All That Pandemic Liquidity Finally Led to Erosion
(Bloomberg Opinion) --
Water Flowing Underground
Such excitement! The Russian army begins to withdraw from the Ukrainian border, or does it? Five nominations to the Federal Reserve are about to be voted on, and then they aren’t. Share prices go down and go back up, but so do bond yields.
Rather than attempt to follow every twist and turn of the geopolitical drama, or all the excitement in Washington, it might be best to focus on the most vital commodity market — liquidity.
Mike Howell of Crossborder Capital Ltd. in London is the doyen of liquidity analysts. By his measure, the liquidity created by central banks has stopped growing and is now in a significant decline. It is the second derivative of the change in the speed with which liquidity is flowing that has the greatest impact on markets:
This matters because the great post-Covid rally has been driven almost exclusively by the provision of extra liquidity. As Howell has demonstrated in the past, the rise in share prices has been achieved merely by by diverting a normal amount of new liquidity into stocks, and is not driven by any over-exuberant increase in allocations to equities.
As he shows, provision of liquidity and the creation of wealth through higher asset prices are intimately connected over time. Falling liquidity, while obviously necessary now that the emergency has passed and inflation is rising, could well signal problems ahead:
Shifts in liquidity have also naturally had a profound effect on bond markets. Yields are rising, but particularly for shorter maturities. The yield curve, or the spread between two- and 10-year bonds, has flattened swiftly in the last few months, suggesting that the market anticipates an early end to the forthcoming tightening regime from the Federal Reserve. A flat yield curve can be a self-fulfilling prophecy, because in practice it tends to force central banks from persisting with higher rates.
A flat yield curve also tends to have a lagged effect on the credit market as it becomes more expensive to refinance debt. Over time, Howell shows in this chart that a flatter yield curve tends to be followed quite swiftly by rising credit spreads. While there is no great issue with solvency at present, this suggests that credit may already be causing problems by the end of this year:
That's what makes it hard for the Fed to continue with rate hikes. But as Howell shows, there is a 50-year history that the Fed never hikes rates once the fed funds rate has risen above the five-year yield. That point could come before the end of 2022, and suggests that it will be very difficult to continue with tightening to the extent that the Fed currently believes necessary to bring down inflation to its target.
The latest survey of global fund managers from Bank of America Corp. suggests that problems lie ahead. The professional money managers surveyed have never before been so confident that the yield curve is going to flatten.
The degree of confidence in flattening is surprising as the current economic cycle only started less than two years ago. But another answer to the BofA survey shows that investors do indeed believe that this has been a very quick cycle that is already nearing its end:
The pandemic administered an unprecedented shock to the economy, so it should not be surprising that the cycle that follows it is also very unusual. However, the degree of confidence that investors are showing in how to navigate these strange waters is a little perturbed. Perhaps most strikingly, fund managers are now more thoroughly underweight in technology stocks than at any time since 2006:
What is strange about this is that even though fund managers are now underweight in technology, they also believe that tech remains the most dangerously overcrowded trade. As such, they’re even more worried about over-excitement in technology than the possibility that pessimism about treasury bonds have been taken too far.
This survey also showed, when it was taken a week ago, that Ukraine is still very low on the risk of concerns. The greatest worry continues to be that central banks will do too much, and the second-greatest is that they won’t do enough. Rather than betraying any great lack of confidence in central banks, it’s probably best to assume that this shows widespread fear that it will be impossible to drain liquidity from the system, having already spawned an increase in inflation and a rally in asset prices, without causing an accident somewhere. For those who want to try to be contrarian, a soft landing would be very profitable for anyone prepared to bet on it.
What to Expect When You’re Expecting (Inflation)
Meanwhile, back in America, the problem of inflation has not gone away. Indeed, there is a fresh evidence that it continues to intensify, although there’s also at least one ray of hope.
That hope stems from this survey by the New York Fed. It shows that consumer expectations for inflation over the next five years actually declined during the last month, despite much publicity about the serious rise in living costs. If inflation expectations are the key to controlling long-term price rises, this can only be viewed as a good sign:
It's a wide-open question whether expectations really matter in driving inflation, which Tyler Cowen addresses in a column today. But it does seem to be the case that once inflation has reached beyond a certain level, about 7%, it becomes much less stable and people are much more prepared to believe that prices will continue to rise. The following chart, produced by Vincent Deluard of StoneX Capital using data from Robert Shiller of Yale University, shows that over history, inflation appears to follow a random walk. The level of inflation now does not tell you all that much about whether it will be higher or lower in three months:
However, when this exercise is repeated only for months when inflation is 7% or higher, there’s a very different pattern. Once inflation is this high, it’s much more volatile and also much more prone to rise further:
That in turn is because inflation, unlike growth in the economy, does not follow a normal bell-curve distribution. Rather, there is what statisticians call a “long tail” on the right side, with very high readings far more likely than very low ones:
This fits with the monetarist theory that inflation needs to accelerate and doesn’t merely stay high when governments are looking for a tradeoff between employment and rising prices. Beyond a certain level, people understand that more inflation is likely and adjust their demands accordingly. It also helps explain why the Fed is so concerned about inflation expectations and to suddenly try to bring price increases under control now, having been far more relaxed when inflation was still rising but safely below 7%.
Much of the rest of the inflation news this week has been rather more negative. The January producer price inflation numbers showed an increase for the month that came in far ahead of expectations. There is certainly no sign as yet of any easing on corporate costs or in supply bottlenecks:
The New York Fed also produces sophisticated statistical measures of “underlying” inflation, based on correlations between moves in different items in the inflation index, and with economic data. Both measures are now comfortably at their highest since the series began in 1995.
Another interesting measure involves weighting the various components of the consumer price index according to their historical volatility rather than the amount that is spent on them. The less the volatility, the greater the weighting. This chart, produced by Calderwood Capital, shows that this has the effect of reducing the heavy loading to housing and fuel in the conventional index. Medicine and education now appear more important.
The idea of Calderwood's Dylan Grice is that this process will systematically reduce the importance of products whose prices tend to move the most in any case. Sadly, even on this measure, inflation is rising faster than it has in decades:
All this shows why the Fed is probably right to have a new sense of urgency. For the next two weeks, the focus will be on whether the central bank will go to the lengths of raising the fed funds rate by 50 basis points in March. Starting with Wednesday’s publication of the minutes for January’s meeting, the Fed’s governors then have a hectic two weeks to get markets ready for a big hike, if that’s what they want to do. They will also need to adjust expectations just as the identity of its most senior governors has been called into doubt by the latest political imbroglio. The stakes are higher in Ukraine, but inflation and monetary policy also have the power to inflict great uncertainty.
Whatever you do, don't lose the use of your dominant hand, particularly if you have to do a lot of typing for a living. This is how my laptop, which I am fast growing to dislike, coped when I asked it to spell the word “imbroglio”:
in Brolio embryo in broad video in Brolio embro video ambrosio embro video
This at least gives me an idea for an opera recommendation. There is much to enjoy in Mozart's early opera Die Entführung aus dem Serail, which is set in a seraglio (and which the computer renders as “It's very wrong i'll steam set audio.”)
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
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