{"id":4626,"date":"2020-01-17T19:17:42","date_gmt":"2020-01-17T23:17:42","guid":{"rendered":"http:\/\/stateofthenation.co\/?p=4626"},"modified":"2020-01-17T19:17:42","modified_gmt":"2020-01-17T23:17:42","slug":"feds-unprecedented-infusion-of-liquidity-creating-biggest-bubbles-ever","status":"publish","type":"post","link":"http:\/\/stateofthenation.co\/?p=4626","title":{"rendered":"FED’s Unprecedented Infusion of Liquidity Creating Biggest Bubble(s) Ever"},"content":{"rendered":"

The Federal Reserve Is The Cause Of The Bubble In Everything<\/h1>\n

Op-ed by Michael Howell,
\nThe Financial Times<\/p>\n

It\u2019s liquidity, stupid.<\/strong>\u00a0Rephrasing the words of Bill Clinton\u2019s adviser James Carville helps explain why many stocks are hitting record highs, why gold is breaking higher and why economies look set to rebound sharply this year.<\/p>\n

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About a year ago we described how\u00a0modern financial systems have grown dependent on central bank balance sheets<\/strong>, and why another round of easing from the US Federal Reserve \u2014 a \u201cQE4\u201d \u2014 was vital for markets. Fed chair Jay Powell has so far proved sufficiently flexible to reverse the balance sheet shrinkage, to which his immediate two predecessors, Ben Bernanke and Janet Yellen, had been committed.<\/p>\n

The \u201cFed Listens\u201d, as the name of its tour of US cities suggests and, true to form,\u00a0recent worries in the repo market spurred the central bank to inject a further $400bn into the financial sector.<\/strong>\u00a0It increased its balance sheet by about 10 per cent between last September and the year end.<\/p>\n

Yet, the Fed\u2019s spin-doctors are trying to persuade us that this is not quantitative easing.<\/strong><\/u>\u00a0Certainly, it has not involved direct buying of US Treasury notes and bonds, but it has still led to a sizeable uptake of short-term Treasury bills. The difference between QE and \u201cnot QE\u201d is mysterious, then, because liquidity has expanded and, in the process, relieved funding pressures and reduced systemic risks. As a result,\u00a0the prices of haven assets, such as the 10-year US Treasury note, have fallen, while risky assets such as equities have gone up.<\/strong><\/p>\n

We measure liquidity through the funds that flow through both the traditional banking system, and through the repo and swap markets.\u00a0The global credit system increasingly operates through these latter wholesale markets, and often with the active participation of central banks.<\/strong>\u00a0For some years now, the wholesale money markets have been fuelled by vast inflows from corporate and institutional cash pools, such as those controlled by cash-rich companies, asset managers and hedge funds, the cash-collateral business of derivative traders, sovereign wealth funds and foreign exchange reserve managers.<\/p>\n

Today, these pools probably exceed $30tn and have outgrown the banking systems, as their unit sizes easily exceed the insurance thresholds for government deposit guarantees.<\/strong>\u00a0This forces these pools to invest in alternative short-term secure liquid assets. In the absence of public sector instruments such as Treasury bills, the private sector has had to step in by creating short-term vehicles known as repurchase agreements, or repos, and asset-backed commercial paper.\u00a0The repo mechanism bundles together \u201csafe\u201d assets such as government bonds, foreign exchange and high-grade corporate debt, and uses these as security against which to borrow.<\/strong>\u00a0While credit risk is to some extent mitigated, the risk of not being able to roll over or refinance positions remains.<\/p>\n

At the same time, markets have remained fixated on policy interest rates, which are supposed to control the pace of real capital spending and, hence, the business cycle. That, at least, is what the textbooks tell us. But\u00a0the world has moved on. We must think of western financial systems as essentially capital re-distribution mechanisms, dominated by these giant pools of money that are used to refinance existing positions, rather than raising new money<\/strong>. New capital spending has itself become eclipsed by the need to roll over huge debt burdens.<\/p>\n

If debts are not to be reneged upon, they must either be repaid or somehow refinanced. However,\u00a0not only is much of the new debt taken on since the 2008 financial crisis unlikely to be paid back but, more worryingly, it is compounding ever higher.<\/strong>\u00a0Our latest estimates suggest that world debt levels now exceed $250tn, equivalent to a whopping 320 per cent of world gross domestic product \u2014 and\u00a0roughly double the $130tn pool of global liquidity.<\/strong><\/p>\n

This refinancing role means that quantity (liquidity) matters more than quality (price, or interest rates). Central banks play a key role in determining liquidity, or this funding capacity, by expanding and shrinking their balance sheets, and in the US, of course, this is closely linked to the Fed\u2019s QE operations.\u00a0Consequently, more and more liquidity needs to be added to facilitate the re-financing of the world\u2019s debt. QE is here to stay. We should expect QE5, QE6, QE7 and beyond.<\/strong><\/p>\n

Take a step back, though.<\/p>\n

A rising tide of liquidity floats many boats, but we know from experience that liquidity-fuelled asset markets usually end badly, as they did in 1974, 1987, 2000 and in 1989 in Japan.<\/strong>\u00a0In this regard, the scale of recent Fed interventions needs to be understood. Last year, US markets enjoyed their biggest effective inflow of liquidity in more than 50 years, by our measures. That liquidity is already spilling around the world, with our global indices registering their sixth best year on record.<\/p>\n