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2022 was an exceptional year for investors. Indeed, never in post-WWII history have we witnessed a joint fall across equity and fixed income sectors of that magnitude. In USD terms, the Bloomberg US Treasury Total Return index retraced by 12.46%. The S&P 500 equity index closed 2022 at -19.44% while the rate–sensitive Nasdaq index was down 33.1%. We have to go back to 1994 to witness a similar outcome. However, back then, both negative calendar year performances were quite shallow: -3.38% on US Treasuries and -1.54% on the S&P 500. Hardly worth a mention, as at the start of that unexpected FED hiking cycle, 10-year Treasury rates sat around 5.75% rising towards 8% by the end of 1994. Carry buffered the sell-off. A buffer that was non-existent in early 2022. Across Europe, a similar harsh dual reset was experienced. So, was 2022 a true outlier? An outlier that will go down in history unrepeated, or can we expect other instances? To answer this question, we will need to look at one of the root causes that made such a special market correction possible.
Clearly, the outlier event is commensurate with the 2009-2023 intensity of FED’s quantitative easing and the short-lived but outsized COVID-19 fiscal stimulus impulse. Might the length of the QE distortion become proportional to the potential fallout as QE is unwound over the years to come? The Federal Reserve (FED) Balance Sheet as a % of GDP topped at 37.4% the moment financial markets peaked in December 2021. Before the GFC (Great Financial Crisis of 2008), the ratio of US central bank liabilities to GDP fluctuated in a 4% to 6% range. In those days, the FED was able to balance stable and positive real economic growth with inflation fluctuating between 2% and 4%. Conventional interest rate policy adjustments were implemented the moment unemployment deviated from the longer-term 5% to 6% level. That regime was thrown out of the window at the end of 2008. The FED bailed out the banking system, pushing through aggressive large-scale asset purchase programmes. This unprecedented unconventional QE policy led to hypergrowth in base money supply, reappearing as excess bank reserves. The term structure of rates collapsed to the downside. Policy rates got anchored at the zero-bound.
The FED paid 0% on these excess reserves (except during the mini hiking cycle over 2018). It was a loud call for yield–seeking investors to wander up the risk curve. Initially, pension funds, banking institutions, fund managers, and insurance companies invested with zeal, under the narrative of improved diversification or statistical decorrelation benefits, into liquid instruments. However, as QE kept going, dubbed back then as eternal QE, many of the above institutional investors poured money into less liquid investment alternatives.
2022 was a rude awakening. Over Q3 2022, a mini-UK pension fund crisis unfolded as the illiquid growth component that many pension funds held onto faced forced liquidation. Effectively, in order to respond to collateral calls on bleeding interest rate swap hedges given uncontrolled spikes in long-term rates; the BoE had to step in. A well-directed QE injection was able to stabilise the pension fund rout. Over H1 2023, the mini-US banking crisis is making more victims than expected. Over the weekend, First Republic Bank went into resolution. Loans and deposits will find a new home at JP Morgan. FRB equity and corporate debt are not part of the rescue and should be written down. The US regional banking stress is another manifestation of the impact of shrinking bank reserves. Such events will lead investors and deposit holders to switch into safe, segregated money market funds. But the genie is out of the bottle: solvent money centre banks will be less willing to fund regional banks across interbanking markets. Questions are raised, and distrust is rearing its ugly head. This process might put pressure on funding costs as medium-sized banks might hesitate to tap the Bank Term Funding Programme. Stigma fear is back. We repeat the question: “Can or should central banks go all the way and contract money supply further in a ‘Volcker fashion’?” It seems that central banks already walk a thin line, and few sound options are left. Financial markets will respond with their feet as they deem central banks want to keep too many plates spinning in the air. Genuine risk aversion has not re-entered. Yet, the most effective way to solve inflation is a financial panic. A genuine deflationary bust will bring inflation and inflation expectations towards target in a highly efficient fashion. Bringing FED policy rates to 5%-5.25% will impact inflation very slowly.
Remember that before QE, the FED managed rates by changing the quantity of reserves in the system. By reducing the available supply of reserves, the FED was able to push up their price, i.e. increase Fed Fund policy rates. Currently, given ample excess reserves, small changes in supply don’t have any effect on Fed fund rates. The FED steers the Fed Fund rate and short-term rates by varying the interest rate it pays banks on their reserves. IOER (interest on excess reserves) sits at 4.9%. At the current pace of balance sheet runoff (non-reinvestment of principal assets and coupons), equivalent to $1.1 trillion per year, returning to pre-COVID levels would take about four years. Returning to pre-GFC times when the FED balance sheet stood below $1 trillion seems a mirage. The base case is that central banks will keep on ‘subsidising’ banks through IOER and leave some banking institutions to live on borrowed time. The moment a bank’s asset base is too concentrated, exposed to illiquid (questionable) commercial real estate, off-balance sheet risks with non-linear trade-offs or engaged in aggressive ALM strategies, bank runs might be around the corner. Bank runs are supposed to be a rare phenomenon. It remains surprising, considering the severe lift in regulatory scrutiny over the past decade.
The imbalance that has been created between financial quantities and real economic quantities has grown out of proportion. From such a standpoint, the fight against inflation by central banks could be thought of as being of secondary importance. It can be thought of that the primary objective of current hiking cycles is to restore the credibility of monetary authorities. The protection of the store of value across respective currencies, be it the USD as the global leading reserve currency or the EUR taking second spot, is at stake. Currency stability goes hand in hand with stable inflation. The moment investors lose faith in a currency,
We reiterate the importance of capturing the dominant signal: how robust are governments and corporates in dealing with less liquidity in the financial system? How well are they prepared to survive under persistent tight financial conditions? Yet, market participants are in continuous search for explanatory simple frameworks that are essentially short-term in nature. Everyone holds onto heuristics, short-cuts, explaining simplified economic relationships between macro aggregates such as inflation, growth and, or unemployment, whilst focus should go towards resilience by economic agents to the current changing monetary policy regime.
Does the next inflation print or unemployment print really matter? Assessing to what extent valuations across public and private assets have adapted to higher long-term discount rates should be central to the investment debate. Effectively, a 1% increase in FED policy rates has a minor downside impact on core PCE inflation, i.e. a mere 15bp with legs far longer than a year. Similarly, a rise of 1% in the unemployment rate might only reduce core inflation by 35bp over the year that follows such an observation. Rising policy rates trickle down to higher unemployment in baby steps.
At the other end of the spectrum, a widening of 100bp on BBB credit spreads will slow down core inflation by about 50bp over an 18-month horizon. Financial market stress has a more direct and efficient impact on pushing inflation lower. So the jury is out. With policy rates nearing terminal levels, can economic agents adapt, or will we run into trouble? It looks as if the ‘winner takes all investment environment’ prevents further market corrections. About five global companies (Apple, Amazon, Meta, Microsoft and NVIDIA) in the S&P 500 generated about two-thirds of the 8.6% YTD index performance. Stellar. In the meantime, excess bank reserves keep on shrinking… what will be the next sector that will run into problems?
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