The Fed vs the ECB. A Risky Bet Against the Curve
Last week, the Federal Reserve announced three rate hikes in 2017, and another three in 2018, with a $600 billion reduction in its balance sheet ($420 billion in treasuries and $ 180 billion in mortgage-backed assets).
The announcement has sparked the concern of inflationists and bubble defenders. A downsizing of the Federal Reserve’s balance sheet! Anathema. As if it had not risen from $900 billion to the terrifying figure of $4.5 trillion, and mainstream analysts are worried about a small decrease. None of them seem to worry about the huge bubble in bonds nor the excess of risk taken looking for a little yield.
Mainstream is so concerned that they have invented a direct correlation of the size of the Fed’s balance sheet to warn of a massive crash in the markets… Except it does not happen. Rates are rising, the dollar is strengthening, the Fed’s balance sheet is shrinking… and stocks are soaring.
Stocks soar because earnings are better, leading indicators improve and financial conditions strengthen, not only because of money supply. Quantitative easing generated inflation on financial assets, while dividends and buybacks created multiple expansion, and now earnings are back to the rescue.
What consensus is worried about is that, between 2017 and 2018, the composition of members of the Federal Reserve will change to a majority that defends sound money, that is, to end the assault on savers and the middle class that QE meant. In the past eight years, fiscal policy in the US has meant an increase in taxes of $ 1.5 trillion and destroyed a similar figure in the value and purchasing power of the main source of wealth of the United States citizen: deposits. The largest transfer of middle-class wealth to the government seen in over fifty years.
The Federal Reserve is already almost 300 basis points behind the curve. It should to have raised rates much faster.
Meanwhile, in Europe, the ECB is not just behind the curve. It is so far away it does not see the curve.
If the ECB continues with its monetary policy while normalization accelerates in the US, the vacuum effect will multiply.
What is the “vacuum effect”? The world’s US dollar supply shrinks as demand for the currency soars, generating capital outflows in countries that are not a global reserve currency and into the US. This vacuum effect, added to the repatriation of dollars from US companies, is a major risk for the European Union. With more than 1.3 trillion euros of excess liquidity in the ECB, the EU would face the opposite scenario. Supply of euros massively exceeds demand.
Some will say it is an opportunity to export more. It just does not happen. European exports outside of the Euro Zone have stalled since the ECB started its quantitative easing program. But what does happen is that international confidence in risky assets denominated in euros diminishes. If it also coincides with a deterioration of solvency indicators – deficit, net issues, interest payments over GDP – this deterioration in confidence can generate a significant risk that, today, few are analysing.
We must remember that the vast majority of global trade transactions are made in US dollar (87.6%, according to the BIS).
Contrary to what many people think, the percentage of global transactions in US dollars is not only high, but has recently risen. In the same period, since 2008, transactions in euros have fallen eight points. It is no coincidence that this collapse in the use of the euro in global transactions, accelerated with the so-called “monetary expansion”.
As we mentioned, the euro risks losing relevance in global trade, and the alleged “export-effect” is inexistent. If the United States finally puts the policy of defending sound money and the savings of its citizens as the center of its policy, it can create enormous uncertainties for a euro that is now used in fewer transactions globally.
You will say that the US cannot survive a strong dollar, but we already dismantled that argument here (“Is the US dollar the new gold?”).
Almost all governments and parliaments in European countries are seized by the single thought the Japan-style futile policy of negative real rates and excess liquidity must continue, despite evidence of the risks it generates, but Japan has huge savings in foreign currency and an enviable financial inflow. The European Union, does not.
If the ECB resists raising rates, when it is an emergency, and reducing asset repurchases, when it has 1.3 billion euros of excessive liquidity, there could be significant risks in a global economy where the euro is an anecdote. If this is a risk with a strong currency, backed by economic powerhouses, imagine what would happen with unsupported currencies, as the European populists want. A disaster.
If we forget the need to strengthen economies before monetary excess ends, the negative consequences will be serious. Of course, when a new crisis arises, some will blame lack of regulation, not reckless policy.
Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).
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