Red Light, Green Light

Earlier this week, we explained how pretty much everything you’re seeing in terms of market swings can be at least partially explained by central bank frontrunning.

Stocks up? Investors anticipate the Fed will delay its next hike thanks to the Brexit debacle. Dollar up? Investors know that even if the Fed doesn’t hike, it’s still technically tightening if other developed market central banks are actively easing. Pound crashing? The Bank of England is set to ease further and cut rates. Yen stronger? Well, that’s because the market believes the Bank of Japan has run out of easing options (think frontrunning in reverse). Gold up? Central banks are printing trillions in fiat money so better have that inflation hedge. Bond yields down? Why wouldn’t they be when central banks provide a perpetual bid?

Every asset class and FX cross is just trying to skate ahead of the central bank puck, so to speak. Consider the following rather amusing commentary from Bloomberg’s Richard Breslow:

“One of the most enduring legacies of the financial crisis is the death of the credible notion that traders flock in and out of ‘safe havens.’ Investors don’t particularly care to seek safety. Why waste the effort when the central banks will be buying the dip if you don’t. Rushes into safe assets represent no more than the private sector flow equivalent of front-running central banks.”

“Investors tumbled even further down the rabbit hole of ridiculous sovereign bond yields after the U.K. referendum. They realized that, at worst, rate hikes were off the table. And at best, the base-case scenario, even more extraordinary monetary policy is coming.”

“Shrewd investors are flocking to the Japanese yen because if the rest of the world falls apart, Sony will just sell more Walkmans domestically?”

It’s also becoming increasingly clear to market participants that each central bank is stuck in its own personal version of Keynesian hell. Let’s start with the Fed. If the Fed hikes (or even leans hawkish), a rising dollar forces China to weaken the yuan. That fuels speculation about a deeper devaluation which in turn weighs on risk assets (like US stocks) causing the Fed to reverse course and adopt a more dovish stance. Risk then rallies. The Fed turns hawkish again. And around we go. It’s like the children’s game “red light, green light.” Only with people pretending to be adults. I’ve shown this diagram elsewhere, but it’s worth reusing it here:

(Chart: Goldman)

As for the ECB, they too are trapped in a vicious easing circle. The bank’s QE program stipulates that they can’t buy bonds with yields below the deposit rate. But buying bonds pushes yields down. So the more bonds they buy, the faster the universe of purchase eligible bonds shrinks. The only solution is to either buy different kinds of bonds or keep lowering the deposit rate. They’re chasing their own tail.

And then there’s the Bank of Japan, which owns an astounding 55% of the Japanese ETF market. What happens to the value of those holdings if they stop being accommodative and Japanese stocks collapse? Further, what happens to the bank’s massive collection of Japanese government bonds if yields rise? It’s not like they have to mark them to market, but there would be serious questions about the extent to which a central bank can maintain any semblance of credibility while operating from a negative equity position. Only one way to avoid this: keep on easin’. That of course assumes they can figure out how. Here’s a bit from BofAML:

“JGB purchases are approaching their limit, and the introduction of the negative interest rate has made them more difficult. The fact that the BoJ’s introduction of a negative interest rate policy with a three-tier structure set off a round of extreme yield declines and excessive yield curve flattening is evidence of JGB supply-demand distortion. We believe the policy target will shift from quantity to interest rates. With no prospect of achieving its 2% inflation target in the near future, the BoJ will face demands to switch to a sustainable monetary policy.”

Let’s just be clear: there’s not an extraordinary monetary policy that’s “sustainable.” That’s why these policies are called “extraordinary” and “unconventional.” They are, by definition, not “sustainable.”

But now there’s no way out. For anyone. Minutes from the Fed’s June meeting (released on Wednesday) pretty clearly suggest that the FOMC realizes this. Here’s Citi:

“The minutes of the June FOMC meeting showed a divided FOMC. Participants are struggling for ways to assess the implications of the apparent slowdown in the labor market, and manage the rise in global geopolitical and economic uncertainty.”

In a way, all the hand-wringing over “global” concerns is ironic. After all, it’s excessive central bank accommodation that’s created the conditions whereby 25bps can mean the difference between short-term stability and chaos in markets. And let’s not kid ourselves. At the end of the day, this isn’t about economics. It’s all about keeping markets elevated. On that note, we’ll close with a graphic from Citi which shows the “large” impact Brexit could have on the US economy.


(Charts: Citi)

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1 Comment

  • Gordon Gulitz

    July 7, 2016

    Such a bleak picture. Seems like rough times are ahead. Thanks for your insight.