The synchronisation of warning signals

Nick Hubble

Australia didn’t even have a recession in 2008 or 2009.

China’s enormous stimulus programme and a wave of immigration saw to that. It was a demonstration of the power of countercyclicality. As long as some parts of the world are doing well, their boom will offset others’ busts.

That’s why the business cycle used to be called the trade cycle. If there was a boom somewhere, there was a bust elsewhere. Booms and busts were synonymous with trades surpluses and deficits. What kept the international economy on an even keel was the counteracting effects of this.

Prices in booming countries would rise until they could no longer compete with the countries where a bust had prices falling. Eventually, fortunes reversed. The exchange rate added a rebalancing effect.

That’s what’s going wrong in the eurozone now. The lira and the deutschmark are unable to adjust for their nation’s bust and boom. Instead, prices in Greece and Italy will have to fall. But that’s another story.

The trouble with countercyclicality is that it’s disappearing. And not just in the eurozone. I call it the synchronisation of business cycles.

Recessions and monetary policy are steadily synchronising around the world. Trade flows aren’t reversing over time. Only small nations like the UK and Australia are well protected by their currency fluctuations.

China manipulates its currency with a peg, Europe’s is fixed between its nations despite their differences, and the US has the global reserve currency. This messes with the natural rebalancing effect their trade deficits and surpluses should have.

The system’s imbalances are growing, not self-correcting. Economists now talk about global growth and global slowdowns instead of regional booms and busts that offset each other. And create investable trends.

One consequence of all this is that all sorts of other features of the economy and financial system have synchronised too. Policy response, for example.

Just about every major central bank in the world turned to quantitative easing (QE) around the same time. A remarkable new policy that Zimbabwe’s central banker Gideon Gono was ridiculed for using suddenly became mainstream everywhere at the same time.

In the end, my message about synchronisation is that it’s dangerous. We lose the counterbalancing nature of countercyclicality. A crash will be far more severe. That’s why 2008 was so bad.

The trouble is, it’s very hard to figure out when a global downturn will occur. You have to take into account the whole world’s condition. No one region is likely to break out into boom or bust anymore. Everyone will together.

So, unless all the warning signs across the whole world are flashing red at the same time, a crash isn’t really likely.

But they are. And it is.

Your list of warning signals

A huge list of financial warning signals went off at various times over the last few years. But what’s striking now is that they’re going off in a synchronised way. The indicators are flashing red at the same time. Here’s a summary.

Donald Trump’s trade wars are escalating. Washing machines and solar panels were just testing the water. Steel hit the hot-button political issue. Next is intellectual property. The response could be harsh. And the end result is simple – less economic growth.

Another risk of the trade war is a surprising one. The US dollar is still the world’s reserve currency. It has to be widely available for trade. But clamp down on trade and that availability falls too.

Countries and companies who borrowed money in US dollars must repay their debt in US dollars. What happens if the supply of those dollars falls and the price spikes? A rerun of the 1997 Asian financial crisis.

The Libor-OIS spread measures how much banks are charging to lend to each other over and above the central bank rate. It has spiked to levels not seen since 2008, surpassing the European sovereign debt crisis level. A JP Morgan strategist called this “the story of the year”. It suggests the banking system is very suspicious of its own liquidity. Banks don’t trust each other to repay their loans.

The US ten-year Treasury yield has reached heights not seen since the 2013 taper tantrum. When the American central bank tried to reduce its QE back then, all hell broke loose in financial markets. Until it gave up.

Central bank QE is set to decline for the first time this year. The link between financial markets and central bank balance sheets will be tested on the way down, not just the way up. Japan’s central bank owns 75% of its exchange-traded fund (ETF) market. Switzerland’s central bank owns $2.8 billion in Apple shares. Imagine what selling will do.

Money supply indicators are falling around the world too. The faster money moves around and increases in amount, the more it facilitates GDP growth and makes debt easier to pay. A slowdown does the opposite. M1 money supply growth for the G7 and Europe’s biggest seven economies has fallen below 2% for the first time since 2008. M2 money supply in the US is already shrinking.

There are signs of irrational exuberance too. International M&A deal-making hit the $1 trillion mark the earliest ever this year. The previous peaks were of course 2007 and 2000.

We took a look at the yield curve last week too. It’s nearing a recession prediction.

Perhaps worst of all is this warning in financial markets. It was a huge contributor to the 10% correction of February. And that was only the beginning.

As ever, central bankers are well behind the curve. With all these warning lights coming on, they’re still busy tightening monetary policy. The Federal Reserve’s new chair raised interest rates 0.25% yesterday. The European Central Bank has begun discussing interest rate increases while unemployment is still out of control in southern Europe.

Just as in 2007, we won’t know we’re in trouble until it’s too late. And central bankers will be the last to know.

The problem is, they’re the ones in charge of interest rates. If they keep hiking them into a crisis, they trigger that crisis. That’s what has happened over and over again in the past. It’ll happen again.

Until next time,

Nick Hubble,
Capital & Conflict

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Category: Central Banks

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