Over the last three months, we have seen how badly central banks can be wrong about the real economy. In October 2018, the Fed, ECB and BOJ have still planned monetary policy normalization i.e., the end of QE and interest rate hikes to match them up with inflation. However, the level of market distortions due to ridiculous monetary policy was so large that the central banks has become powerless in responding to the problems of the real economy.
Is the recent policy change only an attempt to support numerous speculative bubbles like U.S. equity market, government bonds and corporate bonds? Or maybe their burst and the next financial crisis will be a tool to take over what remained of monetary sovereignty and transfer us to the new monetary system? In order to explain well the subject, I had to go back in time over a dozen years.
Pumping the bubble 2001 – 2008
After the tech bubble burst, the U.S. economy has fallen into recession. After that, the WTC attacks happened. In order to “save” the economy, the Fed cut interest rates from 7% to 1%, while George W. Bush (one of the most stupid U.S. presidents in history) has announced the program, that lead to a situation where every U.S. citizen could afford to own a home. There could be only one effect: a huge real estate bubble.
Most financial institutions have been aware that those mortgages are very dangerous. Some banks knowing what was going on were getting rid of the toxic debt, producing packs constisting of thousand pieces of mortgages, and then selling them as structured financial products. This procedure was to remove bad debt from their balance sheets before the bubble bursts.
However, it is impossible to predict when the eventual bubble burst. In effect, many investment banks instead of getting rid of MBSs (mortgages) have been investing in them, hoping to sell for a higher price in the future.
Eventually, as a result of Wall Street’s greed, foolishness of politicians and the Fed’s activities, the entire monetary system almost collapsed.
During that time, the society was intimidated by the vision of financial armageddon and politicians has voted for 800 billion dollars aid for the financial sector. In addition, the Fed has launched 16 billion dollars (equivalent of the U.S. annual GDP at that time) credit line, without any consent or supervision, which ultimately came to light two years later during testimony before Congress.
In order to fight with the crisis, central banks used tools that have never been seen before. Printing the currency to buy financial assets, which among U.S. citizens were not very popular, was hidden under the so-called Quantitative Easing. Low and zero interest rates were masked under the “ZIRP policy” (zero interest rate policy).
Some time ago Albert Einstein said that, ” The definition of insanity is doing the same thing over and over again, but expecting different results.” In my opinion, top central bankers knew exactly what they were doing and what would be the final result of it.
Europe Crisis in 2011
QE which has begun in the U.S. has been quickly implemented in most countries. Before that, Europe kept up sound policy (thanks to conservative Germany), until the debt crisis has happened in southern Europe due to the low interest rates. In well managed countries like Netherlands, Luxembourg, Germany (in the past) or Switzerland it is possible to keep low interest rates without adverse consequences. However, in the socialist southern Europe they have led to the housing bubble and sharp debt level increase.
At some point, investors have realised that Italy, Spain, Greece and Portugal may not be able to pay off their debts, which led to the sharp sell-off of these countries bonds.
There have been two solutions:
a) Restructuring the debt of the southerners and the bankruptcy of institutions that eagerly have been buying extremely risky bonds and eventually the breakup of the Eurozone. Rather unacceptable scenario.
b) Abandoning the principles of the conservative policy promoted for years by Germany and implementing currency printing in order to rescue the political project – European Union.
Ultimately, Europe has joined to the U.S., Japan and China, and the substantial currency printing have started. However, the newly created currency (euro) have not flown into the economy. Instead, government bonds have been purchased for which there was no public demand. All these activities were to reduce the cost of debt and “stimulate” the economy. Corporate bonds, have been also purchased, so European companies had access to the cheaper loan than the U.S. government.
At this point, it is worth mentioning, that over a few years central banks of the U.S. Eurozone, Japan, China, UK and Switzerland have printed an equivalent of 15 trillion dollars. These huge amount of money have been used to buy government bonds, corporate bonds, stocks, REITs and various types of toxic assets.
Back to normality
In 2015 the Fed has finished QE. This gap, however, has been filled by the Bank of Japan which still have been printing. After some time, global central banks have started to talk about monetary policy normalization. The graph below shows that the peak of the global central bank balance sheet expansion fell in mid-2017, after which Fed, ECB, BoJ and BoE have limited the scale of their easy policy. Graph also shows that the years 2008 – 2016 have been the period of interest rate cuts prevalence. In 2017-2018, however, the most important central banks have been solely raising interest rates. Keep in mind that the printing reduction is still printing, but on a smaller scale.
