Food for Thought

Read time: 3 min

Today will be a much shorter edition than usual as I am travelling and have been busy all week with other business.

Once again markets are rallying ahead of the FOMC on a very wishful pivot narrative.As I have previously mentioned, this almost relentless move may have much more to do with Gamma Flows and Deal Positioning than anything fundamental.

Regardless for now we know that the following correlation holds:Dollar Down + Rates Down = SPX up.

Just over a month ago I shared this image with you ahead of the last FOMC.Chasing noise did not payoff last time, I wonder if it will this time.

I will go through this week's price action in more detail in my usual Weekly Macro Note on Sunday.For now, while everyone is focused on short-term interest rates and looking at the market as though it were a one-factor model, I want to share with you some thoughts as to why rates may not be the most important thing to consider, and certainly not the only one!

Long-time readers will not be surprised to hear that I consider Liquidity and QT to be the much important factors.

So let me quote results from some research done on this topic.

In his book “Capital Wars, the Rise of Global Liquidity” Michael Howell argues that in the last few decades “the economic background is characterised by the need to finance large outstanding debts, rather than to finance new capital projects, balance sheet capacity, i.e. Liquidity, is crucial, and the cost of capital, i.e. Interest rates, becomes secondary.”

Estimates of Global Debt vary, but the figure is generally reported to be somewhere between 250% to 350% of GDP

“The 2007-2008 Global Financial Crisis (GFC) and the subsequent policy response evidenced that interest rates are not the main channel of monetary transmission. This period demonstrated unambiguously that setting the short-term interest rate is, by itself, an inadequate monetary policy tool, and that so-called forward guidance on rates, quantitative easing (QE) and quantitative tightening (QT) policies, and changes in banks' regulatory capital asset ratios matter much more. Using these latter tools, both Central Banks and Financial Regulators can affect the aggregate growth rates of money and credit by slowing or stimulating the expansion of banks assets and liabilities.”

Meanwhile, Borio of the BIS, notes that “By disturbing balance sheet quantities and specifically the balance sheets of financial intermediaries that invest and directly supply credit to the private sector, the policy-makers can affect risk-taking, wealth and collateral values, and, hence, GDP.”

The ECB seems to concur, warning in 2011 that "Global Liquidity, both in times of abundance and shortage, has a range of implications for financial stability. Surges in global liquidity may be associated with strong asset price increases, rapidly rising credit growth and in extreme cases excessive risk-taking among investors. Shortages of global liquidity may lead to disruptions in the functioning of financial markets and - in extreme cases - depressed investor risk appetite, leading to malfunctioning markets".

Circling back to my initial statement that QT and the reduction of the Balance Sheet is likely to be a much more important transmission mechanisms into financial markets than setting interest rates, the Banque de France states in 2018 that “most of the channels through which QE(monetary policy) might work are entirely independent of the accompanying level of nominal interest rates.”

Thus as we approach the end of the rate hike cycle, I want to remind folks that the Fed plans to sell $100B in assets well into 2024.Both the BOC & RBA have begun shrinking their balance sheets,the BOE intends to begin in Nov,and the ECB is hinting at a start in 2023.

Much more to come from me over the weekend, in the meantime I hope this provides some food for thought and a slightly different perspective than everything you will be reading today in the Financial Media.

Thanks for reading,

Antonio C. Nobile

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