The Great Central Bank Pivot – Investment Watch

Guest post by David Stockman of Contra Corner:

The Great Central Bank Pivot is underway around the world, but it’s not what Wall Street has been praying for. Instead of another round of easing to stem the obvious downturn in economic activity, central banks are rushing to raise interest rates by 75 or even 100 basis points quickly to stem the increase in inflation.

Just yesterday, for example, the hitherto accommodative Riksbank of Sweden increased its target rate by 100 basic points, impacting the market. Not long ago, however, the Swedish central bank seemed to be forever locked in a zero interest rate policy (ZIRP).

But here’s the thing: even after a 100 basis point increase, the Riksbank’s target rate will be only 1.75% in a context in which the Swedish CPI was placed in August 9.8% I/I

That is correct. The Swedish inflation rate has been accelerating at an infernal pace, but until yesterday the central bank sat complacently on basically zero rate policy, thus giving the notion of being “behind the curve” a definition completely new

Moreover, this acceleration in inflation was not the result of energy or other exogenous pressures from global markets alone. As one analytical service explained, rising inflation in Sweden is broadly based across most sectors:

It was the highest rate of inflation since June 1991, with prices for food and non-alcoholic drinks jumping 14%, the highest since February 1984 (vs 13.5% in July). Additional upward pressures also came from the cost of housing and utilities (15.1% vs 9.1%), transportation (9.6% vs 12.4%), recreation and culture (3 .9% vs 3.8%), restaurants and hotels (9.8% vs 8.9%), and miscellaneous goods and services (5.1% vs 5.4%).

Y/Y change in Sweden’s CPI


The Riksbank’s action is therefore symptomatic. Global central banks have been chasing the chimera of “low inflation” for years. In doing so, they flooded the financial markets with massive amounts of excess liquidity and credit, while driving themselves further and further behind the curve of the inflation that was implicitly being built into the system.

As a reminder, the combined balance sheets of the world’s central banks stood at $4.7 trillion in 2003 and now total nearly $43 trillion. This influx of liquidity, in turn, set the monetary table for rising inflation, first in financial asset prices, and now in goods and services due to commodity market disruptions caused by the Washington and NATO’s sanctions war against Russia and the Covid-19-induced unrest in Russia. global supply chains.

Central banks have therefore turned almost on a dime, from stimulating more inflation to a desperate attempt to quell the inflationary pressures that are rapidly being built into the wage cost structure.

Indeed, this was the heart of the Riksbank’s shocking 100 basis point rate hike:

“The risk is still great that inflation will take hold, and it is extremely important that monetary policy act to ensure that inflation falls and stabilizes,” officials said in a statement. “Monetary policy now needs to act more than expected in June.”

…..”It would be even more painful for the Swedish economy if inflation were to remain at current high levels,” officials said. “By raising the policy rate further now, the risk of high inflation over the longer term and thus the need for further monetary tightening later on is reduced.”

The above rationale is the essential mantra of all central banks, including the Fed. Until they have definitive evidence that wage cost pressures are easing, they will keep raising rates. After all, like the proverbial carpenter, when your only tool is a hammer, you keep hammering away at the nail.

In the case of the Riksbank’s main action, there was indeed another drop in the wind. In other words, unlike the Fed, the ECB and other central banks now holding back, Sweden’s central bank also predicted that next year would bring a full-blown recession:

The Riksbank cut all of its growth forecasts and now expects the Swedish economy to do so contract 0.7% next year instead of expanding by that amount.

Of course, there’s always an actor who doesn’t get the message; in this case, it is the case of the monetary basket known as the BOJ (Bank of Japan). He still maintains his insane commitment to “yield curve control,” which means he will buy unlimited amounts of government debt to keep the 10-year bond rate pegged at a ridiculous 0.25%.

But the BOJ’s stubbornness is not actually an outlier or an aberration. On the contrary, it is symptomatic of where all the Keynesian-dominated central banks of the world were just a few months ago: that is, they hung on to the mistaken idea that the trend level of inflation was too low because rates were below. their sacred 2.00% targets.

Now, however, even Japan’s CPI is rising. Thus, Bloomberg pointed out today that,

Japan’s inflation accelerated to the fastest pace in more than three decades, excluding distortions from tax hikes, causing headaches for the central bank this week as it tries to explain why it should continue monetary stimulus when inflation is well above its 2% target.

In fact, the year-on-year increase in headline CPI has increased from 0.2% in September 2021 to 3.0% in August 2022. This is a 15X gain in the second-order derivative.

