Central Banks On Tilt

June 17, 2022

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Central Banks are struggling with policy as their own insolvency continues to rise.

“There is no sign of a broader slowdown in the economy”
Jerome Powell, Chairman of the Federal Reserve

“POWELL IS PERPETUATING THE CRASH OF 2022”
Keith McCullough, Hedgeye

Last week the central banks displayed how far they are from resolving current challenges, and some made stunning inaccuracies in their assessments and statements.

Let’s start with the Fed

In particular, Powell’s statement of “no sign of broader slowdown in the economy” is simply absurd.

Q1 2022 GDP currently stands at -1.5%, from around 7% in Q4 2021. Furthermore, the Atlanta Fed GDPNow forecast for Q2 2022 is currently zero.

This means that GDP for the first 6 months of 2022 is running at a negative growth rate on current data, from 7% at the end of last year. Powell says there is no sign of a slowdown here:

This could hardly be a more consequential error. The Federal Reserve last week chose to accelerate its interest rate rises to 75bp, even though the US economy may already be in a recession!

Furthermore, the full statement and forecasts were consistent with the idea that the Fed is far from done in its tightening cycle. No FOMC member sees rates below 3% by year end and the terminal rate over the cycle is unlikely to be below 3.8%. In addition, the Fed would like to see several declines in the CPI before changing its stance and positive real interest rates accross all maturities, which with CPI currently at 8.6% is a very strong statement.

The Fed and Powell have famously changed their stance on a dime in the past. However, according to this statement, there is no Fed “put” on the stock market and unlikely to be one for some time.

In Europe the central banks were very active

The Swiss National Bank raised rates for the first time in several years and by a full 50bp, beating the European Central Bank (ECB) to the punch.

The ECB continues to struggle with its policy. Not only have bond yields been rising sharply this year with the explosion of European inflation, but they have a problem with “fragmentation” which is sharply rising Italian bond spreads relative to German bonds. It is supposed to be one currency after all, and so any wide differentiation between bond markets is the market’s way of introducing the possible break up of the European currency.

Italian bond yields have now risen above 4%, and spreads are widening.

So alarmed was the ECB that it convened an emergency meeting to address this “fragmentation.” The outcome was disappointing as all they could come up was a plan for a plan to resolve the issue.

This is a deep seated flaw in the Euro from the outset as described by Martin Armstrong:

“The ECB claimed that its commitment to the euro is its anti-fragmentation policy. They have said that this commitment “has no limits.”

The remaining question is whether any real concensus can be built on this. Do northern European countries really want to invest in other EU countries with much higher debt?

The ECB has still not started to raise interest rates and has a long way to go. It needs an answer urgently.

The Bank Of England raised 25bp

A smaller rate rise from the Bank of England (BOE) means there is still a long way to go. The BOE seems more concerned about the economic consequences, but this means that the tightening cycle will last for longer and have less impact in reducing inflation.

The Bank of Japan keeps government bonds detached from the swaps market

As discussed in my Weekly Insights few weeks ago, the Bank of Japan (BOJ) situation is also resisting higher bond yields. The Bank of Australia had adopted a similar approach but Australia’s attempts blew up several months ago. The BOJ has been committed to maintaining 10 year government bonds to a yield of 25bp, even though market swap rates have moved materially higher as you can see from the chart below.

At the end of the week the BOJ announced that despite the market distortions and the general trend to higher interest rates and bond yields, that their policy would continue as is. The BOJ is taking a radically different direction from other central banks. Time will tell as to whether they will be able to hold the line. The Yen reverted to its weaker trend on the announcement so their import costs are likely to continue to drive inflation higher.

The BOJ continues to massively increase its balance sheet, and so also the risk to its insolvency, as discussed below.

Central banks have losses on their bond portfolios at multiples of their capital

Central banks have another issue which is rarely discussed. Rising bonds yields are increasing their insolvency.

Since 2008 the size of their balance sheets has exploded as never before as central banks bought assets, mainly bonds at very low interest rates. Now exploding bond yields raise new challenges for the central banks as they have massive losses on their purchases. The ECB has losses that are around 11 times their capital according to Goldmoney.

Rising bond yields create new problems for central banks. They are already insolvent and bond yields keep rising so this insolvency continues to rise. Investors have not thought through this problem sufficiently as any failure by any central bank would expose the whole system.

Summary

Central bank policy has continued to grow in its scale and impact over recent decades. While the effectiveness of their actions is an open question they are so consequential for the markets that they have become a central factor in investment strategy.

Central banks are supposed to be able to backstop the monetary system, and specifically the banking system. The credibility and productivity of the whole system depends crucially on their ability to act effectively.

What we saw this week was a range of reactions from the central banks and very little concensus. Global growth continues to decline, but central banks remain stung by the overshoot in inflation and so are conflicted in their decision process. The US is taking the toughest stance but their statements seem to misrepresent the state of the economy.

Central banks remain deeply reactive in the focus and the timing of their actions. This runs the risk of central banks being a destabilzing influence as they can end up reinforcing the cycle. The Fed is currently accelerating a growth downturn they say does not exist.

Central Banks are behaving increasingly erratically and face a range of problems they are struggling to resolve. The core problem is one of excessive debt and weak growth, that has continued to develop over recent decades. Now they also have to face the consequences of the extreme and experimental additional policies introduced to resolve the core failure of their growth policies.

Investors now face a range of issues they may not have been prepared for. The realization that much of the prior growth was temporarily manufactured and the ability of policy to maintain, let alone perpetuate, the prior growth is now highly compromized.

Investors need to adjust quickly in increasingly unstable conditions. This means ensuring that investment strategies are well designed for the new environment.

Best Investor standards are robust and durable through any conditions, and introducing options trading has been extremely valuable in the current environment.

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