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In 2019, global central banks did a complete 180 degree turn with their monetary policies. After a half-hearted attempt to normalise interest rates during 2018 failed miserably, the total assets of the Federal Reserve, European Central Bank, Bank of Japan and People’s Bank of China climbed back to $19.9 trillion by December of 2019 –very close to their 2017 highs.

If you squint your eyes, you can see the feigned attempt to normalize monetary policy in the chart titled Total Assets of Major Central Banks. Yet, just this marginal move caused panic in markets. Chairs Yellen and Powell described the Fed’s Quantitative Tightening (QT) program as something that would be running in the background and as boring to the markets as watching paint dry. However, it turned out to be the catalyst for a freeze in the junk-bond markets and a stock melt-down by the end of 2018. On December 19, 2018, the Fed implemented its fourth rate hike of the year, increasing the Fed Funds Rate by 0.25% from 2.25% to 2.5%, and signalled two additional rises in 2019 were in store. 

At that point, Powell assured that the Fed balance sheet runoff was on ”autopilot.””We thought carefully about how to normalise policy and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy to adjust to incoming data. I think that has been a good decision. I think that the runoff of the balance sheet has been smooth and has served its purpose and I don’t see us changing that.”

But the Fed’s “autopilot system” had a software glitch so dangerous that it would have made Boeing notice--because it almost immediately led the market to nose-dive. That week, the Dow Jones Industrial Average (DJIA) recorded its biggest weekly loss in more than a decade, and, on December 24, the S&P 500 entered bear market territory on an intraday basis. As a result, both indexes finished the year with the largest annual losses since 2008. The Fed’s autopilot system was quickly turned back to manual, but not before creating significant dislocations in the market. On March 20, 2019, the Fed announced that the paint had started to peel and was intent on soon ending its QT program. 


Four months later, on July 31, the Fed announced its first interest rate cut since December 2008 from 2.5% to 2.25%. The reduction of interest rates was billed not so much as a rate-reduction cycle but as a “mid-cycle adjustment.” After adding almost $3.60 trillion in assets to its Balance Sheet in the wake of the Great Recession, in an act self-described as a “profile in courage,” the Fed was only able to unwind a cowardly $0.75 trillion. Leading one to conclude no one at the Fed had the real courage to normalise. 

But the damage was already done. The Fed’s unprecedented destruction of $100’s of billions in base money supply left banks with a shortage of reserves. The QT process took excess reserves down from $2.2T, to $1.4T. That may still sound like a lot of liquidity, but given the demand for US dollars and the bias on the part of banks to hoard cash, it is not nearly enough. In any case, the Fed’s prediction that its QT program would be a harmless and boring exercise goes down as another stark illustration of the utterly opaque condition of its crystal ball.  

The trouble in money-market land began on September 17 of 2019, when the repo rate rose above 10% for certain loans, as banks refused to lend money--choosing instead to hold on to their cash. The Repo market consists of overnight secured lending between banks and is influenced by the Fed Funds Rate (FFR). The Effective Fed Funds Rate (the actual rate banks get access to unsecured loans) spiked well above the high-end of the Feds target. 


By October 15 of 2019, the Federal Reserve realised this was not a transitory problem and began buying short-term Treasury debt at an initial pace of $60 billion a month. Chair Powell has assured markets its purchases of short-term Treasury bills would continue into the second quarter of 2020. But just don’t call it QE: Fed officials contend these purchases are nothing like the bond-buying stimulus campaigns employed by the central bank between 2008 and 2014. The basic mechanics of this ”non-QE” are exactly like QE’s 1, 2 & 3. The Fed is expanding its balance sheet and buying bonds for the purpose of providing liquidity for the banking system. This means certain financial organisations out there are seriously hurting for cash. Otherwise, they would never have needed to pay 8% over the current borrowing rates targeted by the Fed. 

The truth is there is an acute dollar shortage that has formed, which was caused by the drainage of liquidity from the Fed’s QT program. The fragility of the Repo market is especially concerning given its attenuation following the credit crisis a decade ago. Banks are simply required to hold more reserves now than before 2008, and around $750 billion of those reserves were taken away and burned due to QT.

Therefore, the good news is this current crisis is not yet similar to 2008, where distressed assets were being hypothecated by insolvent entities—at least not at this point. The bad news is, what we have now is a liquidity crisis so acute that solvent financial institutions were having to exchange high-quality assets for overnight loans at double-digit interest rates. Just imagine how ugly things will get in the Repo market once those assets become impaired, and the borrowing institutions become insolvent during the next recession. 


For those that still doubt the fragility of markets and the economy, just remember the complete shutdown of the junk bond market and plunge in asset prices that occurred at the end of 2018—the Russell 2000 lost 25% of its value from September to the end of the year. Wise investors will understand that the current economic construct clings tenuously to the misplaced hope that central banks can keep the paper-thin skin on these asset bubbles from bursting.

Investors are now dealing with a protracted earnings recession, anaemic global growth, dysfunctional money markets, an inverted yield curve, a virus that has taken the Chinese economy offline, a massively overvalued equity market, a debt-saturated global economy and governments that are without sufficient fiscal and monetary room to help. This illustrates clearly the tenuous nature of the bond bubble and that it will someday implode like a supernova---sending yields skyrocketing on a long-term basis. However, it most likely does not yet mark the start of the epoch debt bubble debacle that is in store. We will need a surge of inflation expectations or the credit markets to shut down for that to occur. Nevertheless, we are moving closer to that eventuality every day. 


Global Central Banks must stop their gross manipulation of sovereign debt yields and allow interest rates to rise from the current insane levels. Having $15 trillion worth of negative-yielding sovereign debt around the globe is unprecedented and extremely dangerous. We must let real estate prices fall to a level that allows first-time home buyers the ability to handle a 20% down payment and to service the mortgage. Stock prices should never be 1.6 times the size of the underlying economy, as they are today. The normal level for this ratio is 0.8. The government should also seek to cease propping up the financialisation of the economy, which is the primary destroyer of the middle class. Debt must be restructured instead of inflated away. Then, after this great reset, we can finally have a long period of viable prosperity for all. The question is, do we have the courage to take the pain necessary to achieve that goal? The economic chaos is coming anyway; the sooner it occurs, the less painful it will be.   EG

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