by Alasdair Macleod, GoldMoney:
A recent Bank for International Settlements paper warning of unappreciated risks in foreign exchange markets echoes my earlier warning in an article for Goldmoney published over a month ago describing derivative risks in FX markets.[i]
In this article I also show evidence that banks in both the US and Eurozone are reducing the deposit side of their balance sheets by turning away big deposits which are ending up in central bank reverse repos, parking unwanted liquidity out of public circulation. The great unwind is well under way.
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Credit contraction is not only driving a bear market in financial assets, but the exposure to malinvestments by rising interest rates is having negative consequences for the non-financial economy as well. Private equity, which has thrived on cheap finance used to leverage targeted businesses, is showing signs of unwinding with two major Blackrock funds suspending redemptions.
As we approach the season for year-end window dressing, we must hope that the volatility in thin markets that often accompanies it does not destabilise global financial markets.
Inflation and stagnation
Make no mistake: interest rates have bottomed at the zero bound and can go no lower. The forty-year trend of declining interest rates has ended, with an initial rally, which six weeks ago had halved the value of the 30-year US Treasury bond. The suddenness of this change probably needed a pause, and that is what we have today. Since October, there has been a spectacular recovery in bond prices with this UST bond yield dropping ¾% to 3.5%.
Fears of price inflation have been replaced in large measure by fear of recession. Having dismissed monetarism, bizarrely for a Keynesian led establishment analysts and commentators are now frequently citing the slowing of monetary growth as evidence of a looming recession. Perhaps this means that the failure of their economic models has them grasping at straws, rather than being evidence of a conversion to monetarism. But what is definitely not in the Keynesians’ playbook is a combination of inflation and recession, commonly attributed to an unexplained phenomenon of stagflation.
A moment’s thought explains the coincidence of the two. Inflation of total credit (both by central banks and commercial banks) transfers wealth from private sector actors to the State, its licenced banks, and their favoured borrowers. It acts as a suffocating hidden tax on economic progress, impoverishing ordinary people, and through their desire to protect themselves from credit debasement, driving otherwise productive capital resources into “safe havens”, such as physical property and financial speculation. There comes a point where the stimulative effects of credit expansion, which is a device to trick markets into thinking that things are better than they really are, becomes outright destructive.
If it was otherwise, currency debasement would work even history plainly shows it to be a destructive, failed policy. And in extremis, nations as diverse as 1920s Germany and today’s Zimbabwe would have been roaring successes from an economic point of view with their nominal GDP soaring off the scale. By way of contrast, post-WW2 Germany and Japan adopted monetary policies which led to strong currencies, yet they still outperformed the socks off the inflationary Anglo-Saxons.
Both the empirical evidence and logic are ignored by policy makers and an investment establishment dedicated to believing otherwise for the sake of their macroeconomic dogmas. Like drowning men, they grasp evidence that the initial surge in prices, attributed conveniently to covid, supply chain disruption, and sanctions against Russia is slowing. And that increases in the CPI will subside. Undoubtedly, they will. But this is a statistical aberration because high numbers will drop out of the back end of a rolling statistic. It allows perennial bulls to call an end in sight to interest rate rises, and with a recession in prospect for that trend to be reversed. QT will be replaced again with QE — that is certainly believable.
These expectations for the inflation outlook and therefore interest rates are too glib. As well as compensation for temporary loss of possession of credit and for counterparty risk, interest rates are bound to reflect a creditor’s view of changes in a currency’s purchasing power. Much of the time, a central bank can impose an interest rate policy on markets, as the evidence shows. But there comes a point where, recognising the debasement of a currency the market forces a central bank to concede higher rates. The market in question is usually the foreign exchanges.
This is why with the path clearing towards a new softening of interest rate policy, the dollar has weakened dramatically against the other principal currencies along with the fall in US Treasury yields for longer maturities.
As to the course of future interest rates, we must make an assessment beyond the visible prospects for a recession. We must anticipate central bank policies and their consequences: will they abandon inflationism and seek to protect their currency, or will they prioritise protecting the economy from recession, from the illusion of financial wealth created by interest rate suppression, and to protect deteriorating government finances?
When fiat currencies can be readily expanded to deal with all these escalating problems, whatever the stated intention of monetary policy inflationism proves irresistible. And all the more so, when the alternative of credit restriction is bound to crash the economy, financial markets, and government finances.
Commercial bankers are not stupid, and with over-leveraged balance sheets are certain to try to protect themselves from mounting bad debts in a recessionary environment. The extent to which they do so throws an additional burden of credit creation onto central banks. But all the evidence shows that central bank monetary policy has a far greater impact on a currency’s valuation on the foreign exchanges than equivalent variations in commercial bank credit. Therefore, the effect of central bank credit replacing commercial bank credit is to rapidly undermine a currency’s value.
