By Eric Peters, CIO of One River Asset Management
“The Fed is “all in” on re-establishing price stability,” Fed Governor Waller pronounced in pleasantly direct language. “Experience has shown that markets need time to adjust to a turn from accommodation to tightening.”
In response to questions, Waller spoke with blunt determination: “I don’t care what’s causing inflation, it’s too high, it’s my job to get it down. The higher rates and the path that we’re putting them on, it’s going to put downward pressure on demand across all sectors.”
Powell offered his own sober message, “A soft landing is our goal. It is going to be very challenging. It has been made significantly more challenging by the events of the last few months – thinking of the war and of commodities prices and further problems with supply chains.”
New York Fed economists provide a bit more precision, arguing that “the chances of a hard landing are about 80%,” starting in Q4 2022.
Something will break. Something always does.
Digital did and the regulatory landgrab has started in full force. Lagarde, with plenty of serious policy decisions ahead, observed that “crypto assets and DeFi have the potential to pose real risk to financial stability.”
Spain’s Minister of Finance, Montero, announced digital asset owners would need to declare holdings and trading “in anticipation of regulations that would soon be carried out throughout the European Union.”
The East-West divide is clear in policy focus. President Xi is focused on growth, vowing to “strengthen macro-policy adjustment and adopt more effective measures to strive to meet the social and economic development targets for 2022 and minimize the impacts of Covid-19.”
Strains in emerging markets are being managed from within. Sri Lanka’s 22mm people are in the most severe economic crisis in nearly a century and India’s Foreign Secretary Kwatra underlined, “India stands ready to help Sri Lanka through promoting investments, connectivity and strengthening economic linkages,” beyond the $4bln aid already provided.
The East-West center of gravity between global war and peace sits in Kaliningrad, a tiny Russian province pressed between NATO countries. Lithuanian President Nauseda offered that “Russia cannot be stopped by persuasion, cooperation, appeasement or concessions.”
Elevated rhetoric continued when Russia’s Foreign Minister Lavrov drew comparison to Hitler’s war against the Soviet Union. “The EU and NATO are bringing together a contemporary coalition to fight and, to a large extent, wage war against Russia.”
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Liquidity Unknowns I: How much QT is too much QT? We don’t know. There is no tidy math formula, no general equilibrium model, no linear approximation that will tell you. The trouble is, in a world of false precision, everyone wants a number. And policymakers have a hard time saying, “we don’t know,” especially when it’s true. Through the week ending June 22, balances with Federal Reserve Banks – previously known as ‘excess reserves’ – stood at $3.115trln. Powell guided the market that the end point for the Fed balance sheet would shrink another $2.5trln to $3trln. How does that math work?
Unknowns II: Yet again new tools were needed in this cycle. To make sure rates didn’t fall below the Fed’s floor, they needed a broader mechanism to absorb excess liquidity. That mechanism was private sector access to the reverse repo facility. Remember the 2018 period of QT. Excess reserves were $1.9trln before liquidity conditions started to bite in September. Private sector reverse repos were basically zero. Today? $2.5trln. The Fed’s liabilities are acting as the riskless asset to private money funds in a way. The Fed clearly thinks reverse repos will decline. We don’t know. Behavior could drive it up if everyone wants liquidity and wants to face the Fed. As reverse repos rise, excess reserves decline. QT has more liquidity plumbing risk today – tools can turn into weapons.
Unknown III: The risks are different but the strategy with QT is the same – start small, increase gradually, and then let it run. It isn’t the obvious choice. Reducing the pace as liquidity is withdrawn is a more natural path – you typically slow as you approach a stop sign, after all. We will know when the tightening – both in liquidity and interest rates – has gone too far. Weak links will break. Digital plays the role of EM in this cycle – big enough to be noticed, not enough to get policy to stop. Asset deflation, a USD credit crunch, and risks from maturity transformation has led to capital controls with 11 digital intermediaries. As in the Asia Crisis, the ecosystem will respond to gain independence and resilience.
Unknown IV: Digital is the warning sign, not the circuit-breaker. Typical candidates – a rapid rise in the US dollar, EM currency and debt crisis, and banking strain – are just not applicable. After each crisis is a response, and those responses act like a vaccine against future ‘shocks.’ Emerging markets have insulated themselves with large holdings in the US dollar. Currency depreciation forced EM central banks into more orthodox positions well ahead of the Fed, ECB, and BOJ. Banks don’t have the space to make the mistakes of the GFC, with leverage financing pushed to capital markets. But markets have not been weaned from liquidity. To the contrary, each crisis has increased dependency on Fed liquidity.
Unknown V: The adjustment in broader markets is orderly. How else would it be? Disorder is how it ends, not how it starts. “It is like jumping from the 100th floor of a building and saying, ‘so far, so good’ halfway into the drop,” a prolific investor remarked when confronted with “contained” language head of the GFC. Liquidity transformation in traditional markets, the driver of digital weakness, is everywhere. And it is a so-far, so-good story. ETF discounts make the point emphatically. An illiquidity pocket means that ETFs would clear the way closed-end funds do – hunting for a price where a buyer is willing to absorb the liquidity risk. Mortgage ETFs are down 9.7% for the year and trade exactly on net asset value. So far, so good.
Unknown VI: What we can see is rarely the problem. The grandest mismatch resides in private markets. “Prior to the pandemic, many had already grown concerned about public market valuations and were exploring private capital markets in the hopes of addressing lower return projections for their traditional 60/40 portfolios.” Pronouncements like these became the norm. A generation of “J-curve” investors – the pattern of private investments to draw capital and then deliver rapid returns – was born. Everyone wants a liquidity buffer. Nobody has one. And in the everything bubble, to get one you are selling assets in the hole. You sell what you can. You promise never again, even if enticed by the Fed toolkit. Until it happens again.