Financial Times columnist and author David Stevenson, argues that the liquidity creating role of central banks and our increasing reliance on quantitative easing may lead to a dystopian monetary future
When I was young the only con or magic trick I could half decently perform was the three shells and a pea game – juggling was beyond my physical abilities and most card tricks required a much higher level of intelligence. That crudely executed shell game taught me the importance of deceiving observers by distracting their attention from the real action. As an investment commentator I sometimes sense echoes of this con in the actions of central banks. They love to focus our attention on that momentous decision about interest rates – will they, won’t they – but what you and I should actually be watching is off-centre, with the dynamics of their balance sheets.
To be clear, I’m not saying those interest rates don’t matter, they do. Especially as they begin to impact on that all important 2.6% barrier which many bond investors (including Bill Gross) think is the real signal for a bear market in bonds. But if you subscribe to my vision of the ‘Low Rates, Longer’ thesis, even a short term peak interest rate of 2% or, god forbid, 2.5% (at a push, and the Fed better get a move on) is not hugely relevant. Just like the Grand Old Duke of York, central bankers will get to those lofty heights of 2.5% and then come marching straight back down again because we’ll be one step away from recession within a year or two, as the business cycle naturally ebbs and flows.
The real game in town is the balance sheet, rather than interest rates, as it is more likely to trigger a recession. Put simply central banks and especially the US Federal Reserve, want us to believe that their balance sheets are too big and that QE needs to be unwound. The stated aim is for what’s called balance sheet normalisation, with the US Federal Reserve slated to cut the size of its US$4 trillion balance sheet by US$1-1½ trillion over the next five years. Good luck with that!
To understand why this vain attempt will fall at the first hurdle we need to head back into the world of economics and the concept of debt stock and capital flow that is key to determining what might happen next to central bank balance sheets. The prevailing myth is that QE has resulted in absolutely bloated central bank balance sheets and no one is doubting that some drastic slimming is required: i.e. the stock of assets and liabilities is way too big and needs to be squeezed. But observers who closely watch global liquidity and capital flows beg to differ. London based research firm Cross Border Capital is dedicated to monitoring the stock of central bank debt and the flow of capital and it reckons that we’ve all got the numbers wrong.
In a recent report they estimated that “aggregate World Central Bank QE is already turning lower, but importantly from mid – rather than high – levels, therefore, questioning the popular belief that world domestic monetary policy is still ‘excessively loose’. This is particularly true for the US Fed.”
Balance sheets only seem bloated if one sticks to the old central bank model, a narrow one which simply assumed a limited number of powers and minimal, short term focused, money market operations. In our liberalised, capital flow focused global economy, central banks have a much bigger role to play. In effect they operate less like central banks and more like an active sovereign wealth fund on steroids whose job is to manage national liquidity, control credit creation and generally reduce systemic risk. In this model the US Fed might actually just have the balance sheet it needs – but is about to reduce it to lower, more dangerous, levels.
Which brings us to the flow of capital markets lubricated by QE. Experience teaches us that major financial crises usually occur when big, speculative, cross-border flows of capital are coinciding with persistently tight central bank money. It’s these abrupt changes in capital flows, and their interaction with central bank balance sheets which cause the big moves in real rates. So where are we with those flows? Back to Cross Border Capital again on the big moves of the last few years that are about to unwind in flow terms. “Taken in absolute size, cross-border capital flows, over the past year, represent some 17% of developed market central bank liquidity injections, 68% of emerging market central bank liquidity injections, and a huge 157% of frontier market central bank liquidity injections.”
QE = Quite Essential?
Here’s the really important bit though. Over the last three years an astonishing US$3 trillion of capital “quit China, the Eurozone, Japan and the other Emerging Markets,” according to Cross Border Capital. “In the comparable period beginning 2007, these same economies enjoyed US$1 trillion of net inflows”. Obviously, QE has a role to play in these flows not least in Europe, where 70 cents in each Euro printed by the ECB’s QE programme looks like it left continent. With the ECB now joining in the QE slowdown that outflow will probably now turn into an inflow.
Step back from all these cross-border trends and we see a worrying situation brewing. China is looking stronger than ever, while European outflows are declining sharply as the mainland economy stabilises. The US, by contrast, is determined to shrink its central bank balance sheet whilst its president engages in inspired mayhem.
In this scenario do you think that central banks are really about to stick, monk like, to a new regime of squeezed balance sheets, especially when the proverbial populist inspired dung hits the fan? Of course not.
Let’s rehearse what I think is the likely scenario for the global economy over the next 2 to 3 years. Capital flows switch markedly (out of the US, into China and Europe) while the US and the European central banks attempt to shrink their balance sheets even as they try desperately to increase interest rates.
Volatility, especially in the FX markets, increases markedly whilst the business cycle also nears its peak. A slowdown looms and global capital flows pick up again as a result. Come late 2018 the US Fed discovers that it has most room for manoeuvre – it has managed to get interest rates to 2.5% and slimmed down its balance sheet markedly.
Responding to populist pressure as the economy slows, the US Fed drags down interest rates to 0.5% again. But it’s not enough – the shock power of such a move isn’t anywhere near what it used to be.
The Feds balance sheet starts to grow again markedly and global investors push their money back into the US while dollars flood out of Europe and the emerging markets again. Other central banks (especially our own) have even less room for manoeuvre – rates are lower and balance sheets bigger – so they resort to increasingly desperate monetary experimentation including helicopter money and variants of modern monetary theory. Calm returns and everyone realises that the myth of ‘Old Central Banking’ with its narrow fiduciary responsibilities and slimmed down balance sheets is just that: A myth. Welcome to the New Global Order and a New World of Central Banking.
David Stevenson is an experienced investment commentator and author, writing for a number of leading publications including The Financial Times, where he is a columnist, the Investors Chronicle, and AltFi News