In today’s Money Morning…the boom-bust cycle…a very big experiment…the quantitative easing cycle…and much more…
Last week, I wrote about how passive investing — that is, investing mindlessly into indices of stocks based on nothing more than their valuation — has created big market distortions by concentrating world investment flows into a small handful of mega-cap stocks.
Well, the other big market distortion, in my view, has come from quantitative easing (QE). That is specifically the massive bond buying program that has been going on in the US. This has underpinned soaring global markets.
This has been called ‘the everything bubble’.
The way I see it, the bond buying is about to end, and now they are going to do the exact same thing in the stock market. Let’s call it ‘Operation Pivot’.
Let me show you how this unfolds…
But to get there, we need to first think about how the economic cycle works.
The boom-bust cycle
Our financial markets are a highly leveraged system. Debt amplifies the results of whatever part of the cycle we’re in.
During boom times, we increase debt at the same time that productivity increases.
But that can’t last forever.
And in the lead up to contraction — the inevitable bust part of the cycle — we have a slowing of productivity growth, while leveraging continues.
It’s the age-old economic law of diminishing returns in action. That ‘law’ also explains why the first bite of a tasty dessert is usually the best…but by the end you sometimes feel sick.
Anyway, this process leads to interest payments on debt eating — no pun intended — more and more into the profits of our productivity.
As this debt burden really starts to bite, we see defaults on loans.
Businesses start to borrow less as they cannot get return for their money, or because they are struggling to pay current debts. We also see banks get stricter with their lending practices as defaults rise.
This restriction in lending leads to a decrease in our productivity as the money to fund growth is quickly pulled away.
You can see how debt amplifies both the up and down swings of the cycle. It’s given freely in booms and viciously removed in busts.
What I’ve just described is the core essence of the boom-bust cycle. And, as I said, it happens because we use debt to fund our productivity, not just equity (cash savings and investments).
Now, to be clear, I think the use of debt is one of humankind’s greatest accomplishments. I don’t think it’s any coincidence that we’ve seen exponential growth in technology, standard of living and medicine, and almost every other area of our lives since we began to seriously use debt.
By the way, if you are interested in the history of money and debt, I suggest you check out a book by Niall Ferguson called The Ascent of Money. Or if you prefer, you can find a video series on it here.
The point is…
Debt is a core component of our financial system. The problem is we don’t really put too many restrictions on it.
Which has led us to…
A very big experiment
Right now, we’re in the middle of a giant monetary policy experiment called quantitative easing (QE).
Basically, it means that already leveraged up markets have also been supported by central bank bond buying.
The first thing that QE does is keep markets orderly and predictable. For example, this prevented the cascading margin calls we could’ve seen during the pandemic.
The following chart shows the wall of money that the Fed is using to support markets. This is the Fed balance sheet since the GFC. You can see in the chart that they started to reduce their balance sheet right before the pandemic kicked off in early 2020.
The second thing bond buying is especially good at is pushing down interest rates.
The primary tool that central banks use to influence interest rates is the overnight lending rate. In the US, this is called the ‘fed funds rate’. In Australia, it is simply the ‘cash rate target’.
The idea is that this overnight lending rate will flow through and influence all lending time frames, though, that doesn’t always occur to the level it needs to.
So sometimes central banks get creative to influence specific lending time frames. This is generally referred to as yield curve control.
The Fed did this in 2001 with Operation Twist. The Reserve Bank of Australia did it in March 2020 by setting a yield target on the three-year government bond.
This RBA target is what underpinned such cheap 2–3-year fixed home loan rates over the last couple of years.
This brings us back to quantitative easing and general bond buying. It suppresses market driven interest rates in whichever maturities the central bank is buying them.
And central banks can do this for a long time due to their power over money creation.
But there are now further complications…
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The quantitative easing cycle
The complicating factor now is that we’re seeing inflation in the US.
Interest rates will need to rise to combat inflation. This means the Fed won’t be able to buy bonds, as that lowers interest rates. It will become counterproductive.
At the same time, the share market is looking quite overpriced. Especially the tech sector. A crash in the share market has great potential to destroy a post-pandemic recovery. This is because of the potential for cascading margin calls leading to a rapid deleveraging.
This is the conundrum policy makers have got themselves into.
Interest rates need to rise to combat inflation, but this in turn threatens the share market. So what can they do?
I think the next form of quantitative easing we could see out of the Fed is mass-scale equity index buying. This is the ‘Operation Pivot’ I mentioned at the start of this article.
I would expect a move like this to come in somewhere between a 20–30% correction in the market. The goal here would be to stabilise the market and prevent a full market crash of 40–60%.
Does this idea sound crazy?
It really shouldn’t.
The Bank of Japan (BOJ) has been buying equities in massive quantities for quite some time. This is what the BOJ’s balance sheet looks like:
In fact, the BOJ is the largest holder of Japanese shares.
If you look at the top 10 shareholders for a Japanese company, you will frequently see the BOJ there. They own about 20% of Fast Retailing, for example, which is the largest component of the Nikkei 225.
Passive investing has already distorted the markets, and the BOJ has been doing the same thing in the Japanese market.
When the US share market next has a correction, we may well see the Fed buying equity indices in massive quantities. This will lead to a further distortion of market valuations.
This is the new quantitative easing cycle — a constant shift between buying government bonds when interest rates need to be kept low and buying share market index ETFs when interest rates need to rise.
The market is now addicted to the free money parade. This experiment is not over yet. We just need to be prepared for its next version. Enter Operation Pivot.
Until next week,
Editor, Money Morning
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