Friday, December 28, 2018

The Arrival Of The Credit Crisis

The Arrival Of The Credit Crisis

Those of us who closely follow the credit cycle should not be surprised by the current slide in equity markets. It was going to happen anyway. The timing had recently become apparent as well, and in early August I was able to write the following:
“The timing for the onset of the credit crisis looks like being any time from during the last quarter of 2018, only a few months away, to no later than mid-2019.”
The crisis is arriving on cue and can be expected to evolve into something far nastier in the coming months. Corporate bond markets have seized up, giving us a signal it has indeed arrived. It is now time to consider how the credit crisis is likely to develop. It involves some guesswork, so we cannot do this with precision, but we can extrapolate from known basics to support some important conclusions.

The Fed’s room for manoeuvre will be severely restricted by rising price inflation, which it can only combat with higher interest rates. Higher interest rates will become a debt trap springing tightly shut on government finances, forcing the Fed to buy US Treasuries under cover of monetary stimulation. The true reason for QE will be that with a rapidly escalating budget deficit exceeding $1.5 trillion and more, the Fed will want to suppress borrowing costs compared with what the market will demand. Economic conditions will be diagnosed as a severe case of stagflation. In reality, the US will be ensnared in a debt trap from which the line of least resistance will be accelerating monetary inflation.

It is easy to conclude the EU, and the Eurozone in particular, is a financial and systemic time-bomb waiting to happen. Most commentary has focused on problems that are routinely patched over, such as Greece, Italy, or the impending rescue of Deutsche Bank. This is a mistake. The European Central bank and the EU machine are adept in dealing with issues of this sort, mostly by brazening them out, while buying everything off. As Mario Draghi famously said, whatever it takes.

We can see that the global credit crisis has now been triggered. It always happens at some point anyway. The proximate triggers have been non-monetary, being the combination of President Trump’s fiscal reflation late in the credit cycle, and his imposition of tariffs on imported goods. The weakening of other economies from Trump’s tariff war is an additional factor undermining the global economic outlook.
Given these fiscal developments, the Fed had no option but to seek to urgently normalise interest rates, bringing on the credit crisis.
Inaction by the Fed would have undoubtedly seen price inflation accelerate, even allowing for the confines of a heavily suppressed consumer price index. The slowing of the US economy has, at least for the short-term, reduced price inflation factors. But as argued in this article they are unlikely to last.
These monetary developments have come at a time when two important central banks, the ECB and the Bank of Japan, are still applying negative interest rates. The disparity between these policies and that of the Fed, besides creating monetary and currency strains, will almost certainly lead to them both revising monetary policies. Only this month, quantitative easing in the Eurozone ceases, and bond prices are likely to fall significantly without it. A rise in the ECB’s deposit rate from minus 0.4% will surely follow, and it is hard to see how a developing systemic crisis in the region can then be prevented.

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