With Central Banks Dwindling, Investors Should Take Protection
Do you have a lot of money? Lose sleep on that bloated bank account? Maybe not. But avoid thinking about Jerome Powell and Christine Lagarde, who should lead us all out of the global cash glut. Faced with the same pandemic-era problem, the Federal Reserve and the European Central Bank have come up with the same solution: slashing monthly net asset purchases. Unfortunately for the financial markets, they will go down at the same time, and 2022 will be the year of “tandem” – the fastest drain of liquidity in a decade.
monetary data It suggests that advanced economies are awash with money, thanks to central banks’ voracious appetite for buying financial assets. In March 2020, amid the financial panic over Covid-19, the Federal Reserve Bank of New York was making money to purchase up to $75 billion in assets every day. Around the same time, the European Central Bank announced an emergency program targeting a total of 1.85 trillion euros ($2.15 trillion) in purchases. Abundant cash helped governments, businesses and families survive the lockdown. Cash flow collapsed but bankruptcies hardly increased. Asset markets and the real economy have emerged from the crisis on a solid footing.
The Covid public health crisis appears to be ebbing, but the injection of money has never stopped. The two central banks still buy roughly $235 billion in assets every month between them. Since neither the United States nor the European Union has any capital controls, this extra cash flows freely across borders, flooding markets everywhere. For global liquidity, it does not matter much which of the two central banks is buying.
The result was a frenzied rise in almost all assets, suppression of borrowing rates, inflated stock prices, and even the creation of non-existent assets. The financial system has to invent new types of assets because there is not enough to absorb the deluge of central bank liquidity. More than 6000 cryptocurrencies are now in circulation, not to mention the indestructible tokens, which are supposed to establish ownership of digital artworks that are easily copied.
With inflation rising, central banks curb purchases. The European Central Bank has already begun, announcing a move towards a “fairly low pace of net asset purchase”. The Fed essentially promised to do just that this quarter, warning markets that “moderation in the pace of asset purchases may soon be warranted.”
In two respects, the key term here is “moderate”. First, it reveals banks’ concern that markets will react too abruptly to a policy change. Second, this is not true. The two banks’ net purchases are set to go from the current pace of $235 billion a month to zero in 12 months, a slowdown of about $20 billion a month.
The last time net purchases in the US were reduced, resulting in a “taper tantrum” in 2013-14, the pace of the Fed’s slowdown was $8.5 billion per month over 10 months. But at the time, the European Central Bank was preparing to start its own buying, providing markets with a counterweight. When the ECB implemented its phased approach in March 2017, it took 21 months to complete, reducing net purchases by an average of €3.9 billion per month. The snail’s pace – and the European Central Bank’s resumption of net asset purchases after 11 months – helped offset net securities sales by the Fed.
In both cases, the two central banks offset each other’s influence, dampening the overall effect. But this time, the two banks are set to taper off side by side, amplifying the impact on money flows. This should terrify investors. accident Pioneering Research By Xavier Gabaix and Ralph Koijen show that flows do not only move asset prices; They move them disproportionately. Adding dollars to the stock market can increase the overall market valuation by $5. A subtracted dollar can have the opposite effect, reducing the total valuation by $5.
There are no larger or more predictable outflows than a major central bank’s purchasing schedule. As the world’s two major central banks prepare to close the taps, financial markets are on alert. Frontier assets like NFTs are likely to be the first to fall – but experience suggests that no asset class is immune to the liquidity drying up. As tandem gradually develops, investors and asset managers will need all the downside protection they can get.
Mr. Valatsas is Chief Economist at Greenmantle, a macroeconomic and geopolitical consulting firm.
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