While the most predicted recession in the developed world is about to ignore the consensus and not show up, the news that has been labelled “good” until recently continues to cause concern and lead to stock market falls. At a first glance, it seems like a paradox, doesn’t it?
Let’s not forget, however, the context that developed economies have not encountered for decades: an extremely high inflation, which started before the war in Ukraine, was amplified by the war through the explosion in energy prices and shows no signs of going away any time soon. This is the number one enemy against which the “weapons” of the big central banks are aimed: quantitative tightening, by reducing the holdings of bonds on their balance sheets, and raising interest rates.
All these measures are essentially aimed at two things: lower consumption and higher unemployment. I know, it sounds very cynical, but it makes a lot of economic sense. As long as potential GDP growth is not achievable in the short term, the imbalance between aggregate supply and demand, which prevents a sustained fall in inflation, can only be solved by more expensive credit, more generously rewarded bank deposits and a halt to the wage-price race through a less tight labor market. That means unemployment.
In this context, in a counter-intuitive causal chain, news of further retail sales growth or job creation above expectations is seen as bad news by financial investors. That’s because as long as economies show no clear signs of “cooling”, the big central banks in the West will only continue to raise interest rates to lower inflation. So we need bad economic news to see the stock markets rise again.
The problem is that the task of Western central banks is more difficult than it first appears. And that’s because of Eastern central banks. A recent article in the Financial Times notes that since last spring, the Fed’s balance sheet has shrunk by $580 billion, which logically should have led to tighter monetary conditions. Yet, markets still seem to enjoy abundant liquidity. The explanation could be that both the Bank of China and the Bank of Japan continue to pump significant liquidity into the money market. The former to support the economy and the latter in its the yield curve targeting process i.e. government bond yields targeting.
According to Citibank, the net result is that, globally, the liquidity injected was $1 trillion, which is substantially more than the liquidity drawn by the Fed from the market. Such a situation is unlikely to continue in the medium term as the Bank of China would like to avoid fueling a real estate bubble, and the future governor of the Bank of Japan does not seem to be a fan of yield curve control. A halt to liquidity injections in the Far East could induce the stock market correction that has been surprisingly slow to appear despite repeated interest rate hikes in the US, eurozone and the UK.
The conclusions are perhaps unexpected. Let’s not wish for excessively good economic results (not even in Romania) and let’s look carefully not only at the near East, but also at the Far East.
Have a nice weekend!
