Panic among central bankers

A central banker who turns from shrinking their balance sheet to unlimited government bond buying in a week is panicking. The moment central bankers panic, the market doesn’t have to. It means that a turn in monetary policy is rapidly approaching. Now Britain, for that is what this is about, is an island, but the cause of the interim intervention is universal and has to do with shrinking liquidity. The moment liquidity declines, the likelihood of financial mishaps increases. We are now in the danger zone. The peak in liquidity was reached in March last year, and since then all kinds of risky assets have been falling in value. This will not stop until monetary policy (read interest rates) pivots. For that to happen, inflation has to fall markedly, and/or there has to be a major financial crash. For the British, the fall of the sterling, the sharp rise in interest rates, but especially the problems at UK pension funds prompted the Bank of England to intervene. LDI is already seen as the new subprime and if these risks spill over to the continent, we will be in for a treat. Yet the problems in Britain are insufficient to change the Fed’s mind. In fact, the ECB is already at the same level as the BoE. Both banks are raising interest rates and engaging in quantitative easing at the same time. The BoE for pension funds and the ECB for Italy, in both cases because of excessive use of leverage.

Meanwhile, Prime Minister Truss gets the blame, but that is not justified. Actually, it is the greed of the risk managers who cleverly exploited the aversion to career risk among pension fund managers. Economics is about financial incentives, and with a risk manager who is simultaneously selling a product, it is rather thick on the ground. Truss is as unconventional as Thatcher and, as with Thatcher, the supply-side focus is unlikely to lead to the desired long-term effect. In the short term, though, the measures might benefit Truss. With the cap on energy bills, there will no longer be a family in the UK that worries about energy bills. That is different in continental Europe. Taxes are being cut, albeit mainly for the rich, but the aim is for the final tax revenue to go up. That is quite possible if lower taxes and the abolition of the bonus ceiling prompt bankers to return to London (and pay taxes there). Moreover, Truss is going to make Keynesian investments with borrowed money. At the moment, voters only feel the benefits of that and much less the drawbacks. There is a chance that next year the UK will be seen as the example of the country that managed to break out of stagflation. On the European continent, they want to impose an additional tax on energy companies, a way to push up the price of energy further. Next week they will talk about further measures, but it will not be easy to get all European countries to agree, and half-hearted solutions will not win politicians’ elections. Truss possibly will if her popularity rises next year thanks to recent measures. Then there will be a temptation in other countries to copy Truss’ policies like Thatcher’s and with that, the modern monetary theory will be back in full force.

October is the traditional month for a stock market crash, only such a crash usually follows a previously excellent investment year. That is not the case this time. For many investors, 2022 is the worst investment year ever. For European investors who also did not hedge the dollar, it is not too bad. It is mainly because of the carnage in the bond market. One advantage of the rapid rise in interest rates, however, is that serious alternatives to equities can be found increasingly within bonds as well. With it becoming increasingly clear that inflation has peaked in the United States and looks hard to beat, the likelihood of inflation coming in below market expectations is rapidly increasing. This does not mean that inflation will not remain structurally high over the next decade, but there are wave movements in the interim, if only because of base effects. Those base effects are already improving significantly for the world from next February. That will clearly improve the mood of central bankers. With markets taking a more realistic view of the likelihood of recession (probably still overestimated in the case of the US) and also with fears of stubborn inflation well underway, there is less risk as a result. The biggest risk now is not further rising interest rates, but the impact of inflation and the cooling economy on corporate earnings. Earnings expectations have already come off by around 4 per cent and it is possible that the market is also already counting on further declines in earnings expectations, after all, we are looking ahead to the most predicted recession ever. There will be another benchmark moment soon when the third-quarter results are released.