The Fed has already pivoted

The big picture of the market, in a nutshell, is as follows: The COVID-era stimulus went a bit overboard and at the same time the pandemic messed up supply chains and the labor market. As a result, the genie of inflation got out of the bottle, and the energy crisis isn’t exactly easing the problem. In a rapid and surprising inflation, most stocks have taken a hit, as can be seen from the stock market indices. Central banks turning from friends to foes has also threshed stocks.

The latest data point on producer price inflation in the US came in above expectations in November, reinforcing the narrative of a persistent and slowly receding inflation monster. If this story holds true, central banks will continue to tighten monetary conditions for a long time to come, and equity investors won't be having much fun.




But what if I told you that the world's most important central bank, the US Federal Reserve, has already turned its coat? It may be that the maximum monetary tensions are behind us, and we are already heading in a different direction.

So argues Michael Howell of CrossBorder Capital. CrossBorder tracks money movements globally. The central view is that liquidity drives the market. Liquidity can be understood as money in a broad sense, where Howell includes cash and deposits and the sources of credit that can be drawn from banks and shadow banks etc.

Liquidity, he says, is the leading indicator of what the market and the economy will follow with a lag. This view is quite logical, because it is difficult to pay much for any security if you have no money to buy it with. And when money is plentiful, people tend to pay even too much for whatever they're buying.



(I've also read his obscure book Capital Wars, which I can recommend if you're interested in a more technical approach to money. )

Here is a graph that investors often see: the Fed's entire balance sheet. As you can see, it's shrinking as we speak.

However, despite the speeches by Fed officials and the slow contraction of the central bank's balance sheet, the liquidity situation has actually improved in Howell's terms recently.

This graph shows the S&P 500 stock index and next to it, let's call it here “the net Fed liquidity”. What a wonderful term! That's effectively the Fed's balance sheet minus the reverse repo account. All you need to know about the reverse repo is that in practice it sucks liquidity out of the market. Then the TGA, the treasury general account, is subtracted from it. The TGA is a sort of federal checking account at the Fed that pays for federal spending. It's logical, because all the money that's sitting in the federal account is not in the economy and out of the market.



In principle, the effects of the Fed's balance sheet contraction have been offset by the fact that the treasury account, from which spending is paid, has been allowed to contract sharply in recent times. In other words, money has been splashed into the economy.

Be as it may, stocks have rallied after the Fed's balance sheet reduction measures have been effectively on pause for months. Liquidity will increase and with it the trend of the S&P 500 may reverse upwards. Or at least the worst pinch is over.

The starting shot for central bank prudence came in September, when the Bank of England almost spilled the milk. Rapid monetary tightening dried up liquidity in the government bond market. As a result, the interest rate on long bonds shot through the roof, which was about to fuel a financial crisis as the leveraged players came close to collapse. While central banks on both sides of the Atlantic have continued to tighten monetary conditions, in practice they have become more cautious. At the same time, central bankers' comments on future rate hikes have also softened.

At this point, it is worth distinguishing between two things in monetary policy. By raising interest rates, the central bank can raise the price of money, making people and businesses more cautious about borrowing. This cools economic activity, easing inflationary pressures.
Another way to regulate monetary conditions is the balance sheet activity. By buying government bonds and intervening in the market, central banks have eased monetary conditions. At the same time, their own balance sheets have ballooned heftily. In principle, a central bank can simultaneously raise interest rates and fight a potential liquidity crisis by inflating its own balance sheet, i.e., by injecting central bank dough into the system.

Much of the borrowing in today's world takes place because old debt needs to be refinanced. Therefore, interest rate developments may not be as efficient a tool as in the past.

As we all know, the global economy has become heavily indebted in recent decades. The world has around $350 trillion in debt. According to Howell, around a fifth—or $70 trillion —should be refinanced every year. Note that at a higher level of economic affairs, debt is never actually repaid, but rolled over by taking on new debt. In Howell's view, this is why central banks can’t tighten monetary conditions indefinitely, but the large balance sheets of central banks are here to stay. Yes, you can raise interest rates, but supporting the market with bond purchases can ease the pain of the fight against inflation.

