Central Banks have a bond yield problem.
QT to the rescue? Or just wishful thinking?
“The problem with rising interest rates and bond yields: on a mark-to-market basis the major central banks are insolvent with balance sheet liabilities now exceeding their assets.”
Alasdair Macleod
In order to reduce inflation the Fed must tighten financial conditions . In addition to interest rates rises, the Fed can also implement QT. This simply means they will be reversing some of their QE, the massive asset purchases since 2010. As you can see from the chart below the S&P 500 has correlated closely with the Fed’s balance sheet. Don’t balance sheet adjustments work both ways?
“Since 2010, changes in the balance sheet explained nearly one-third of the move in the market’s multiple, and every 100-bp drop in the balance sheet could shave 29 bps off the S&P 500’s forward P/E.”
Gina Martin Adams
The Fed wants an alternative tool, in case interest rates push up bond yields too far, so tightening with QT, rather than interest rates, might be preferable. However, it’s not clear how fewer bond purchases will support bond prices and lower yields.
The deeper issue…
- Higher bond yields will increasingly challenge central bank solvency, which raises new issues. QE may boost inflation, so it has to stop, but QT could add to solvency problems by taking away the biggest buyer of bonds, which could also lead to higher yields. Catch 22. I’m not sure this has been thought through.
The key point…
- This could be a factor in how slow the Fed is in responding to high inflation. The risk is that the Fed does not have the “tools” to address inflation without resolving this solvency issue.
What Experience Shows Us…
However you do it, experience shows that you can’t tighten financial conditions without lower equities. The chart below shows that financial conditions are more or less the mirror image of the S&P 500.
“Furthermore, given that the last two tightening cycles have seen financial conditions tighten by +2.25-2.5% it would suggest we haven’t seen the low in stocks yet.”
Julian Brigden
Central Banks are now insolvent. More so if bond yields rise further.
“The hope is that they can raise the cost of credit marginally to bring demand back to non-inflationary levels and call a gradual halt to their bond purchases. However, it is all delusion.
Just by looking at the dollar, we can see how entrenched these pressures are today. Figure 1 shows the amount of currency and credit expansion (M3) which is yet to be reflected in the expansion of GDP.“
Alasdair Macleod
Most likely:
“the gap between M3 and GDP growth will be reduced by further price rises for GDP components ….. clearly, there is much more pressure on prices to rise from past currency debasement, and monetary policy is furiously denying it.“
Alasdair Macleod
Don’t confuse Fed’s hopes with the scale of the problem they have created
While the Fed hopes that this will be a smooth tightening cycle with minimum disturbance to markets and the economy, they are ignoring the scale of the stimulus they delivered and the distortions it created.
There are several components to the boom and now it looks like tightening financial conditions are coinciding with tightening fiscal conditions. That doesn’t unwind harmlessly because they want it to.
The fed now runs the risk of compounding the problem by not addressing it fully without delay. Remarkably, today it is still buying assets and still has not raised interest rates. The discretionary Fed even substantially increased its long dated purchases just last week.
Every day the Fed gets further behind.
Gold Still Favored Over Growth Stocks
Slowing growth and increasing inflation risks still favors gold over growth stocks.
Declining growth is about to intensify going into Q2 2022 and will deepen Quad 4 conditions.
Before the year started, I stated a preference for Gold Miners relative to Growth stocks like QQQ. So far this reallocation has produced a 25% outperformance in less than two months.
Nothing suggests it is time to change Quad 4 focus and allocations.
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