Overzealous central banks are making another horrible mistake, so batten down the hatches


Raising rates to defend your currency doesn’t always work in all cases, as Sweden’s Riksbank found this week. It went for a jumbo 100 points but still failed to stabilize the krone, weaker this year even than the pound and the euro.

While the UK media focuses on the British pound, the biggest story in global markets is extreme currency weakness in China, Japan, Korea and Taiwan. The yen is at a half-century low in real terms against the dollar, triggering outright foreign exchange intervention by the Bank of Japan on Thursday. The Chinese yuan weakened beyond the 7.0 psychological line, risking capital outflows similar to the 2015 currency crisis.

Exchange rate ructions on this scale by a quartet of global creditors with $5trillion (£4.4trillion) in foreign exchange reserves are invariably warning signs of trouble in global finance. Some of us remember the crash of 1998 when a chain reaction blew up hedge fund Long Term Capital Management, forcing Greenspan’s Fed into a dramatic retreat.

Markets were expecting the Fed to hike rates by 75 basis points this week. They did not expect its chairman, Jerome Powell, to lock himself so irreversibly into further increases. “There is no way out of this aggressive position. They’re pretty much bound to do another 75 at the November meeting and then 50 in December,” says RBC Capital’s Tom Porcelli.

At the same time, the Fed began draining $95 billion a month of dollar liquidity through quantitative tightening. This squeezes offshore dollar loan markets. It’s slow torture for borrowers in the developing world with dollar debt.

The Fed works from a new Keynesian model that ignores the quantity theory of money. That’s roughly equivalent to $2.5 trillion in QT just two quarter points of a rate hike. There is a contradiction in this statement. Bernanke’s Fed has long insisted that quantitative easing is a necessary and powerful stimulus: now Powell’s Fed says QT is just background noise.

Markets think otherwise and will act accordingly. They are extremely sensitive to liquidity “flow” effects.

Michael Darda of MKM Partners says the Fed’s real policy rate has risen 360 basis points in the past seven months, “something that has only happened three other times in history, all associated deep recessions and bear markets”.

The Fed is obsessed with legacy inflation, heavily skewed at this point by the real estate component of the price index known as “shelter”. But the shelter is sticky. It is 18 months behind the real estate market.

This has led to a surreal situation: a rise in 30-year fixed mortgage rates to 6% over the past year has sent the real estate sector into a tailspin. The NAHB housing index peaked last December and fell at a faster rate than during the subprime mortgage crisis in 2007. If it’s inflationary, I’ll eat my hat.


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