The Fed was the only central bank which has raised interest rates several times (from 0.25% to 2.5%), and reduced the balance sheet. The Bank of Japan have also announced printing reduction. Whereas the ECB have provided a specific date to finish QE – the end of 2018.
The decade of zero interest rates and massive liquidity injections (printing), have led to the situation where U.S. stocks, government and corporate bonds need continuous support from the central bank.
Over the entire 2018, emerging markets equities has fallen by 24% in dollar terms, similarly stocks in Europe. Only the stock market in the U.S. performed well, mainly due to the Trump tax reform (dollars returned back to the U.S.) and massive buybacks.
Jerome Powell, the first Fed chairman having real business experience since the 1980s, has been claiming that for him financial markets do not matter, and what only matters is the real economy. He has been also saying that the interest rates will be raised at least until they are equal to real inflation. So, in October last year, the Fed has announced 3-4 interest rate increases for 2019 and the balance sheet was to be reduced by 600 billion dollars a year. Despite the Trump pressure, who has been insisting to stop rate hikes and reduce balance sheet runoff, Powell has been unyielding. What really matters is the Main Street, not the Wall Street. And all of a sudden November and December 2018 came.
In just 7 weeks, the S&P 500 index (80% of the total NYSE capitalization) fell by 20%. Russell 2000 (small companies) and Nasdaq (technology companies) lost over 25%. The corporate bond market freezed. For the first time in history, no corporate bonds were issued for the period of 40 days due to the lack of buyers.
The market worth more than 7 trillion dollars, in which 3 trillion dollars is a BBB rating debt (just 1 notch above the junk level), has been started to hit. The chart above shows that the junk debt (below BBB) is worth 1 trillion dollars. In my opinion, it is at least three times higher. Rating agencies are pressured by the U.S. government to overstate the credit ratings. They have already done this in 2000 (Enron and Worldcom scandals) ad repeated it seven years later; awarding the highest rating of doubtful loan products of extremely overvalued homes owned by people without assets or income.
Six weeks of panic was enough for the FED to completely soften.
a) They announced that there will be no interest rate hikes in the near future. Trying to regain some credibility, the possible 2020 increases were mentioned.
b) 50 billion dollars of QT per month (balance reduction), i.e., 600 billion annually, has been lowered to 15 billion per month, and only until September when QT finished definitively.
c) The Fed Members have announced that the Quantitative Easing policy (formerly used only during the crisis times) will become a regular tool used by the U.S. Central Bank.
d) During the next crisis, the Fed will use tools that were considered too extreme to be used during the “Great Financial Crisis of 2008”.
e) The head of the Fed also announced that he would consider an introduction of negative interest rates.
f) To calm the financial markets, a 60-minutes speech has been organized in which both Jerome Powell and his predecessors, Ben Bernanke and Janet Yellen, have been calming investors.
g) In a flash of sincerity, Yellen said that central banks do not have adequate tools to fight the next crisis.
A few words about Europe. As stated before the financial system in Europe that is in a much worse situation than in the U.S., will not last for so long without the ECB bonds purchases. Officially, the QE in the Eurozone has been finished in the middle of January. However, only two weeks later, some problems have appeared in the economy that were material enough to introduce currency printing, but in another form. It should be emphasized that the financial system in Europe has resisted without the ECB support, only for two weeks.
Bank of Japan – the largest testing ground
It is believed officially, that zero interest rate policy together with the QE have been introduced for the first time after the 2008 crisis. This is not true; Japan has been the first country to drop the rates to zero level in 1999, and after that it launched the QE. However, the rest of the world have not heard about such a monetary policy until 2008, when it has been applied globally.
Currently, the Bank of Japan has already owning almost 50% of the government debt, and 80% shares in the stock ETFs and Japanese REITs. At the end of 2018, BoJ was one of the 10 largest shareholders of 40% companies listed on the Tokyo Stock Exchange.
Such huge amounts of bonds, stocks and real estate have been purchased using investment funds to hide from the public how many assets the BoJ actually owns. The most important fact, however, is that all assets have been purchased at zero cost! Ultimately, the funds used to buy them have been created from the air.
a) Despite the announcement of loosening monetary policy Fed continues to reduce the balance sheet and does not lower interest rates.
b) Economic growth in China is at the same level as in the middle of the recent crisis. Europe is in the recession, as well as Japan. The U.S. economy is slowing down very quickly.
c) The yield curve (10y – 2y) is already at the level of 0.16.
d) Despite the temporary improvement on the corporate bond market, the situation is still disastrous.
