The world’s central banks in dogfight

Stocks rallied yesterday on news that Bank of England was stepping in to prop up the country's bond market to stem an epic drop in gilts. Retail inventories continue to grow which may lead to pain for retailers.

What in the world? Have you been to New York City? If not, let me paint a picture for you. I am standing in the middle of one of the city’s iconic avenues, and I am looking straight up. I see gleaming buildings of all shapes and sizes, more than you could count without the aid of pencil and paper. Some of those buildings, especially the newer ones, seem to defy the rules of architecture. I can also see countless cranes swinging to and fro, hoisting large bundles of steel girders, used to erect even more novel, taller additions. Lowering my gaze to street level, I see waves of people, all walking with purpose. When the throngs stop for a red light, you can almost feel the tension buildup in the crowd, eager to pour through the intersection at the first break in the cross-traffic. And then there are the bikes. Lot’s more than I have ever seen in my lifetime in New York. Some of them, the brightly painted blue or yellow ones are prodded along by once-pedestrians eager to get to their destinations earlier, yet. Still other bicycles, the black ones wrapped in what appears to be electrical tape, tote brightly colored coolers and containers, filled with food and product deliveries to be dropped on desk and doorstep within hours or even minutes of a mouse click. Those cycles are electric powered, their pedals are just for show; they swoop in and out of traffic with confidence and fearlessness. It seems like this little island is the center of the world. If you didn’t know any better, you might assume that the US, in a broader sense, is an isolated island itself, with ties to the outside world optional and inconsequential.

Back to my desk, here in my office, crowded with screens, notebooks, and yes, a good old HP calculator, many floors above those eager crowds. My back is to the window, so I cannot marvel at the sea of tall spires. What I see from this view is that the US is far from an isolated island. I see a US Central Bank with resolve not seen in decades. A resolve to fight inflation at all costs, even the likelihood of a recession and job losses. Yields on sovereign debt, unarguably the lowest risk investment on this island, have leapt to heights we have not seen since The Great Recession. Those rises in yields are not just an aberration, they are noticeable even when zooming out the chart to cover many decades. It is noticeable because of not just its magnitude, but also the short period of time it took to get to those levels.

I am not the only one who notices the yields. Investors on other islands, Europe, Japan, England, and still others have noticed the higher yields on this island as well. Most all islands are struggling with painful inflation, causing stress for their citizens. Economies are slowing and recessions are looming. This island, though its economy is contracting, appears to be strongest of the weakened flock. That too is noticed by investors on those other islands. That causes those investors to seek the high yields offered by this island’s bonds. They must sell their local currencies and buy this island’s currency, the US Dollar, in order to by those higher yielding bonds. That causes the Dollar to rise in value and their local currencies to fall in value. Weaker local currencies make US goods more expensive when purchased on other islands. It gets more challenging yet. A barrel of oil pumped out of the ground on any other island can only be purchased by converting to THIS island’s currency. So, when the US Dollar gets stronger, just about everything gets more expensive… especially for those OTHER islands.

There are other side effects as well. Those foreign investors who are rushing to buy higher yielding US Treasuries on this island are selling their local sovereign debt causing them to tumble. The tumbling foreign debt markets cause havoc on their banking systems as liquidity gets squeezed. Their central banks must act. In order to limit further damage, foreign central banks must raise local rates along with THIS island’s central bank in order maintain some sort of parity. When that fails, foreign central banks must deploy extraordinary methods. At least one of those islands stepped in to stave the freefall of its currency by purchasing it in the open market. Its currency is falling faster than others because it has been keeping its interest rates low, thus stimulating its economy when most others are doing the opposite. Yet another island’s newly formed government decided to lower taxes and increase stimulus spending to ward off a recession. This caused its currency to weaken further and its sovereign bond market to plunge, accentuating its liquidity squeeze. The move left its central bank with no choice but to announce an unprecedented bond-buying binge in order to slow the selloff. The move caused this islands bond market to rally causing 10-year maturity sovereign debt yields to fall by nearly ¼ percentage point, a rare single-day move. Those lower yields on this island paved the way for a stock market rally after days of painful losses. Meanwhile, overnight, while citizens on this island slept and dreamt of further gains, another big island received some troubling news. The possibility of a decline in economic growth next year. That caused a fall in its currency and a rise in the US Dollar, this island’s currency, thus adding to the cycle of pain. Fear of a global economic decline caused futures for this island’s equity markets to sell off overnight, leaving those dreams of further gains in equities less likely to come true.

If you do come to New York City, take in the sites, check out the great museums, parks, entertainment, great food, and perhaps stop by my office for a visit. Be wowed by the spectacle, but by all means, please do not be fooled into believing that what happens on other islands, small or large, near or far, does not affect what happens on this island.

YESTERDAY’S MARKETS

It was a British invasion for markets yesterday with all indexes rallying in response to the Bank of England’s announcing a public market bond buying maneuver. The S&P500 climbed by +1.97%, the Dow Jones Industrial Average rose by +1.88%, the Nasdaq Composite Index jumped by +2.05%, and the Russell 2000 Index leapt by +3.17%. Bonds advanced and 10-year Treasury Note yields lost -21 basis points to 3.73%. Cryptos gained +1.45% and Bitcoin rose by +2.60%.

NEXT UP

• Initial Jobless Claims (Sept 24) is expected to come in at 215k, slightly above last week’s 213k claims.
• Quarterly Annualized GDP (third Q2 revision) is expected to be -0.6% in line with the prior estimate.
• More central bank hawk talk from: Bullard, Mester, ECB’s Lane, and Daly.