The Tap Closes

The US equity market had a bad day last Friday, a bad week, a bad month, and a bad year too. If this continues, 2022 will be the worst year for US equities since 1974. As if that were not enough, it is also an terrible year for bonds. The bond market is on track for the worst result since 1920. So much for the neutral portfolio. The reason is as simple as it is sobering. The Federal Reserve, the system of US central banks, has been twisting its policies in a way that even Paul Volcker would have envied. The Fed is intent on both slowing the economy and removing liquidity from the financial system. Two hard knocks for financial markets. This is never a smooth process, but the current speed is remarkable. It is also the moment when the risk of financial accidents has rapidly increased.

According to the Fed futures market, there is now a 90 percent chance that the Fed’s policy rate will stand at 1.5 percent in June. This week, the Fed is likely to raise the policy rate by half a percent. There is now a 75 percent chance that the policy rate will be higher than 3 percent by the end of the year. At the beginning of this year, markets were still expecting a policy rate of 1 percent at the end of this year. The Fed wants to curb demand, create fewer jobs, reduce investment, and cool consumption. The US yield curve is now flat as a dime, indicating that the Fed will succeed. Although at the time of writing, the Fed has only raised interest rates once by a quarter, the announcements are already having an effect. Mortgage rates in the United States are above 5 percent, up from 3 percent at the beginning of the year. Naturally, this means that applications for new mortgages are falling and fewer houses are being sold. The Fed’s policy is also making the dollar strong against just about every currency, not good for US exporters. US purchasing managers see the outlook deteriorating. The Fed does not have to do the job alone. China’s lockdowns since March have slowed exports, production, consumption, investment, and the property market in that country. Combined, this is happening so fast that one might even wonder whether there is any growth left in China at all. When the second economy (the first based on purchasing power parity) does not do well, it also affects the world economy. Incidentally, the downturn in China hits Europe harder than the United States, and in Europe, the Fed is helped by the Russian invasion of Ukraine. This will almost certainly cause a severe recession on the European continent.

The Fed is also helped by the drying up of liquidity in the financial system. The Fed is about to undertake quantitative tightening but has actually already started to do so. It is also called sudden stealth quantitative tightening. The US government receives a lot of taxpayers’ money this time of year. That draws money out of the system, because the proceeds are not immediately spent. The Fed is also withdrawing money from the system via the repo market. So it is not so strange that investors sell shares and bonds. The big question is, of course, whether the policy so far has been sufficient to reverse inflation. We have probably seen the peak, but I fear that inflation will be more persistent this year and next than what markets and also the Fed currently assume. Rising energy and food prices are driving higher wages. Despite higher inflation, consumers continue to spend. Apparently, a recession or a sharp correction in the stock market is required to curb growing consumption. This reduces the likelihood of a soft landing. In addition, structural factors allow inflation to remain high. These include an ageing population, deglobalization, the costly energy transition, and the fact that China no longer wants to be the world’s deflation engine. Then there are also temporary factors that make for higher inflation. For example, wars are always inflationary. It also leads to higher oil prices and, because there are many days between the production and consumption of oil, all of that has to be pre-financed. With 100 million barrels a day, this amounts to many hundreds of billions, all of which disappear as liquidity. Problems in supply chains have also increased this year. In addition, the pendulum between labour and capital is swinging ever further in the direction of labour. Social media play a major role in this. Social media have already ensured that the approach to the corona crisis was much more robust than usual, that the sanctions against Russia were also much tougher than usual and that now the power of employees is also much stronger than usual. Trade unions are superfluous, a social media boycott is enough to ensure that workers get their way.

In almost every liquidity crisis of the past decades, accidents happen in the financial system. The cause is that debts are too high, but a financial crisis is never about solvency, it is about liquidity. In a liquidity crisis, suddenly existing debts can no longer be refinanced. It takes less to get to the Minsky moment. The difference with the liquidity crises of recent decades (e.g. the Mexico crisis, the burst of the Japanese double bubble, the dot-com bubble, the euro crisis, etc.) is that this time inflation is so high. Every previous crisis caused deflation, not inflation. That makes it difficult now for the Fed to lend a helping hand when things go wrong. Markets probably do not realise yet that the Fed-put is gone for now, or at least that the strike on that put option is a lot lower than where everyone thinks it is. On top of that, the strong dollar is not good for Europe, which will soon no longer be able to buy its energy in euros, but only in hard dollars that have to be earned first. This will probably mean that long-term interest rates will have to rise in Europe. Because Japan for the time being is sticking to a fixed ten-year interest rate (yield curve targeting), the yen is rapidly weakening, which is rapidly improving Japan’s competitive position compared to Europe, the United States, and even China. The only way to solve this is for long-term interest rates to rise in Japan as well. This means that the tap will be turned off not only in the United States but also in Europe and Japan. Now we have to find out which country, bank, or large company will be in trouble this time.