‘The bank is something more than men, I tell you. It’s the monster. Men made it, but they can’t control it.’
John Steinbeck, The Grapes of Wrath
Among all the champagne, parties and glamour at the World Economic Forum last week, there was a lot of gloom too.
In case you are not familiar with the World Economic Forum, every year, elites meet up in Davos, Switzerland to talk about the global economy.
The US–China trade war…social unrest…a global slowdown, they all dampened the mood.
But there was a lot of worry about central banks too. More specifically about what central banks are planning — or not planning — to do.
Elites are nervous at what could be lying ahead of us. We are worried too.
After the 2008 crisis, central banks flooded the economy with money and lowered interest rates to kickstart the economy. Now central banks are trying to normalize rates…but they could be running out of time.
The Fed has raised rates eight times since 2016. The European Central Bank (ECB), on the other hand, has kept rates stuck at 0 and the bank of Japan at negative levels.
Australia avoided 2008, but has kept interest rates at a record low of 1.5%.
Things could sour before they go through with their plan to normalize.
It is a two-part worry for investors
Yet, as we told you before, this is a two-part worry for investors.
There are low interest rates, but there is also the central bank’s balance sheet.
Central banks are holding onto a lot of debt, as you can see in the chart below.
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| Source: Yardeni Research |
The Fed has barely started the process of reducing their balance sheet. [openx slug=inpost]
What’s the danger? Bloomberg explains:
‘The Fed has never done a two-variable experiment at the same time as they’re tightening policy,” said Lisa Hornby, a U.S. fixed-income portfolio manager at Schroder Investment Management. “The market has been scared by the fact that it’s a reversal of the policies that have been happening for years that have helped all risk assets.”
‘As the balance-sheet unwind slowly drains liquidity from the financial system, some in the market are suggesting bank reserves are once again poised to become scarce, forcing banks to tap additional funding. Combined with a surge in Treasury-bill issuance — in and of itself partly driven by the government’s need to replace the Fed as a regular buyer — that’s helped push key money-market rates higher, especially in the market for repurchase agreements.
‘“Even though the Fed might be holding rates at 2.40 percent, the clearing rate for repo is much higher than that and I think that’s a result of this quantitative tightening and balance-sheet unwind,” said Bret Barker, a fixed-income portfolio manager at TCW Group in Los Angeles.’
No one really controls anything
Translation: This is an unprecedented central bank experiment. If QE and lower interest rates policies injected liquidity in the markets, and gave a push to asset prices, then the reversal could decrease liquidity and we could see asset prices plummet.
We are already seeing property prices falling around the world.
Investors are keeping an eye on the US Federal Reserve’s meeting this week. They are hoping the central bank will backtrack. That it will bail them out once again.
They are expecting slower — or even that they put a stop on — interest rate hikes…and for a slower balance sheet reduction.
They may get their wish. The Fed has already said they are prepared to be more patient…that they ‘wouldn’t hesitate to adjust the pace of the balance sheet reduction if it creates problems for markets’. This week’s message may be no different.
Have we seen the last rate hike from the Fed? Maybe. Maybe not.
But we think that there is a big debt problem here, which makes us more vulnerable for the future.
Banks may take a break, they may have even missed the chance to raise rates…but we will run out of time on this debt bomb at some point anyway.
Markets are trying to influence central banks…banks are trying to direct the economy…but at the end of the day, it’s all an illusion. No one really controls anything.
We may not be able to change the direction the wind is blowing, but we can control and revise our sails.
Best,
Selva Freigedo