A few thoughts: Why I think that CB can do very little at this point:

By Feb 29April 17th, 2020Blog
Central Banks Balance Sheet

A few thoughts: Why I think that CB can do very little at this point:

A few thoughts: Why I think that CB can do very little at this point:

Let’s start with the balance sheets.

Central Banks Balance SheetThe very role of any easing (quantitative or normal) is to push long-term interest rates down by supporting long-term debt and pushing down the front-end of the yield curve.

All CBs in the world went berserk on interest rates: real interest rates are today negative in almost every developed country. Negative real yields are pushing pension funds in a corner from where they can only buy more illiquid and high-risk assets.

In addition, it was a hidden purpose of QE -programs to also create a “wealth effect”, by increasing the values of financial assets and making people feel “rich”. Central Bankers will never admit this intention, but it is a fact that inflated financial assets may help institutions to put pig-lipstick on reality.

Even today, the effects are not understood by all, but they depend heavily on the ability of the programs to push down (converge) the yields of bonds in different classes. With yields across the globe at record lows, where’s the beef?

In 2008 the economy collapsed due to unsustainable debt structures, but since then, government, corporate, and private debt has only increased. On top of that, at the end of 2019, the global stock markets were priced at perfection: high multiples and very moderate recession expectations.

Even if a small recession is at the gate, central bankers will have very few tools to combat it. Because of the current zero-rate policy, all they can do in a recession is print more money and buy more assets.

But what is left for the central banks when a pandemic is on the way of killing at least 2 quarters of economic growth?

Well, very little.

With the exception of providing artificial CB liquidity, which is mostly useless against recession/virus scare of investors. What most do not get on CB liquidity is that it exacerbates the bull market by providing abundance of cheap credit and a ‘persistent buyer’ (the CB).
QE pushes investors to riskier assets and speculation by providing credit from the central bank. But, this only works, when the investor sentiment is bullish.
When the fear grips the investors, there’s no way for the stock markets other than down.
While the stock purchases, through e.g. ETFs, could keep the markets from tanking completely, they do not really resuscitate anything, and they will also be ineffective against investor stampede.
Besides, this is not only a matter of investor sentiment: revenues and earnings will be crashed for at least 2 quarters.

We see two possible outcomes:

  1. Prolonged stagnation, aka Japanification.
  2. Artificially propped economy that will implode after few years creating inequality and eventually social riots.

Neither of these options is preferable, to say the least, but the first one may work for some countries, like China and Germany. But not for the whole world.

Just look at Japan. Bank of Japan’s (BOJ) zero-rate policy has been around for 20 years. Can it go on forever? Maybe, but will it be effective?

BOJ owns 77 percent of every ETF in Japan and is the top-ten holder of 90 percent of Nikkei 225 companies. BOJ also owns over 50 percent of the Japanese government’s bonds, and its balance sheet is now larger than Japan’s GDP. This is probably not the idea of capitalism of neo-monetarists.

Unfortunately, the path in the West will soon be identical to Japan’s. In fact, the US has already taken the first steps in that direction. Even though the US has a 3.7 percent unemployment rate, the lowest since 1969, the Federal Reserve has lowered rates to emergency levels. In addition, just recently the Fed injected $278 billion into the securities repurchase and unofficially launched QE4. Let’s also not forget that the ECB has also restarted its own quantitative easing at a pace of 20 billion euro per month in Treasury purchases.

On the other hand, Japanification is not an option world-wide because the Japanese economy lives on exports and high labor productivity. If all countries need to live on exports they can only export to Mars (I am sure Musk is thinking to do that).

Japanification is probably an outcome that developed countries may not be able to achieve.

This is not to say that CBs could not try something desperate.

Fed Chair Jerome Powell came out 15 minutes before the closing of US markets with the following statement:

“The fundamentals of the U.S. economy remain strong. However, the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.”

Ambiguous language that the low liquidity of a tired market, at the end of the worst week of the last 10 years, took as an opportunity for a little rebound.

At the end of the day, sellers almost disappeared and S&P 500 gained 73 points in 15 minutes, Dow 622 points and Nasdaq 207.

The late announcement of Powell almost saved the day but it certainly did not save the week.

The S&P 500 index had peaked on February 19 at a closing high of 3,386 – after skyrocketing 30% last year despite a slow-growth economy, and after spending the first seven weeks this year disregarding average corporate earnings, the coronavirus outbreak in China and all the issues this would pose for US corporate supply chains and revenues.

Eventually, it started to sink in.

Since then the S&P 500 has plunged 12.8%, to 2,954, the level of September 2018.

The most splendid rally of 2019 evaporated in 10 days.

And here came Powell with his naked gun.

Central banks may be able, briefly, to return some trust to the financial markets but for the economic repercussion of the Coronavirus they cannot do anything.

Even coordinated cuts (and the market is already discounting 100% probability of 25bps in March from the Fed and 50% probability of 50bps) may not be that effective. Negative rates are a tax on savings and you cannot tax savings for too long without repercussions.
So, we’re effectively all in a slow-moving train that was supposed to be launched at full speed and we are slowly realising that is already derailed.

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