Central Banks: A Foot on the Gas Pedal but No Brakes

Although the ECB left interest rates unchanged on Feb 3 and President Christine Lagarde has attempted to show that the glass is half-full, by saying that the ECB won’t “rush decisions” on a policy course, “the markets” see the glass as half-empty, and continue to factor into prices a four-time interest hike this year through a sell-off of bonds.

Thus, the yield on German five-year bonds has moved into a positive region for the first time. Earlier this year, that occurred with ten-year bonds. Yields on “peripheral” bonds increased proportionally. The spread between German and Italian bonds has risen to 150 basis points.

In other words, the markets are already increasing the cost of money, creating tough conditions for the refinancing of corporate and government debts globally. As for corporate debt, credit default swaps on U.S. corporate bonds are being bought at a high rate, namely $197 billion worth in January compared to $123 billion in December. According to ISDA, the last time there was such a volume in CDS – insuring investors against defaults on corporate bonds – was in March 2020, the month in which all markets were in total distress and the Federal Reserve was buying every dollar-denominated asset in the world to avoid outright crashes. There are not, however, other signs of likely defaults even in junk bonds.

When and if the Federal Reserve does finally get around to making small interest rate increases, a thousand mega-bubbles are ready to explode, as financial investor Jeremy Grantham warned (cf. SAS 5/22).One of them is the housing market in the United States, where average rents rose 14%, while the prices for buying new and existing homes increased by 17-18% in 2021. The combination of unaffordable homes and unpayable rents will result in a wave of defaults similar to the 2007-08 “mortgage meltdown”.

The Fed knows this,which is and why there is no sign yet of the “tapering” of quantitative easing (QE), which Federal Reserve OMC meeting reports said would occur; and still less of the “quantitative tightening” and “rate hikes” which the Fed is alleged in every media account to be carrying out in order to “control inflation”.

On Feb. 3, according to official reports, the amount of Treasuries and MBS held by the Fed was up $1.55 trillion on compared to the same date one year ago. This is more than what it would be, had the Fed just kept purchasing $120 billion in Treasury and MBS securities – not to mention the announcement on Nov 3, that it would reduce those purchases to 90 billion in December.

Thus, the Fed has kept flooding the banks with liquidity despite the rising inflation. Hoping to control an earthquake, it is creating a tsunami.