A War on Two Fronts
The old adage says: “The Fed will continue to hike until it breaks something”.
Most of this sentence has already become a reality. The first major casualty of the central banks’ rapid hike cycle is the regional banking system in the US.
But, after a week of rate hikes on both sides of the Atlantic, central banks have shown that they are willing to continue to hike rates, even after something has clearly been broken, and while there’s no assurance that the storm is over.
SVB and Signature, two arguably big players in the US regional banking space, are consigned to the regulator, and history, while First Republic is being kept alive by its bigger rivals, in a bid to stave off contagion. Credit Suisse, one of Switzerland’s two biggest institutions, standing for 166 years also collapsed. Deutsche Bank, which at this point suffers more because of its tarnished history than because of its present position, is also in peril.
Since SVB’s collapse, roughly $120bn in cash has been pulled from the American regional banking system. About half of that money went to bigger systemic banks and the other half to money market funds which experienced the biggest month of inflows since the Covid-19 crisis. Fractional reserve banking, the system by which a bank keeps only a fraction of deposits available for withdrawal, makes banking a Trust business. If trust is eroded, no bank can stand.
Yet, despite the noise of banks breaking, central bankers have opted once again to flag their inflation-fighting credentials.
This time around, instead of treating inflation as transitory, they chose to treat financial instability as such. Central banks across the board used the same page from the playbook: “The financial system is strong, and we have the (non-interest rate) tools to fight instability if it needs to be”.
To be sure, they have reiterated their “Put”, i.e. their commitment to print money and throw it into the general direction of trouble. But most importantly, they reminded investors that rates will remain high as long as inflation remains a problem.
When all is said and done, however, we have entered (in the US) the area of 5% interest rates. This is the area where most financial accidents happen. From 1994 to 2000, when the Fed consistently kept rates in that range, no less than four major accidents occurred: The Mexican Bond Crisis, The Asian Crisis, the Long Term Capital Management Crisis and finally the Dot.Com Bubble.
A “War on Two Fronts”, with a primary focus on inflation, seems like a big risk.
It has, however, become a necessity. Their 2021 predictions that inflation is transitory weren’t panning out even before the war in Ukraine made everything much worse. The Fed performed a U-turn and focused singularly on inflation fighting, producing the sharpest rate hike in over forty years. To turn around once again to feed markets with cheap money, while inflation is triple the level it would be comfortable with could be construed as an admission of failure, detrimental to its prime mandate and independence.
But most importantly, it would be detrimental towards their ability to influence markets. The ‘secret’ of central bankers, is that their biggest weapon is signalling. If they signal many future rate hikes, they might as well do less. Market forces, which always act in an anticipatory way, will do the much of tightening for them. If they signal more cheap money on the way, investors can relax and invest, flushing the markets with cash themselves.
Many investors believe that central banks could have reversed course and paused rate hikes. If central banks' intentions aren’t believed, however, the ability to signal could be lost. That could mean more money printed during crises and sharper rate hikes in times of inflation. God forbid a time when both are needed at the same time.
Could central banks have paused for a couple of months, and hike later if necessary? Yes. But markets would have probably taken the pause as a preamble to rate cuts (which they are already pricing in), and hiking could have been even more difficult.
Pundits may easily cry “policy error”, and could even claim they are right if the next thing breaks. Right and wrong is a game of publicity, however. Real policymakers with great responsibility in their hands, increasingly find themselves with few, if any, good options.
A War on Two Fronts, inflation and financial stability, is not a choice for central banks. The fact that things have come to that is telling of the problems that we are faced with:
The end of the great moderation
The shifting geopolitical landscape that is upsetting established supply chains
The return of secular inflation over 2%
The high levels of global debt
The chronic absence of strong fiscal policies to sustain growth
Poor demographics and low productivity plaguing developed market growth
The consequence of past political decisions made during an environment where it was assumed that low macroeconomic volatility and cheap money would last forever
Central banks are powerful, to be sure, but they are not omnipotent. They can support growth for a long time, but they can’t conjure it out of thin air. They can’t fix productivity problems, global warming, zero-sum worldviews or social acrimony. They can simply regulate the flow of money and be the lender of the last resort, not without constraints. Since the GFC, governments have left a lot of the economy running to central bankers. The signal for long-term investors should not be the central bankers’ pivot towards an easier money regime. It should rather be when governments decide to work closely with them to produce much more robust economic planning.
For the moment risks are elevated. Central banks could have chosen to capitulate to market demands and lowered them for now, but jeopardise their ability to be effective in the future. As we said, no easy choices here.
This is an inherently volatile environment and could remain so for a long time. Investors should make sure that their portfolios, and themselves, are well-positioned for volatility. A world where problems can’t simply be fixed with Quantitative Easing is one many might have forgotten. But, for all its volatility, it is in this world where bond yields are high enough to give returns to defensive assets and value to diversified portfolios. It is in this world that yield curves will eventually become steep enough to re-incentivise lending. It is in this world where active management and trusted advisers can add a lot of value to long-term planning.