haven, is probably not the best move either. This is no time to put all your money on one horse, no matter how safe it looks.

Far better to find stable, income-producing assets that align with the macro trends. It’s more work, but pays off in time.

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*Patrick Watson is senior economic analyst at Mauldin Economics. This article is from a regular Mauldin Economics series called Connecting the Dots. It first appeared here and is used by interest.co.nz with permission.