After more than a decade of chained stimulus packages and extremely low rates, with trillions of dollars of monetary stimulus fueling elevated asset valuations and incentivizing an enormous leveraged bet on risk, the idea of a controlled explosion or a “soft landing” is impossible.
The second problem of believing in a soft landing is underestimating the chain reaction impact of even allegedly small corrections in the markets. With global debt at all-time highs and margin debt in the United States alone at $773 billion, expectations of a controlled explosion where markets and the indebted sectors will absorb the rate hikes without significant damage to the economy are simply too optimistic. Margin debt remains more than $170 billion above the 2019 level, which was an all-time high at the time.
The Federal Reserve can’t expect a soft landing when the economy didn’t even take off; it was bloated with a chain of debt-financed stimulus packages that have made the debt soar and created the perverse incentive to monetize all that that the federal government overspends.
The idea of a gradual cooling down of the economy is also negated by the reality of emerging markets and European banks. The relative strength of the U.S. dollar is already creating enormous financial holes in the assets of a financial system that has built the largest carry trade against the dollar in decades. It’s almost impossible to calculate the nominal and real losses in pension funds and the negative result of financial institutions in the most aggressively priced assets, from socially responsible investment and technology to infrastructure and private equity. We can see that markets have lost more than $7 trillion in capitalization in the year so far with a very modest move from the Federal Reserve. The impact of these losses is not evident yet in financial institutions, but the write-downs are likely to be significant into the second half of 2022, leading to a credit crunch exacerbated by rate hikes.
Central banks always underestimate how quickly the core capital of a financial institution can dissolve into inexistence. Even the financial system itself is unable to really understand the complexity of the cross-asset impact of a widespread slump in extremely generous valuations throughout all kinds of assets. That’s why stress tests always fail. And financial institutions all over the world have abandoned the healthy process of provisioning, expecting a lengthy and solid recovery.
The Federal Reserve tries to convince the world that rates will remain negative in real terms for a long time, but borrowing costs globally are surging while the U.S. dollar is strengthening, creating an enormous vacuum effect that can create significant negative effects on the real economy before the Federal Reserve even realizes that the market is weaker than it anticipated, and liquidity is significantly lower than it calculated.
There’s no easy solution. There’s no possible painless normalization path. After a massive monetary binge, there’s no soft hangover. The only thing that the Federal Reserve should have learned is that the enormous stimulus plans of 2020 created the worst outcome: stubbornly high core inflation with weakening economic growth. There are only two possibilities: to truly tackle inflation and risk a financial crisis led by the U.S. dollar vacuum effect or to forget about inflation, make citizens poorer, and maintain the so-called bubble of everything. Neither is good but they wanted a decisive and unprecedented response to the pandemic lockdowns and created a decisive and unprecedented global financial risk. They thought money creation was not an issue and now the accumulated risk is so high it’s hard to see how to tackle it.
One day someone may finally understand that supply shocks are addressed with supply-side policies, not with demand ones. Now it’s too late. Jerome Powell will have to choose between the risk of a global financial meltdown or prolonged inflation.
