Monday 10, January 2022

What would the Fed do?

The Fed is the church of markets, and J Powell its high priest. How the Fed reacts to events, especially how it reacts to market movements, is the most important driver of markets. Since 2000 the Fed has demonstrated its willingness to step in if markets get nervous. The consequence of this is to keep the show on the road, but with an increasing amount of debt in the system, and with it, negative real interest rates.

For at least twenty years pundits have been saying that there is too much debt in the system. In Japan they’ve been saying it for nearer thirty years. The strange thing is that a weakening currency and increasingly capital formation have not happened. The developed world has moved short term rates to zero in close lockstep, which has spared the world the forex instability that would otherwise have happened. Governments have tolerated fiscal and current account deficits which would have been thought to be intolerable in the past. This has all happened without any consumer price inflation. For some reason, the debt has only succeeded in inflating asset prices. Of course, we’ve seen a tidal wave of Chinese factory workers join the global workforce, as well as a massive increase in female participation almost everywhere in the developed world.

It seems to me that it’s difficult for central banks to maintain their line that inflation is transitory. I am sure that in the long run it is transitory, but in the long run we are all bankrupt. At some point soon, surely, wage settlements with big employers (the NHS, Tesco, the Royal Mail) will start running at 6% or more, which will create the famous spiral. To keep control of this the Fed will have to act. But with the US public financing requirement as big as it is, ten basis points is a lot of money.

I don’t want to get carried away with powder keg or nitroglycerine examples, but you can see why well known commentators, and many others, are bracing for a major crash. The market is different today, although quantifying this is difficult:

• much, much more equities are held in ETFs, which are 100% invested. If end investors liquidate, there is no buffer: stock will be sold to meet redemptions dollar for dollar,

• much investing is rule based. A lot still is in 60:40 portfolios, or even variations on this that take account a fixed preference (typically based on age). This will cause bonds and stocks to be correlated more strongly than in the past.

• global markets are very correlated now. Global news media focussed on US markets. A lot of foreign capital has flowed into dollars and US equities. The globe as a whole is short of dollars. The US has been happy to generate more and more dollar assets to sell for dollars.

• crypto is an asset that will be very closely tied to US investor sentiment.

Making predictions is easy as long as one doesn’t specify a timeline. That’s exactly what I shall do.

Carbon Credits

Chris Dark is banging on about carbon credits again. Here. Don’t get me wrong: I think he’s right. The EU introduced the Emissions Trading Scheme decades ago, but it seems that it’s finally beginning to bite. The theory is that as the EU withdraws tokens from the market, to constrain the ability of industrial companies to emit carbon, the permits will start to become very valuable indeed. Because people value being able to drive and keep their homes warm.

Futures seem to be the natural way to take a view on this. Or ETFs, such as $KRBN. I believe that some legacy carbon emitters, such as E.on of Germany, have already loaded up on these permits, to the extent that these permits may be worth more than the rest of the company put together. To risk the stock one would have to do some more research. This article explains quite well how the system is designed to work. Although it’s not perfect, it’s a lot better than giving people tens of thousands of pounds to buy an EV. It must be equivalent to a carbon tax with a bundled redistributive element.

Recent price action indicates that markets are not convinced that these thing are a good thing.

The future is already here

It seems odd to think of Zoom as a disruptive technology. The first release of Skype was eighteen years ago. It does more-or-less everything that Zoom does, but better and cheaper. But a big change in attitude has been triggered by the pandemic. I think we’ll never quite go all the way back to the way things were.