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The end of the ‘liquidity supernova’ from central banks - by Andrew Evans-Pritchard - 11.01.22

This article by Andrew Evans-Pritchard for the Telegraph begins with these ominous words " US Federal Reserve is finally tightening monetary policy, but is the world now sitting on a time bomb? "

Hell hath no fury like a central bank fighting to regain lost credibility. If 2021 was the year of ultra-loose money and rampant inflation, 2022 is the year of retribution when chickens come home to roost.

The US Federal Reserve has switched almost overnight from friend to foe. The latest Fed minutes compound the policy shock, with tremors spreading through the global bond markets and the interlinked nexus of credit contracts and exchange rates. Everything is tightening.

Morgan Stanley says investors were assuming just five months ago that there would be no US rate rise until April 2023. Today markets are pricing the first rise within a couple of months, the start of four staccato hits in rapid succession this year.

Worse yet for tech stocks levitated by quantitative easing, the Fed is not only itching to end fresh bond purchases vivacissimo, but also intends to start selling down its $8.8 trillion portfolio within months. Quantitative tightening (QT) is coming much sooner than expected.

Krishna Guha from Evercore ISI expects the Fed to start QT in June and quickly to reach cruise speed of $750bn a year. If inflation persists, there could be a rate rise every meeting. This is what happens when a central bank falls badly behind the curve.

Omicron is almost a market irrelevance at this juncture. Investors can see what the health establishment seems curiously determined not to see: that the clinical data is benign; that T cell memory is holding up just as fundamental immunology would suggest; that all but a small minority in most countries is either vaccinated or has comparable cell immunity from prior infection; and that we are no longer looking at the same disease - as Oxford’s Sir John Bell put it.

There could still be a surprise from zero-Covid China as an unstoppable variant meets a defective vaccine in a ‘virus-naive’ population. That aside, the critical economic and market variable as we head into 2022 is what central bankers do about a wage-price spiral of their own making.

The jump in US headline inflation to 6.8pc is what finally caused the dam to break at the Fed, complemented by the 23pc rise in house prices over the last year, more extreme than the subprime bubble before 2008.

It is as if the Federal Open Market Committee looked into the mirror and collectively asked itself how it could justify injecting further emergency stimulus into a red-hot economy growing near 7pc (on the Atlanta Fed’s instant GDP tracker). Or asked how it can justify the most steeply negative real rates in modern history when the economy has hit capacity constraints and unemployment is at 3.9pc.

Stock markets normally cope fine when the Fed starts to raise rates, interpreting it as a sign of economic health. Deutsche Bank says the S&P 500 has risen 7pc on average over the first nine months during post-war episodes. Markets climbed steadily higher for three years after the Greenspan Fed first raised rates in 2004 and kept raising them 13 times.

But debt ratios are higher today and QE has changed market chemistry. Chairman Jay Powell’s attempt to unwind asset purchases by $50bn a month in late 2018 set off violent moves on Wall Street and led to global contagion. He capitulated.

The optimistic view is that this time is different. Goldman Sachs says there is a safety cushion of $1.5 trillion of commercial bank liquidity parked in short-term ‘reverse repos’. This could be used to soak up US Treasury bills and cover some of the US government’s vast funding needs.

Matt King, Citigroup’s global market strategist, begs to differ. What drives asset prices in our brave new world of QE is the ebb and flow of fresh purchases. “Markets are more sensitive to changes than to levels. As the flow of new money creation has dwindled, the rally has become dangerously narrow. It's best not to linger too long in crowded spaces,” he said.

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