Truth or Lies
Updated: Jan 16
This article was written by Richard Horswill. All views and opinions are strictly his own.
Central bank policies continue to be under the spotlight as their initial transitory call on inflation has been brought into question. As the global pandemic has persisted far longer than originally anticipated, disrupting supply chains, particularly in zero COVID policy jurisdictions (China), pressure has been brought to bear on central banks to tackle the sticky inflation that is driving concerns over living standards. Political interventions in monetary policy are not unheard of and with the US mid term elections in November 2022, policy makers are fearful the the current inflation will be blamed on the incumbent party. The Democrats under Biden are seemingly pressurising the Fed Chair to act more swiftly than the originally intended dovish path predicted, and the most recent CPI numbers have clearly lit a fire in political circles – and thus a more hawkish policy mantra has emerged, more than likely driven by political fears. However, could this be the makings of a policy error that is likely to impact the market in the way of suppressing demand and thus sending the global markets into a tailspin as new dollar creation through bank lending is curtailed, potentially creating the circumstances that may lead to a recession. Perhaps the yield curve can provide us with some possible answers.
The yield curve represents a line that plots interest rate yields which have equal credit quality but different maturity dates. The ideal slope of the curve should be upwards, reflecting the rationale that longer maturity yields are higher which is indicative of positive economic growth. Thus, growth and inflation expectations into the future are reflecting positive the monetary expansion that provides the financial lubrication that markets need in order to expand and thrive.
Considering the current shape of the US treasury yield curve, one can see that there has been a compression of yields, showing a flattening pattern over the entirety of the curve which might well be perceived as a worrying trend that has been with us for some time now; suggesting that investors are not entirely satisfied that the global economy is on a sustainable path. Historically, this has been reflected by an inversion in the curve resulting in future rates dipping below nearer term rates and as a leading indicator, this generally predicts economies moving into recessionary periods. The real question here is which market is telling the truth: equities – although valuations have fallen back recently – have been on a historic tear and will continue on that path regardless of the Fed tightening cycle, or the bond market, which indicates that possible trouble is ahead. Of course, the Federal Reserve has been suggesting through the policy of forward guidance that rate increases are now absolutely necessary in order to contain the inflation risks which has pressurised equity markets; however, bearing in mind that current inflation has been driven by supply chain disruption, should the Fed really be tinkering with monetary policy when the problem isn’t really a monetary one? It seems that they have no real bearing on the current trajectory of inflation.
Many will argue that the Federal Reserve’s policies have been instrumental in exacerbating inflationary trends in the form of quantitative easing which many believe is “money printing.” This of course is not true, although the mere suggestion that the policy is inflationary has helped central banks in periods of low inflation to use an element of psychology against investors who may be sitting on cash, fearful of monetary devaluation. To clarify my interpretation of QE, the process is merely an asset swap which provides the intention of the central bank to attempt to suppress interest rates whilst providing the institutions that have sold their bonds with a different form of collateral which can be used to provide for new commercial lending. At no point can the reserves be used to purchase other assets such as bonds, equities, commodities or real estate. The only way monetary creation can occur is through new commercial bank lending. Governments of course can provide temporary fiscal stimulus by borrowing to provide immediate financial gratification, as occurred during the pandemic. This merely pulls forward future demand to the present which then has to be repaid in the future adding further to the overall burden of debt.
Moving forward, expectations surrounding interest rate increases, QE taper and balance sheet reductions are high, which creates the real possibility of providing for yet another liquidation moment in the stock market. If this moment occurs and a correction of, let’s say, 30% across broad equity markets happens how will the Federal Reserve react? The Powell pivot has been seen previously so the likely course of events is that a rear guard action will be the response, reversing the supposed interest rate increases and reverting to type in the renewal of QE assisting equities to recover as the playbook has previously shown. This specific action would crush any credibility that the Federal Reserve might have had particularly when they have set a course to fight inflation. The current speculative activity in the bond market will be equally as devastating, as the speculative short bond sellers who have forced rates up across the curve in anticipation of the hawkish Fed moves will be forced to liquidate, sending yields crashing down as the safe haven trade will be to be long bonds. Gold and cryptos will also be significant beneficiaries, along with the overall commodity complex. Supply chain inflation may well persist but as global markets normalise as the pandemic becomes endemic, the disinflationary and ultimately deflationary trends will again likely dominate providing for the Japanification of the global economy. This was the course we were on before the pandemic and is the likely course following the viral diversion.
Politics and monetary policy are not a good mix. The independence of the institutions should be maintained at all times, but I fear that due to the undue influence from the political hacks, the creation of the conditions for the biggest bubble in history to at least deflate temporarily or at worst pop are very much on the horizon. The macro trade can be a slow and laborious timeline, but as Ernest Hemingway was supposed to have commented, bankruptcy was gradual then all of a sudden. The following weeks will be fascinating as we move towards the Federal Reserve March meeting. As we hopefully leave one crisis, the next may be just a hair’s breadth away as the yield curve is telling us a likely truth and a policy error could be imminent.