Something broke this morning. Bonds, stocks and commodities all fell. Government bond yields around the world surged. Australia in particular got kicked in the shins all round with a jump in bond yields and a big drop in stocks.
Why are all these asset classes tumbling in synch? Surely investors escaping stocks go into bonds, or vice versa? How can both fall at once?
The answer, as always, is central banks. They can pull money out of all asset classes at once. For now, even when they just mention the prospect it has the undesired effect of jolting all markets.
We’re seeing a global rerun of 2013’s taper tantrum. Central bankers are at various stages of cutting back on their support for the world’s financial markets. And financial markets don’t like it one bit.
The Bank of England is talking about higher interest rates, the Federal Reserve is scheduling them in, and the ECB is “moving ever closer toward unwinding its massive monetary stimulus,” according to Reuters. In the midst of all this so called hawkishness, we have the Bank of Japan. It announced the removal of the limit on BoJ purchases, basically mimicking Mario Draghi’s “whatever it takes” motto.
The complication in all this is that financial markets are very liquid and efficient enough at transferring capital internationally that central banks’ policies have an effect on each other’s markets. For example, the fact that there is a definite possibility of a firm maybe we’ll see tightening in Europe, the UK and US means trouble in Japan.
Which begs an important question about central bank cooperation.
Who breaks ranks?
If things go wrong in one particular region of the world, will central bankers act together or focus on their domestic economy? If inflation breaks out in Europe, or Japan sinks back into deflation, will other central banks stop to think about how their monetary policy is adding to the problem?
During the taper tantrum of 2013, the Fed was quite explicit about its America First style policy. Germany is threatening a similar approach, as we’ll see in a moment.
This is one way things could get out of hand. If central bank cooperation breaks down as the appropriate monetary policy in different parts of the world starts to look different then things get dicey.
Remember, the booms and busts of the past are all related to central bank interest increases. We’ve begun the cycle once more. How long will it take this time? Where will it lead us?
Central banker constraints
If central bankers run financial markets, it’d be a good idea to examine their constraints. Just how much money can they print, how many bonds can they buy, how many stocks can they own and how much inflation can they bear?
For example, central bankers used to focus on the NAIRU – the non accelerating inflation rate of unemployment. If unemployment gets too low, that causes inflation. Wages and spending surge to push up prices. (The fact that all those workers are employed doing something, which increased the amount of things to be bought, escaped economists.)
Anyway, the NAIRU was a constraint of monetary policy. It warned central bankers the economy was too hot. Interest rates had to rise. Guestimating the NAIRU thus gave you the trading edge on interest rates. And your mortgage.
That was back in the day when monetary policy was a matter of interest rates. How nostalgic. These days there are new constraints.
Figuring these out in advance allows you to predict monetary policy. For example, what if central bankers run out of things to buy under their Quantitative Easing programs? There’d be a rather big shock as the support for the economy suddenly dries up.
Sound odd?
Bank of America Merrill Lynch analysts explained the issue is already popping up at Germany’s central bank. The lack of government bonds in some parts of the eurozone mean that the ECB has been pushing the Bundesbank to buy more German bonds instead. But the Bundesbank might’ve spat the dummy:
“With issuer constraints likely to become a problem further down the line, the Bundesbank may no longer be willing to take on some share of the additional buying needed to compensate for (a) the ECB not buying Greek bonds and (b) a lack of bonds in Estonia or Slovakia for example and more recently Finland, Portugal and Ireland.”
The ECB is worried it will run out of bonds to buy in the future. And the German central bank doesn’t want a part of that problem. So it’s slowing down how many German government bonds it agrees to buy.
If you don’t quite follow, that’s because it’s a totally bizarre situation. All government programs eventually create these absurdities. The good news is, the consequences are predictable. And that makes them tradeable.
The tension created by the ECB’s QE can be eased in three ways. The ECB can start buying assets other than government bonds – this is the Japanese solution where the Bank of Japan now owns a huge chunk of the stock market.
The other member states could borrow lots of money to create new bonds for the ECB to buy.
Or the ECB has to reduce the total amounts of bonds it buys
This is the taper that is causing markets to shudder right now. The point is that it’s imposed by the lack of things for the ECB to buy, not by an ECB decision.
We’re not actually close to running out of assets for the ECB to buy. The issue is more subtle. Which brings us to the first central bank constraint I’d like to bring to your attention to – the Capital Key.
When the ECB was created, countries contributed capital to get it up and running. The amount was calculated based on each country’s share of GDP and population, with equal weights given to each. These contributions give you the Capital Key – the share each country has to contribute.
When QE began, the loose rules were that ECB purchases had to be in line with the Capital Key. It turns out they haven’t been. As mentioned above, there aren’t enough bonds in certain countries. The Germans want the policy back in line. So the Bundesbank is refusing to buy more German government bonds. The constraint is tightening.
The second constraint is inflation. As explained above, if inflation breaks out in one of the central banks’ zones, it will have to tighten or allow inflation to go out of control. But the stagflation of the 70s showed us that inflation and good economic times don’t necessarily go together. A central bank could be forced to choose between the stock market and government budget on the one hand and inflation on the other.
Last but not least is a new constraint that came up in a conversation with my dad. It was a bit of an epiphany. Central bank action as it stands basically leads to the end of capitalism.
The end of capitalism
Can central bankers paper over any problem in just the right way? If a bank goes broke, they finance the bailout. If a government goes broke, they buy the bonds. If the stock market falls, they buy the stocks. If unemployment rises, they print more money. If the currency rises, they announce more QE. If inflation rises, they taper.
In such a world, more central bank action is a remedy for all symptoms. But it also destroys the patient.
If central banks own, or stand ready to own, just about all financial assets, then prices no longer reflect anything meaningful. The stock market doesn’t reflect shareholder value, corporate finance or anything else used to signal rational economic behaviour. Governments no longer have to worry about fiscal accountability whatsoever. At least the ones who can issue their own money.
In such a world, prices are meaningless and there is no accountability. The two functions of capitalism are to allow prices to direct economic behaviour and to provide accountability for those who waste resources – make a loss.
Not that many people will notice the change. The stock market was only ever a casino to them. Governments and central banks exist for bailouts. Debt was a way to pay for something unfordable. Prices were unfair.
Take for example a British person’s first debt – their student loan: “Three-quarters of UK university leavers will never pay off their student loans, even if they are still contributing in their 50s, according to the Institute for Fiscal Studies,” reports The Financial Times.
That’s a great way to welcome young people to the world of debt
In an economy reliant on central bankers to the point where capitalism is dead and its basic accountability functions are gone, two things will happen. Crises and a reset. You see, governments don’t let crises get out of hand. At some point they change the rules and create a new system.
Bretton Woods, the dollar reserve system and many other such “resets” have happened in history. They usually have dangerous consequences for people with accumulated wealth. You need to opt out a chunk of your wealth from the current system.
That might seem rather difficult. How do you definancialise your life? How do you hide from the government’s grasp?
Gold is the go to option. But there’s another obvious solution that’s already working well for the Chinese, Venezuelans and Japanese. It can also make you rich.
Until next time,
Nick Hubble,
Capital & Conflict
Category: Central Banks