Year-on-year change in Japan’s CPI, September 2021-August 2022


However, BOJ chief Kuroda and his parrots in the financial markets really believe that Japan’s core inflation is still too low and that the BOJ should continue to pump massive amounts of fiduciary credit into the system until central banks conclude that inflation has reached the sacrosanct 2.00. Target % on a sustainable basis.

“The current cost-push inflation is bad for consumers, but the BOJ will continue to taper, hoping it will eventually turn into positive inflation,” said economist Yuichi Kodama of the Meiji Research Institute Yasuda. “The central bank’s policy will not change until Kuroda’s term ends, as this is Kuroda’s last big chance. to really reactivate inflation”.

In the last four words in bold you have the real disease of the present age. Central monetary planners latched onto the absurd idea that the job of central banks is to increase inflation. Even 25 years ago, the very idea would have been laughed out of town, even by Keynesian economists.

But groupthink is a contagious thing, and over the past two decades it has thoroughly infected every major central bank in the world. Consequently, the rampant money-pumping has gone far beyond what was previously imagined.

What this means, of course, is that taming this round of global inflation is a whole new ball game. The coming financial and economic carnage, therefore, will make even Volcker’s crushing of the inflation speculators four decades ago look like a Sunday school picnic.

Without a doubt, just consider how quickly interest rates are rising with no visible slowdown in inflationary momentum yet. Yesterday, the two-year yield, much more sensitive to short-term interest rate expectations, rose to 3.946%its highest settlement since 2007.

More importantly, the chart below makes it clear that the government debt traders are now facing the sleepwalkers in the Eccles building. In other words, the two-year Treasury note has almost risen 400 basic points of its Covid-low compared to only 215 basis points for the Fed funds rate.

In other words, bond traders are waking up from their decades-long slumber. The Fed’s “put” under the bond market, also known as quantitative easing (QE), no longer exists, even as it releases $95 billion a month in bond sales (QT) in its desperate effort to fight against inflation.

What is striking about the chart below, however, is the speed and breadth with which the previously sleepy 2-year note market adjusted to the actual central bank pivot now underway. And there is much more to come.

Consequently, rising interest rates in an awakened, unpegged bond market is what’s really going down. In an economy saddled with $88 trillion in public and private debt, this is certainly a recipe for carnage.

Yield on 2-year Treasury bonds, from February 2020 to September 2022

Likewise, the yield on the 10-year US Treasury note is also coming to life. It rose to 3.489% yesterday, its highest settlement level since 2011, and to 3.447% on Friday. But that was just a warm-up for today, as the 10-year benchmark broke out of its trading range, breaking above 3.60% at its high.

Needless to say, there is still a long way to go to return the government’s benchmark security to a yield that is in sustainable territory in real (inflation-adjusted) terms. In turn, this means big trouble for the stock market, even on a technical basis.

In other words, the famous trade of TINA (there is no alternative) is ready to join Queen Elizabeth in the afterlife. According to Strategas, less than 16% of S&P 500 stocks have dividend yields higher than the yield on the two-year US Treasury note and less than 20% have dividend yields higher than the yield on the 10-year note.

These numbers mark the lowest rate since 2006, and yet the Fed’s inflation battle is just beginning.

To be sure, the perennial bulls aren’t ready to give up the ghost just yet and are tirelessly resourceful in spotting false evidence that inflation is turning the corner and the Fed will soon be free to go back to pumping money. modality of the last three decades.

But we’d say not so fast. Inflation is a complex and multi-vector phenomenon. The fact that the monthly numbers can always be picked judiciously, implying that inflationary pressures are easing, does not mean that the battle has been won.

For example, a new canard is that rising rental rates are finally tapering off, due to the recent sharp weakening of the housing market. As the blue bars below show, the monthly rate of change is still very high by the standards of recent history, but is down significantly from peak levels last fall.

true enough But the problem is that all those blue bars rising on the right side of the graph are cumulative. Real households now face annual rent increases that are more than double those of the recent past on a year-on-year basis.

It’s these big bites out of paychecks that have driven up wage demands, thus fueling the wage-cost-price spiral that now has a strong head of steam. And it is the spiral, in turn, that will prolong the period of high inflation and keep the Fed’s feet firmly on the monetary brakes.

Annual change in the CPI for house rent, 2018 to 2022

As it happens, the Fed should follow Sweden’s example tomorrow and hike to a maximum of 100 basis points. We don’t think they feel it, of course, but that doesn’t actually do anything.

Sooner or later, interest rates will have to reach levels that allow real returns after inflation to be restored to investors in reality, as opposed to central bank fiduciary issuers who have cleaned the market at false levels during years.

And this is the true meaning of the Great Central Bank Pivot.

Guest post by David Stockman of Contra Corner.

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