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The borrower is the servant of the lender

By David Scott | Monday 3 July 2017


In the week the world's top central bankers delivered what appears seems to have be a collective message that quantitative easing is being put back in its box and interest rates are going up. Until  now stock and bonds have being  trading higher on the premise that the total pot of global liquidity was still swelling despite rising Federal Reserve rates - courtesy of ongoing European Central Bank and Bank of Japan bond buying programmes, most of all. Mario Draghi's change of tack on Tuesday had the most impact, far more than any of the recent Fed utterances. All of a sudden the usual central bank noises have suddenly harmonised over what the Bank for International Settlements calls the "great unwinding" of easy money. 

Hours after Draghi spoke, U.S. Federal Reserve chief Janet Yellen was warning of high asset price valuations, another Fed member was talking about putting the Feds balance sheet on "autopilot", and Bank of England Governor Mark Carney had earlier in the day changed his tone from saying that now was not the time to think about rate hikes to saying they would soon have to be discussed. Despite the initial knee-jerk moves, markets remained relatively cautious, wary that subdued global inflation and wage growth - which policymakers openly admit they are struggling to understand - will delay their reactions. Between them, the Fed, the ECB, the BoE and the Bank of Japan have bought up almost $15 trillion of bonds over the last eight years, roughly three-quarters of what the U.S. economy is worth.

The current rate of accumulation is still almost $200 billion (154.26 billion pounds) a month, split almost equally between the ECB and BOJ. Even if $50 billion was removed in the next six months or so as the Fed trims its balance sheet, the direction is still an increase.  But the mood music has changed and markets don’t like the thought of an end to money printing expansion.
As if to reiterate Janet Yellen’s message there were other comments from notable other US officials in the US last week. Early In the week San Francisco Fed president John Williams said that "there seems to be a priced-to-perfection attitude out there” and that the stock market rally "still seems to be running very much on fumes." Speaking to Australian TV, Williams added that "we are seeing some reach for yield, and some, maybe, excess risk-taking in the financial system with very low rates. As we move interest rates back to more-normal, I think that that will, people will pull back on that. 

On the same day Fed vice chairman Stan Fischer more diplomatically delivered the same message: "the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites.... Measures of earnings strength, such as the return on assets, continue to approach pre-crisis levels at most banks, although with interest rates being so low, the return on assets might be expected to have declined relative to their pre-crisis levels--and that fact is also a cause for concern. “Fischer then also said that the corporate sector is "notably leveraged", that it would be foolish to think that all risks have been eliminated, and called for "close monitoring" of rising risk appetites. The above two followed a statement by Bill Dudley, who many perceive as the Fed's shadow chairman, who the day before warned that rates will keep rising as long as financial conditions remain loose: "when financial conditions tighten sharply, this may mean that monetary policy may need to be tightened by less or even loosened.  On the other hand, when financial conditions ease—as has been the case recently—this can provide additional impetus for the decision to continue to remove monetary policy accommodation. “Then to seal the message Yellen speaking in London acknowledged that some asset prices had become “somewhat rich" by saying “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates,” 
Overextension has always been bad for nations, especially nations in significant debt. England and Spain were great powers at one time, and trying to maintain their presence in too many places brought them down.  Overextension threatens a currency, a country's standing in the world, and an economy, and ultimately it threatens globalisation, which affects all the countries of the world simultaneously. No nation that has gotten itself in this situation has gotten itself out without a crisis, or a semi crisis at best. Meyer Rothschild, the German banker and patriarch of the legendary House of Rothschildwho, when asked how he got so rich, attributed his success to two things. He said he always bought when there was blood in the streets—panic, chaos—when despondency gripped the markets. (In old man Rothschild’s case, investing amid the turbulence of the Napoleonic wars, the blood was just as likely to be literal as it was to be figurative.) And he always sold “too soon.” He did not wait for enthusiasm to peak. He always knew when to get out, and he got out in time with all his money. I doubt Meyer would be active in current markets.
During every mania in history people have taken shortcuts, doing things the easy way, and they have always gotten away with it because when things are going up, nobody notices. Nobody cares. In fact, the shenanigans in question are encouraged, because they contribute to the upward trend. During every mania, such behaviour is overlooked. It is seen as beneficial—people want it to happen. Only when everything starts collapsing do people ask, “How could you/we ever have done that? “Central Banks around the world have been printing money at a rapid rate to force interest rates down, to save Bankers and the stock market. But as always happens, market forces or the forces of nature or the forces of reality eventually come to bear, and interest rates in the end will be higher than they would have been otherwise. Many employees and current pensioners who are expecting normal pensions are going to be surprised in the next few years and not in a nice way
Janet Yellen proclaimed in the week that there will never again be a financial crisis in "our lifetimes" and this will probably go down with Ben Bernanke in 2008 saying the fed was not forecasting a recession, just as it was entering it.  The Fed caused the dotcom bubble in the 1990s. It caused the pre-Lehman subprime bubble. Whatever Ms Yellen professes, it has already baked another crisis into the pie. If an economy is built on a foundation of borrowed money, then that economy is living on borrowed time.
One question that I often ask leading economists, fund managers and politicians is what will be the Black Swan the bursts this bubble but in reality I know the answer.  It’s A Technicolor Swan... And You Can See It Coming From A Thousand Miles Away.
Central banks thought that printing money would bring inflation and this would inflate the excessive debt away. Unfortunately their big mistake was not understanding that inflation will continue to fall as long as debt compounds faster than GDP growth. We didn’t learn our lessons the last time around, and so now we are going to pay a very high price for our stubbornness.

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne

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