Not only is there a lot of debt in the world, but countries from the United States to European countries to China and Japan are facing major challenges on the budgetary side. Populations are aging, increasing the health and social spending promised to the public. At the same time, the working-age population is hardly growing, economic growth is slow and the budget remains in deficit. Central banks are almost obliged to play their part in helping countries through this demographically difficult period of decades. Japan is decades ahead of us in this great demographic cycle, with a national debt of over 200% of GDP. The central bank owns almost half of that debt. The Bank of Japan is manipulating interest rates lower, something we are likely to see in the West in the future.

Against this background, it's therefore reasonably clear that central banks can’t remain too tight for very long.

According to Howell, the increase in liquidity is quickly reflected in the market. Cryptocurrencies, which are super-speculative manifestations of the era of loose monetary policy, have recovered little in recent times if we look at Bitcoin. Inside the scene, however, there is a bigger implosion, which can confuse the signal. Another sign is the US dollar. When the dollar weakens, financial conditions around the world ease. It’s worth remembering that many countries borrow in dollars and a strong dollar makes it difficult to manage these loans. A weak dollar is therefore positive for the global economy and for liquidity. This graph shows the S&P 500, the dollar index on an inverted scale and Bitcoin. In practice, the SP500 bottomed out in September/October at the same time as the dollar peaked and then started to weaken. Gold should also go up, as it's sensitive to monetary inflation.

 
A positive yield curve would also feed liquidity, but so far, the yield curves are inverted.

For equities, improved liquidity would mean higher valuation multiples. The way Howell sees the world is that the more liquidity, the more people are willing to pay today for the future performance of listed companies. In layman's terms, P/E ratios would start to stretch again. In particular, Howell favors energy, mining and banks. If I understood him correctly, valuations at the whole market level should start to stretch again.

Investors fearing a downturn may at this point ask why stocks should rise if earnings are falling. But so far, the economy has weathered the shocks surprisingly well, as have the results. And stocks don’t always follow results, especially in the short term (check the graph in the previous Whatsupstonks).

If Howell's view of a central bank U-turn is correct, it reinforces the possibility of a very mild recession, rather than a proper faceplant. Improving liquidity would still help stock prices to stay higher, even in the most hazardous places.

China's monetary policy may also be loosening as the country seeks faster growth after the COVID maelstrom, which will help global results. Cutting just a couple of corners, one could say that the US Fed determines the world's P/E ratio by its P, or price, and the Chinese central bank its E, or earnings. However, China's credit impulse has been rather sluggish so far, so let's keep our horses in the stable for now.

For me, the arguments raised some critical questions. First, because these are rather complex issues, it’s difficult to critically assess liquidity movements and their impact on the market. Second, what if inflation remains at higher levels for longer than currently projected? It may force central banks to continue their tighter stance, although it's quite clear that if a financial crisis threatens because of too tight a monetary policy, higher inflation is the lesser of two evils to bear. High inflation also lowers valuation multiples, as I have discussed before. (Of course, if you start manipulating interest rates, stocks will start floating with inflation like a wine cork in a rising tide.) In addition, the improvement in liquidity is largely due to the spending of the treasury account. It's a little unclear, at least to me, how much of this is coordinated with the Fed. I'm also not entirely sure what level the federal government wants its current account to be set at. It may well be that soon this tailwind will blow out. Then the Fed should run away with monetary tightening for all to see. Or if the Fed continues to tighten the monetary policies, Howell’s view is wrong.

At least Howell has the courage to take a stand with comprehensive arguments, which is always something to be applauded.

To sum up, if he is right, the stock markets did indeed bottom out in the fall. By the spring, the turnaround in monetary policy should be clear to all.

Thank you for reading the post! Keep an eye on liquidity and make good stock picks!