Central banks bring risks to investors

Chart of the week

Chart of the week: The chart shows the increase of freight transports in the USA compared to the stock index S&P 500. In the last 20 years, the amount of transports in the USA was a reliable sign on the state of the economy. If companies sold more, then the transported goods would increase and companies would earn more therefore driving profits and company value up. Since the outbreak of the Covid crisis, this correlation no longer applies.

Why it matters:

The rise in the stock market over the last 1.5 years cannot be explained by the traditional growth of the economy. Stock prices decouple from economic reality, therefore becoming more vulnerable to a potential correction.

The dilemma of the central bank brings risks for investors

The chart shows the development of the M2 money supply since 2000. The M2 money supply is defined as: currency in circulation + demand deposits of non-banks + all savings deposits of an economy. Due to loose monetary policy and government emergency programs, the available financial resources of the entire U.S. economy have risen sharply. Estimates show that about 1/3 of these balances have flowed into the equity markets. The rise in the stock markets is therefore primarily due to a liquidity bubble.

If the money supply increases more than the goods and services in an economy, this usually triggers inflation. The mandate of central banks is to prevent high inflation.

Central banks took a very high risk when they allowed the money supply to rise to solve the Covid crisis. To fulfil their mandate of fighting inflation, they MUST return the money supply to its original growth path.

How are central banks supposed to reduce liquidity to prevent inflation without bursting the liquidity bubble in the stock markets and causing painful losses? The person who solves this dilemma qualifies for the Nobel Prize. There has never been such a wide separation of the money and stock markets in the past.

Currently, the U.S. Federal Reserve is signalling that they plan to begin reducing loose monetary policy this year. The central bank's next decision will be on November 3. Investors currently fear that the Fed could intervene too quickly and too strongly. For this reason, the yield curve is currently flattening.

Since June, the difference between long-term interest rates and short-term interest rates has been decreasing. In recent weeks, short-term interest rates in particular have risen sharply. A flattening of the yield curve is usually an early indicator of weak growth.

The chart shows the purchasing managers' index (ISM, light blue) and an early warning indicator (dark blue) developed by the Philadelphia District Federal Reserve. The chart suggests that we will see very low growth or possibly even a contraction in the economy over the next few months.

All the data currently suggest that we could end up in stagflation.Stagflation describes an economic development with low growth (stagnation) and high inflation.

In such an economic phase, we usually see negative real interest rates.Equity investments that offer a certain protection against inflation are then in demand. That is, shares of companies that have a large market power and can raise prices. As a rule, such shares are found among the substance (value)shares.

‍Who buys bonds today?

Due to the Covid crisis, central banks are keeping interest rates low.

The chart shows the interest rates (nominal yield) of the 10-year U.S.Treasury bonds and the real yield for investors. The real yield is the nominal yield minus inflation. As of this year, this discrepancy between the nominal and real yields is widening. Interest rates are rising slightly but less than they should due to high inflation.

 As a result, almost no investors are buying bonds any more.

The chart shows the proportion of bonds held by private investors (dark blue), banks in investment advice (light blue) and fund managers (orange). The share of bonds in portfolios has been declining for years. However, sovereign debt is rising sharply due to the Covid crisis. One wonders who is actually buying all these government bonds?

The answer is obvious. The biggest buyers of government bonds are the central banks. But in doing so, they increase the money supply. This shows another dilemma for central banks. If they want to reduce the money supply,they must stop buying government bonds. This would lead to sharply rising interest rates and a recession.