The peril that our financial system is facing right now is an accumulation of past interventions by central banks.
Central banks ‘came to the rescue’ in 1987 in the Black Monday crash, the dotcom bubble at the turn of the millennium, the subprime crisis of 2007–09, and last year’s crash arising from the Wuhan virus outbreak.
The markets in each event threatened to crash hard but promises of more liquidity through lower interest rates brought back investor confidence.
However, with each crash, central banks had little time to recharge their arsenal.
They need to raise interest rates higher when the markets are on the path to recovery. The problem is that the markets invariably start declining when they raise interest rates.
Each intervention from the central bank diminishes its impact and leaves it less potent in dealing with the next crisis.
The reason for this is lower interest rates lead to more liquidity and this can cause investors to engage in more speculative behaviour. In turn, this pushes the markets into dangerous territory and sets itself up for another crash.
The last 18 months have brought the world deep into uncharted waters.
Many stocks market indices around the world are trading at nosebleed levels. Some are showing little signs of abating even as many financial and economic pundits are commenting that these levels are unsustainable.
This leaves central bankers in a very tight bind.
They underestimated the extent to which inflation arising from the world coming out of lockdowns would cause on the economy. Their flip-flopping rhetoric has served only to cause more speculation in the markets, pushing them even higher.
What central banks sow, they reap
Central banks don’t want runaway inflation and overheating asset markets.
Inflation causes their fiat currency to lose purchasing power. They want inflation, but not too much of it.
With asset markets, they want to keep prices rising to allow them to inflate away debt. It also sits well with the public as investors feel a dopamine rush seeing their assets rise in price. That is why they issued more fiat currency during the subprime crisis. Interest rates fell to almost zero. Markets stopped their decline and people thought they saved the day.
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A decade on, they face the very problem they’re afraid of. And they brought it upon us.
They now see they’ve gone overboard.
They ran out of bullets.
They fed a beast that they can’t control.
And now it is time to start putting on the brakes using their monetary policy levers.
The problem is, there’s not much else they can pull. They ran out of plausible solutions. Now they only have the tools that can cause a hard landing.
This is a tough choice for them. After all, it would be a bad look if the markets crash as a result of them resorting to these tools.
They need a ‘softly-softly’ approach to tame this beast. Ideally, the central banks want to control market exuberance and achieve a soft landing to a normal state like what we saw in the mid-1980s to around 2000.
This time, they have a snowball’s chance in hell of pulling that off.
A delicate game of chicken and Jenga
But they are willing to try. Hence, the Federal Reserve took the lead to talk about inflation to temper the market’s expectations and change their behaviour on speculating in the markets.
This bit is like the game of chicken.
Investors jump into the markets when the Federal Reserve says what it will do but doesn’t deliver. Investors step out when the Federal Reserve ups the ante on what it’ll do to keep things under control.
In short, investors are trying to collect their profits all the way to the top.
But this time around, it seems like the central banks are getting serious. They’re talking about how inflation is lingering, and therefore, they need to act.
This bit is like playing Jenga.
The investors built the tower and are exuberantly piling the blocks higher and higher. Clearly, this tower will eventually topple.
Meanwhile, the central banks are trying to take away the blocks and make it lower, without toppling it when it is their move.
What would be ideal from the perspective of the central bank is if there is something else that can cause the markets to tumble.
This is why there is so much focus on talking about virus outbreaks and variants. It would be a convenient scapegoat.
Cue…the Omicron variant.
Another month, another variant
It seems like we are living through a revolving door of outbreaks and controlling it with more lockdowns, mask mandates, and getting everyone to take their next booster shot.
At the end of November, the WHO identified a new variant, dubbed Omicron. The announcement brought the markets tumbling sharply.
Except it recovered quite quickly as soon as South African health officials came out saying that this variant is infectious but mild.
I guess the central banks are still holding the ball now. No scapegoat on another outbreak to bring the markets down to more sensible valuation levels.
Will the Federal Reserve have to take out the big club of raising interest rates to control runaway inflation and overheated markets?
You’ll find out before I pen my next update in The Daily Reckoning Australia.
Meanwhile, be cautious in your investing.
God bless,
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Brian Chu,
Editor, The Daily Reckoning Australia
PS: Our publication The Daily Reckoning is a fantastic place to start your investment journey. We talk about the big trends driving the most innovative stocks on the ASX. Learn all about it here.
