I have been waiting for this moment for a while. I have long held the belief that the Central Banks will eventually lose control of the long end. But over the past couple of years it seemed like I was the only one who ever worried about it. Even though Central Banks around the world were shovelling heaps of liquidity into the economy, the markets became convinced that monetary theory no longer applied, and that any injections were accompanied by a decline in the velocity of money.
This massive decline in the velocity of money has masked the effects of all the Central Banks “printing.” If liquidity is pumped into the system, yet it sits inert on the balance sheets of the banking system and is not lent out, then the “printing” does nothing more than drive down the risk free short rate.
Ever since the 2008 credit crisis, the banks have been loath to lend out the excess liquidity. There are many reasons for this reluctance, but I believe the increased capital requirements due to the changes in rules, which were in response to the asinine bank behaviour during the previous boom, is to blame. Here is a quote from a Bloomberg story that captures this sentiment:
Jamie Dimon, grappling with multibillion-dollar legal costs and rising capital requirements at JPMorgan Chase & Co., lashed out at U.S. regulators for putting his bank “under assault.”
“We have five or six regulators or people coming after us on every different issue,” Dimon, 58, said today on a call with reporters after New York-based JPMorgan reported fourth-quarter results. “It’s a hard thing to deal with.”
Now maybe you are saying to yourself they should be under assault. The banks did some pretty stupid stuff during the last boom. I contend that as traders it doesn’t matter one iota if we think this is an appropriate response or not. Our job is not to figure out what should be but instead to focus on what is. And then can be no denying that for whatever reason, the banks did not lend out the money the Fed “printed” and therefore the velocity of money collapsed.
But this collapse in the velocity of money has resulted in an unprecedented Central Bank balance sheet expansion.
Since the start of the first QE program, the Federal Reserve has increased their balance sheet approximately five fold.
This reluctance to lend out the bank reserves has caused the monetary expansion to be much larger than would have otherwise have been the case. Instead of one QE program, we had three. For the Europeans, instead of a zero rate, they pushed rates into negative territory. Global Central Banks everywhere have been pumping like mad, desperately trying to offset the collapse in monetary velocity.
But this massive balance sheet expansion is not without risk. Although markets have become convinced that Central Bank balance sheet expansion is impotent, I take the other side of that trade. I have never once believed that Central Banks cannot create inflation. I acknowledge it is made more difficult when the reserves sit on the banking system balance sheet, but given a determined Central Bank, inflation is almost a surety. The Fed can just keep printing money until their expansion outweighs the decline in the monetary velocity. The only question is how much is required. But theoretically there is no constraint to the Fed’s expansion, so as long as the Federal Reserve is committed, they can cause inflation.
Now we have a situation where these previously inert bank reserves are actually being lent out. Although it hasn’t shown up yet, rest assured the velocity of money is increasing. This is causing the bond market to decline.
A lot of market pundits are claiming this backup in long rates is a failure of both the Fed and ECB’s QE program. Nothing could be further from the truth. This is exactly what would be expected in an economy that has been goosed this hard. QE programs are inflationary. You would expect the curve to steepen. The anomaly is not today’s market action, but the insane bond rally of the past year or two.
The blow off top
The bubble has been in the bond market. This in turn has created bubbles in most other assets, but the driving factor has been the global collapse in risk free yields.
When the German 10 year bund hit 0.05% that was the obscene number. Think about it like the blow off top in gold during the early 1980s. At that time, the market was convinced that Volcker would never be able to tame inflation. He was busy cranking rates, but the market initially ignored his efforts.
Volcker kept increasing the Fed Funds rate until he broke inflation. It was tough, and for a while, the market did not believe it could be done. But eventually monetary theory kicked in. Volcker was far from powerless, it just took a while for his prescription to take effect.
The same deal applies to today’s market. Monetary expansion has not stopped working, it simply needs the same strength of will from the various Central Banks. If they are determined to create inflation, they can create inflation. Full stop. I don’t buy for one second they are helpless in this regard.
The total disbelief the ECB could create inflation was the blow off top in global fixed income with the German bund hitting 0.05%. It was the $800 gold moment.
I have said a hundred times, but I will repeat it again – we are going to look back to this period and laugh at the idea the Central Banks were powerless to create inflation.
It’s a global fixed income bear market
At the end of April I speculated that we were about to enter a global bond bear market (“Apr 30/15 – The coming global bond bear market”). But even I didn’t expect the violence of this move. This has been ugly. The selling has been relentless. Any uptick has been simply another chance to get short.
I would have thought the bond market would have bounced by now, but there has been barely a pause in the decline. There is now no denying we have entered a global bond market.
Although we have declined a long way, the key will be to remember how stretched we are to upside on a long term chart.
Don’t try to buy dips because it has gone too far too fast. We are probably going to get a bounce sometime in the coming days, but that rally will just be a chance to reload on the short side.
Remember the lower price is not the wrong one. Buying fixed income at these dumb prices will prove just as ill fated as the gold buyers who paid $800 and took 25 years to break even on a nominal basis.
Thanks for reading,