FED finally pivoting in March 2023? I don't think so...
It’s been a couple of days since SVB failed and the FED came to the rescue. It didn’t took long for people to call for a rate cut and for the futures market to imply a ~40% probability of a no change in the FFR up from 0% last week.
However, is it really fair to think that the FED will pivot on this recent news? I’ve been saying for a while that there are several points the FED needs to check before changing its monetary path.
Internal Credibility
The internal credibility of the monetary system, in my opinion, is making sure that the excess liquidity in the system has been drained out. Ken Griffen, the CEO of Citadel, just recently in an interview said that the excess money in the system, at the current rate, will only be out by the end of 2023. It seems to me, that even though the US is not in a recession “yet”, the internal credibility of the FED has been mostly achieved.
Personal savings rate is now close to all time lows, risky assets have been repriced, real estate prices are dropping - people are now going back to work with labor force participation rate almost back to 2019 levels. However, inflation is still significantly above their mandate.
Zombies
As expected, as we approached the ZLB in key interest rates and as cash became “trash”, we were invaded by zombies. Not in the literal sense but companies that, according to the article mentioned below, are characterised by:
“zombie firms have leverage above the sample annual median, interest coverage ratio (ICR) below one, and negative real sales growth over the preceding three years.”
According to the study published at the Federal Reserve, most of the zombies are present in the manufacturing industry for listed firms and in manufacturing, wholesale trade and retail trade for private firms.
Part of the work that has to be done by the FED is to kill inefficiencies and excess that was created during the years of “cash is trash” - and start incentivising better capital allocation.
To wrap up this point, it becomes clear that the proliferation of zombies in the Rest of the World and Europe skyrocketed as soon as Central Banks policy stances changed to extreme ease, just after the 2008 crisis. Things are finally changing as key interest rates rose significantly in the last year.
Private and Business Practices
Still in line with the previous point, but in a broader sense, for a capitalist society to work, risks needs to be weighted when taking a financial decision. In 2019 there were already signs that economies were slowing down - and companies with excess leverage would have faced the consequences in 2020. That is.. if Covid-19 didn’t show up.
In 2019, the German economy recorded its weakest GDP growth rate (+0.6%) since the Eurozone sovereign debt crisis. All of a sudden, Covid comes along and Central Banks switch stance. Many of the companies that should have gone bankrupt, stayed alive, and some of this managers - particularly in sectors like real estate - are now feeling unstoppable while driving fast against a brick wall. Hubris is a real thing, and it should be dealt faster rather than later. The year of 2022 was what 2020 should have been. It is important for families and companies to have rational expectations about where we are in the economic cycle and make investment decisions in line with the economic signs that are being given by the economy and the central banks.
It is important, particularly at this time, to remember this wise quote:
“It’s only when the tide goes out that you see who’s been swimming naked.”
-Warren Buffet
To wrap up this point, I just want to emphasise the importance of “know-how” in current times. When cash is trash it’s easy to stay in business. However, as cost of capital increase - it’s really how efficiently you can run your business that counts. In a future article I will write about the importance of “know-how” in the streaming and content production industry.
External Credibility
In a globalised world, where the “garden” needs what the “jungle” produces - we need to make sure that whoever lives in the jungle still accepts our coin to trade. For reference to what I mean by the term garden and jungle I suggest watching this small clip here.
It is known that the EU is dependent on several goods. Some of the most known and widely discussed are energy related. However, the European Union is also used to its high quality of life in relation to the rest of the world - and its citizens are not willing to loose it. Even if it means work two more years to retire.
It is also important to consider that, other countries also want their population to live well. Some of these “in-development” countries, or the so called “jungle”, are at the beginning of most value chains. Thus, they act as inflationary forces and consequently present a threat, assuming no substantial gains in productivity, to the way europeans have been used to living. In the end this is all about a competition between how fast productivity grows and how fast these countries standard of living increases.
CBDCs
Central Bank Digital Currencies.. most people don’t really understand what it is nor what it stands for - in sum, programmable money. The rules of today might not be the rules of tomorrow and that is what you should have in mind regarding CBDCs.
The introduction of significant changes to monetary policy have to be made under an environment of monetary credibility. Particularly when it is something so fundamental like a CBDC.