On the other hand:
a) Trump pressures Fed to lower interest rates as soon as possible.
b) Recently, Trump has appointed Stephen Moor and Herman Cain as members of the Fed. They are supporters of a very easy policy and quick rate cuts.
c) The Fed carries out a very strong PR campaign justifying the need to return to the QE and lowering the rates – most likely to negative values.
d) The ECB withdrew from any attempts to normalize the policy. Negative interest rates and unlimited printing will be maintained. Since our activities are not treated as the QE, then there is no limit for that.
e) The Central Bank of China in the first quarter of 2019 has injected 1 trillion dollars into the financial system in order to save it.
f) The Bank of Japan acts as a safeguard as it has happened before. If somewhere the capital is missing, the BoJ prints like crazy.
Due to all these factors, in the near future we will see a massive currency printing and purchases of different asset classes such as government and corporate bonds. We will also witness of a combination of the direct and indirect stock purchases like the Swiss Central Bank and Bank of Japan already do. In addition, zero or negative interest rates will be introduced, which will be unfortunately associated with a further attack on cash.
The question, which bothers me the most, is if we are going to see a gentle transfer to the three-shift printing, or whether the people who control the financial system will allow for a larger drop in asset prices (e.g., stocks and corporate bonds). The threat of another financial armageddon could be an easy explanation to justify the return to printing. In my opinion, the second scenario is much more probable. Ultimately, 99% of the population does not understand how the system works and it is enough to properly scare them in order to conduct a policy which during the normal conditions would be unacceptable. Perhaps, the whole blame will go to Brexit instead of the central banks, which activities has led to the current problems of the financial system. It looks like a plan which has been tested before: intitiate a crisis, scare the society, present the solutions to the problems and put them into practice.
In my opinion, a future change in the central banks’ policy justified by some turmoil on the financial markets, will lead to the global adoption of the model tested previously in Japan. The fiscal deficit will not be a problem, because it can be financed by the QE. Hyperinflation would not be possible, because printing is coordinated at the global level. Debt also will not be a problem because of its zero cost. Ultimately, a particular country might be able to issue bonds that do not pay interest because they are purchased by the central bank. The debt owned by the various types of funds, which will be released on the market in some time due to the rising inflation will also not be a threat, because the central bank will be able to purchase unlimited number of bonds.
Rescuing the corporate bond market will be a disaster for the economy. Central banks interventions will make investors stop worrying about whether they will recover funds invested in a doubtful quality bonds. This will lead to a situation that have no chance of success, and which, under normal circumstances, would have never been realized.
In the zero or negative interest rates environment, it will be a standard to see extremely high valuations of stocks and real estate. It will be called a new economy.
At some point central banks will become the main creditors of governments (government bonds), and corporations (corporate debt), and they will operate like a huge hedge funds (with large portfolios of stocks and REITs). It seems impossible, however it is already happening in Japan.
Central banks having such a strong position in the financial system will be able to force the governments of the “independent” countries to give up the remains of the monetary sovereignty.
How could it look like? If everything will go smoothly, and the servile economists convince the public and politicians to new solutions, the central bank will hand over some of its competences to the superior institutions (International Monetary Fund or Bank for International Settlements), as part of the new monetary reforms. Subsequently, central bank will transfer corporate stocks and real estate (previously purchased at zero cost) to the government. We will move to a new global monetary system, and the government will receive a cash injection after selling their stocks and real estates taken from the central bank.
If there will be a country reluctant to those changes, then the central bank, owning the majority of the government debt, will be able to determine the interest level. So far, the interest was not a problem because governments could in debt at zero costs. What happens next? Central bank starts to selling off the government bonds, making interest quickly grow from 0% to 10%, eventually reaching 25%. Currency of that country becomes cheaper, inflation is rising every day. The government cuts social expenses because it has no funds to finance them. The economy collapses and the society loses their patience coming out on the streets and protests. The government is forced to resign, and is replaced by people who already have a ready solution. This solution is moving to a new monetary system, reducing the debt level and acquiring the assets from the central bank.
What you have just read can be considered as a “conspiracy theory”. But since I have been involved in real economics, I have experienced at least 10 cases when similar theories have been confirmed in reality. Usually, it happens after a several years after they are ignored and mocked by the media.
Time will tell who was right. But I know that, if in 2006 I would have said that the Fed will print over 3.5 trillion dollars from the air to save the system, after the real estate bubble burst – that none of the media economists have seen, I would be immediately taken as a madman. My job, however, is not to translate the events from the past using slogans which are difficult to understand, but to look into the future.