Inflation concerns back in the frame
Cheap liquidity has been predicated on expectations of weak price rises
— on a “greater fool” presumption.
This is not a criticism of blockchain technology.
Bitcoin will end badly, either when the Chicago Mercantile Exchange launches its futures contracts in two weeks and allows traders to short it, or when the global cycle turns.
A runaway asset boom can last a long time when the G4 central banks are holding real interest at minus 1.5 per cent and spending US$2 trillion a year soaking up “safe assets”.
Academic bulls say the stock of central bank assets is still growing. Market bears counter that the flow is falling, which matters more to them.
Hence the recent rout in high-yield credit. Junk bond funds saw the biggest outflows since 2014 last week.
A parallel retreat is under way in East Asia where US$800m of bond sales in steel, solar and palm oil were cancelled.
These are minor tremors. What threatens the universe of stretched asset values is the return of US inflation. The boom is built on the premise that the Fed will bathe the global system with ample liquidity.
Yet that is precisely what is now in doubt as US unemployment drops to a 17-year low and the dormant Phillips curve reawakens.
The New York Fed’s underlying inflation gauge has jumped to a postLehman peak of 2.96 per cent.
Staccato rate rises by the Fed would ignite a dollar surge, squeezing an estimated US$10.7t of offshore dollar debt. There is a further US$14t of global dollar debt hidden in derivatives and FX swap contracts, pushing the total to US$25t.
Higher US rates would hit through a second channel, raising borrowing rates across the world. International finance is priced off US benchmark rates.
The Bank of England mapped out last July how this could metastasise into the next financial crisis. Its Stability Paper No 42 argued that banks were now much safer than in 2008, when a bad “feedback loop” amplified US$300b of subprime losses into US$2.5 trillion of bank write-downs.
But risk has migrated into nonbank finance from investment funds, pension funds and insurance companies through debt securities, creating a new feedback loop that could be just as dangerous.
Mark Haefele, investment chief at UBS, says it is too early to bail out but the coming inflection point is “something we think about a lot”.
His number-one worry is a US inflation surprise forcing the Fed to slam on the brakes. The triggers could be a rise in earnings growth to 4 per cent, a rise in the “five-year/five-year break-evens” (inflation expectations) to 3 per cent, and a rise in core PCE inflation to 2 per cent. If these happen, run for the hills. His second worry is credit stress in China setting off a fresh capital flight. Sophisticates may wish to short 12-month forwards in the offshore Chinese yuan. The rest of us should buy a few safe-haven bonds and pursue a “risk parity strategy”.
This global expansion is the second longest since the mid 19th century. It has been stretched because the recovery was so weak and because it was slowed by the eurozone banking crisis and the Chinese fiscal slump.
Above all, it has been stretched by debt creation. The world has even less tolerance for monetary tightening today. So does the market for red squiggles daubed with a pole.