The Chinese have been more open about some of the features of its new CBDC. In the article mentioned below you can find more about the Chinese CBDC. However, i’ll quote some of the features mentioned:
“Some of the Features of Chinese CBDC:
The digital yuan (DCEP) does not live on a public ledger. It is controlled centrally by authorities, to be changed if, as, and when political whims require such.
The DCEP is not a peer-to-peer currency but rather requires the use of officially regulated financial intermediation.
It does not have a market-based valuation independent of the old version of the currency. They are tied together.
The digital yuan does not have an algorithmic protocol dictating the production of new assets (akin to money creation), much less an end date at which point no more will be created. It is a currency with a discretionary money supply controlled by the government.
The digital Yuan permits a new method for surveilling the population, creating new data which can be tracked by authorities. Bitcoin has pseudonymous protections for user privacy.
The digital yuan is programmable to the point that the currency can be made to expire, thus forcing consumers to use it up by a certain date. This is a twist on an obscure, unconventional monetary policy innovation known as a Gesell Currency: Expiring Money, which gives the issuing government a heightened degree of control over money velocity.
Programmable money, tied to real-world identities, and universally tracked by a central bank, is like a substitute for the consumer of last resort. Every year that China gets richer, domestic consumption plays a bigger role (exports were 26% of China's GDP in 2010, and 18% last year). If domestic consumption can be tightly controlled, then it's a way to not just increase the volume of consumption but to control the variance of demand for the goods China produces.”
Link
Regarding the US and the EU, I believe the conventional Euro will be kept and simultaneously with the use of programmable money. The CBDC will start as something similar to what we are used to. However, in due time it will change away from its original communication to the public.
In reality it is a way to effectively more than double the tools of central banks and increase the complexity of the monetary system. There is, however, the challenge of creating supply and demand dynamics - but that is something that, in my opinion, will be figured out. I do have some ideas that I might share in a future article.
The Romans for instance already had a dual monetary system where they used a tight currency, such as gold, to high value transactions and a currency that was severally debased like silver for low-value transactions.
Deficits were sustained with systematic debasement of the silver denarius, which by the mid-3rd century had practically no silver left in it. Inflation ravaged the Roman empire.
In 301, one gold aureus was worth 833⅓ denarii; by 324, the same aureus was worth 4,350 denarii. In 337, after Constantine converted to the solidus, one soliduswas worth 275,000 denarii and finally, by 356, one solidus was worth 4,600,000 denarii.
To wrap up, I believe we are moving to a scenario where we will have two different currencies with different policy stances and use cases. Additionally, the more complex the monetary system is the higher the efficiency and efficacy of the system - as it maximizes the Cantillon effect and consequently the time needed to achieve the net neutrality of money.
Weaponisation of Monetary Policy
I’ve been saying over the last couple of years that the printing of money to indirectly subsidise green energy and ESG projects would not be taken lightly by countries like Saudi Arabia or Russia. Putin acknowledge the need for monetary easing and QE in an extreme scenario such as Covid. However, we went too far as the number of renewable energy projects started gaining traction on top of the fiscal packages approved to fight covid.
The case for Energy independence in Europe is as much a security concern for the EU as it is for Russia. Printing money and subsidising ESG and renewable energy is effectively similar to pointing a gun at Russia and other net energy exporters.
The ECB even came to the scenario where they wanted to add to their mandate climate risks through a so called “Major Strategic Review” announced by Lagarde following her nomination.
BuyBacks
According to Bloomberg, in the first month of 2023, announced buybacks more than tripled to $132 billion from a year ago reaching the highest total ever to start a year. The planned repurchases surpassed the previous January record, set two years ago, by more than 15%.”
So why are BuyBacks relevant? Because they help sustain valuations as markets move higher. In the current scenario, where the markets are down significantly off highs, buybacks will provide support and will be significantly more effective. Remember that companies are inflated protected in a way, but the cash used to acquire the shares is not.
Additionally, it is important to understand just how relevant markets are for social, economic and political stability. Particularly when it comes to pensions and reforms that are dependent on the performance of the market.
In one of my next articles I will approach the dynamics of the tech sector layoffs and how important was for Big Tech to over-hire in 2020 and 2021 and the importance of having a higher long term inflation target above 2%. However, if the Central Banks opened up about this no one would be buying bonds.
To wrap up.. One needs to understand that the consistent and clear communication around interest rate hikes should have been clear to banks and other economic agents. I’m still positively impressed on how central banks managed to deleverage the system with out any major breaking point… so far.