The only thing more painful than rising interest rates is the event that causes them to plunge again. That is the lesson of interest rate cycles since the ’80s. Central banks hike rates until something breaks, triggering a financial crisis, and then they cut rates again.
Now, admittedly, there are some rather unusual factors at play this time around. High inflation hasn’t been part of the equation since that cycle I just mentioned began to repeat in the ’80s, for example.
But inflation should only make the cycle more severe, not change its shape. It seems to be giving central bankers all the more incentive to hike interest rates too far too fast, causing an even bigger crisis than usual.
We’ve already got banks in the US going bust because they hold too many government bonds. Government bonds that are supposed to be risk free. But they certainly aren’t when central banks are hiking rates so rapidly. That’s because raising interest rates means lowering bond prices.
Between the end of 2021 and the end of 2022, an ETF that holds long dates US government bonds tumbled from $149 to $90. The UK version halved, sending its pension fund industry into meltdown. But a fund that holds assets is different to banks.
Banks have large liabilities and are subject to bank runs, creating systemic risk. If their assets plunge in value, as they have, then they can get into very big trouble, as they have.
And if this is what’s going on in the world of ‘risk free’ government bonds, what the hell is going on in the rest of the debt markets, where there is supposed to be actual risk and higher interest rates imply a higher risk of default?
Something very bad is going on indeed, according to the bond market. It’s pricing in 75 basis points in cuts this calendar year from the US Federal Reserve. That’s 0.75% in interest rate cuts. About three, depending on the pace.
But here’s the kicker — inflation isn’t expected to fall below the 2% level.
Now, what would trigger a series of interest rate cuts while US inflation remains much higher than the Federal Reserve’s target?
You’ll notice I ask what would, not what could, because the bond market must be pretty confident to be pricing in such cuts already. We’re talking about the expected scenario, not some sort of doom monge
ring.
There’s only one plausible outcome, if you ask me: a severe banking or financial crisis. Like the one that has already begun, perhaps?
This suggests that central bankers should be cutting rates, not hiking them.
Bizarrely enough, central bankers are continuing to battle the bond market’s projections for its policy. You see, the bond market has been predicting an about face from the Fed for quite a while now.
Bond traders simply didn’t think central bankers would be dumb enough to hike rates so far, so fast that it’d blow up parts of the US banking system.
But they were, and they have.
Central banks were created to prevent banking contagion. These days they’re causing it and making it worse!
As former hedge fund manager and self-proclaimed ‘Acid Capitalist’ Hugh Hendry put it on Bloomberg Radio to the audible groaning admiration of his fellow guest, bank analyst Chris Whalen, ‘What we are seeing here is, we are seeing the crucifixion of the common man on the cross of the vanity of Jay Powell’. That’s a reference to the Cross of Gold speech by William Jennings Bryan, which advocated for loosening monetary policy more than a century ago.
Hendry’s point, although it was largely lost in the brilliance of his Scottish elocution, is that central bankers are still feeling utter and complete humiliation for their mistake in causing inflation in the first place. And so they’re overcompensating for inflation by hiking rates too far too fast.
This may seem like we’re ascribing far too many human emotions to the cyborgs that are monetary policymakers but consider how they must be feeling.
They said inflation couldn’t happen. They promised not to hike rates. They didn’t see inflation coming when it peeked around the corner in 2021 in the form of producer price inflation. They said it’d be transitory when it began to rise. They said it wouldn’t go high. And then they copped the response they deserved from the public when they were wrong on all counts.
Now they’re overcompensating by focusing on inflation at the expense of everything else, including the banking system, which many of them are supposed to keep alive.
Indeed, as Whalen goes on to allege in the same Bloomberg Radio interview, the monetary policy part of the Federal Reserve doesn’t speak to the bank and systemic regulation part. Which means the left hand isn’t telling the right hand that the banking system can’t handle another rate hike. And so, the right hand continues to hike interest rates, only making matters worse.
Even more bizarre is the stock market’s version of events. Just like bond markets, stocks predict the future. But, as with all soothsaying methods, the key is interpreting the data.
You see, stocks aren’t exactly crashing in anticipation of the bond market’s anticipated banking crisis.
Historically speaking, bond markets are seen as being a bit more savvy than stock markets when it comes to these matters.
But there is one scenario that allows bonds and stocks to go up, explaining the bond and stock markets’ prediction of the future: rapid interest rate cuts as an overreaction to the banking crisis. We’re talking a reversal of 2022’s simultaneous crash in stock and bond markets.
That was the lesson of 2008 — don’t underestimate policymakers’ ability to goose financial markets. Perhaps it applies even in an age of inflation.
Until next time,
 |
Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
