Time to sober up as America and China remove punch bowl
The US Federal Reserve has refused to blink. The Chinese central bank has refused to blink.
The authorities in the world's two biggest economies appear determined to strike a blow against moral hazard and clear the froth in asset markets, at least until this exhibition of virtue blows up in their faces.
The term "Perfect Storm" is banned by the Telegraph as a lamentable cliché, so let us just say that this is the moment we long been fearing or waiting for – depending on taste – when markets are no longer given what they want.
The Bernanke Put has become the Bernanke Call. The Politburo Put has become the Politburo Call. Rather than putting a floor under asset markets whenever there is trouble, they are instead putting a roof on asset price rises.
Opinions vary widely on what happened in Washington last night. My take is that Fed has just tightened monetary policy. Bernanke shifted the unemployment target from 6.5pc to 7pc, bringing the end of stimulus much closer.
Tapering of QE bond purchases is on track to begin in September. Bernanke's argument that tapering is not withdrawal of stimulus because rates will remain near zero for a long time is specious. Of course it is withdrawal of stimulus, ceteris paribus. Bernanke is of course a "creditist" who puts all his focus on interest rates, rather than looking at the quantity of money, so this confusion is the inevitable result of his model.
He choose to overlook the fall in core PCE inflation to 1.1pc, deeming it "transitory". We will see about that. Note that James Bullard from the St Louis Fed and the one real monetarist on the FOMC dissented on this point, and quite rightly so.
Bernanke choose too to take a rosy view of US growth and the ability of the economy to shake off the effects of the spending sequester and this year's fiscal tightening, playing down such details as the contraction of the Philly Fed's manufacturing index and a fall in the US ISM gauge to below the boom-bust line of 50.
The Fed had a chance to back away after observing the violent effects of QE taper fire-drill on half the world over the last month. It declined to do so.
My guess is that Bernanke does not entirely believe what he said yesterday, but has capitulated to Fed hawks, to the Federal Advisory Council, to the BIS, and to a chorus of QE critics. And perhaps he really has swallowed the line by Mishkin et al that the Fed itself risks blowing up unless its extricates itself from QE by 2014.
Let me point out that the Fed has already "tightened" prematurely three times in the last five years, coming to regret its haste within three months on each occasion.
It talked up the yield curve by 50 basis points in the late Spring of 2008 even though the money supply – which Bernanke does not look at – was clearly buckling. This led to the Fannie, Freddie, AIG, Lehman disaster that Autumn. (Don't tell it would have happened anyway whatever Fed did. That is rot).
It threatened to take away the punch bowl after QE1 and again after QE2, only to double-down later. It has persistently misread the difficulty of achieving economic "escape velocity."
As for the PBOC in Beijing, we are seeing a cold-eyed refusal to intervene with liquidity to stabilise the interbank lending market, where Shibor rates have surged to record highs.
It seems they really do wish to flush out the excesses in the shadow banking system. They view the rampant credit growth after the Lehman crash as a mistake, as indeed it was, and are furious that banks have evaded property lending curbs by going off books.
Credit has grown to 200pc of GDP, up 75 points in less than five years. Fitch says total credit has jumped from $9 trillion to $23 trillion, adding the equivalent of the entire US commercial banking system in five years.
It no longer buttering many turnips. The efficiency of credit – the extra GDP added by each extra yuan of loans – has fallen from a ratio of 0.85 to 0.15. At this point it risks becoming a pure Ponzi scheme, as SocGen's Wei Yao calls it.
So yes, the Chinese are right to be tough, but that does not mean they can easily control the denouement. After all, the Bank of Japan deliberately popped the Nikkei Bubble in 1990, and the Fed deliberately popped the Wall Street bubble in 1929. Whether or not it is deliberate is a greatly overrated element.
At best, we are heading for choppy waters. The HSBC manufacturing index for China fell further to 48.3 in June, so it appears that the industrial recession is deepening. Perhaps it is touching bottom. It had better be, with that kind of credit monster sitting on top of the system.
It is hard to know which matters most right now: the PBOC or the Fed. It is certainly a synergy of nastiness.
What we do know is that the start of Fed tightening is a dangerous inflection point for those markets and countries around the world that relied on the flood of dollar liquidity.
The whole process that flattered their profiles for so long is going into reverse, and it is happening just as the most overextended – Brazil, South Africa, Turkey, Serbia, to name a few – have exhausted their own internal credit cycles. This is where we can expect the stress to appear. The real is down to 2.21 to the dollar today. I see they are already talking about 3 to the dollar at O Globo. Querido Deus.
More later.
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