Monday digest
Posted 12 December 2022
Overview: Fed-up of Fed talk?
Often the most important question of any sound investment process is to ask: “are we missing something?” Regular readers may be becoming almost fed up with our continued discussion of central bank policy, especially that of the US Federal Reserve (Fed). And that’s a useful observation in itself. Are the current market moves really down to the market’s concerns about interest rate policy, or is something else going on?
Our own valuation models have done a good job of tying equity and bond prices together and, for a long time this year, the relationship between bonds and equities was in line with our thinking. However, about three months ago, equities started to diverge and became more expensive than usual, relative to bonds. Our theory was that, in essence, following the period since the start of the year, when investors had been scared of how rapidly bond markets had been moving back to higher yield levels, this was followed by more positivity. Certainly, in the past two weeks, long-dated bond yields have moved down a lot, as a result of more buyer demand pushing up bond prices.
One rationalisation has it that the Fed will ‘pivot’ in its policy of aggressive rate rises, which should make the extent and depth of the central bank- ‘promoted’ economic slowdown/recession less uncertain. Another has it that the Fed will stay hawkish, meaning a greater chance of recession. However, far more simply, it may just be ‘a few more buyers than sellers’, for a number of different reasons. Taking a firm view right now on the underlying story might be somewhat spurious and therefore dangerous if it drives decisions. But there is no denying that the market sentiment has become noticeably more buoyant. While things might change after the new year, when more bond supply may well become available, at Tatton we can see the attitude of those with surplus cash becoming more positive, which in itself is encouraging.
Who’s afraid of the wage-price spiral?
“Gyrephobia” is a fear of spirals, or anything in a spiral pattern. Perhaps, on recent evidence, one might suspect the Fed’s Open Market Committee (FOMC) members have a version of it. All year long, Fed Chair Jerome Powell and his colleagues have warned that supply-side inflation needs to be stamped out as quick as possible to avoid the dreaded wage-price spiral. The fear has led them to tighten monetary policy at the quickest pace in a generation, and they still have some way to go. The worry for investors is that this tightening bias will go too far, plunging the economy into an unnecessarily deep recession.
Evidence for the emergence of a spiral is not yet backed up by the data but, of course, we won’t know until after the event. In other words, if it does happen, the central banks (especially the Fed) will have failed and that means they have to err on the side of caution. Moreover, we think the Fed’s concerns about the possibility of a US spiral are legitimate given the enormous one-off boost to savings provided during the pandemic. This is the one factor not present (at least in the same degree) in other episodes. Already, this stock of spending power has kept consumption going substantially longer than would have occurred when confidence measures were as weak. The fact is that, for all the gloom, the US economy is still chugging along smoothly. As investors, perhaps the takeaway is that we should be fairly confident that inflation will not spiral out of control, even if that means the Fed will stay hawkish for longer than the market currently expects.
Huge, missing and blown out of proportion
One of the world’s most respected financial institutions is ringing alarm bells. In a paper titled “Huge, missing and growing,” the Bank for International Settlements (BIS) warns there is more than $65 trillion worth of unaccounted debt in the global financial system. Of this amount, $39 trillion is with non-US banks, some of whom have access to Fed (US central bank) liquidity through their US subsidiaries, although their main operations are not regulated by the Fed, while another $26 trillion is outside the scope of American regulators, sitting with non-banks. These liabilities positions come from currency derivatives and are not listed on company balance sheets, making them thereby a ‘blind spot’ in the global financial system.
The story makes for nerve-wracking headlines. The BIS is a bank for central banks, but also has a big research role in the functioning of global finance. Its researchers say there is an unbelievably huge pile of outstanding debt that neither they nor the world’s central bankers can keep track of. The obvious implication is that financial stability is under threat. Sure enough, one Bloomberg writer called the $65 trillion a “hidden global debt bomb”. But we think that is a little sensationalist.
The missing debt is not really missing, nor is it really debt in the conventional sense. Rather, it is a market for swapping currencies (FX swaps) which, for regulatory reasons, firms do not have to record on their balance sheets. Since the borrowing is backed up by hard currency, the risks are low. What’s more, fluctuations in the exchange rate between the currencies are covered by margin payments – as laid out in the contract at the beginning. FX swaps are designed to allow smoother trade across borders without introducing counterparty risk. Given their two-way nature, they are neither strictly assets nor liabilities. As such, only the net position needs to be recorded on a balance sheet, but not the amount of swaps outstanding.
The reason BIS estimates such a huge figure for the FX swap market is because they are very useful instruments, used by banks and non-bank institutions alike. However, trillions of dollars in off-the-books contracts means the world’s financial institutions are much more intertwined than they might otherwise seem. Shockwaves can therefore spread much more easily than policymakers previously thought. As the BIS points out, this is particularly worrying for central banks with a big global footprint, whose policy changes will affect asset holders around the world in unpredictable ways. Due to the nature of how FX swaps are recorded, central banks and the BIS cannot see them and cannot always manage them. But this does not mean they are unregulated, and much less that $65 trillion is “missing” from the world’s financial system. So, while saying $65 trillion is “missing” is a stretch, BIS is right that regulators should start looking for it.