By Michael Every of Rabobank
Magic, Minsky, and Munich Moments
One does not need to be much of an analyst to see markets have experienced a “magic moment”. Apart from long duration government bonds, the prices of most assets have levitated, even the biggest heaps of steaming rubbish. Now markets are starting to be concerned the spell might be breaking. Not the ultra-easy monetary policy from central-bank prestidigitators; they will keep sawing price discovery in half for as long as it takes. Nor the (US, and to a far lesser degree, EU) fiscal policy assisting in a glittery leotard. Indeed, the fear is not that the reflation trade is not working, but rather that it is.
Real rates in the US, while still negative, are rocketing. If not stopped, this has the potential to see the magic end like Houdini, who died from an offstage punch to the guts. Yet it was always magical thinking to expect so many rabbits being pulled out of so many hats would not push up long US yields near-term; or that absent structural reform, deflation would still kick in longer-term; or one and then the other. In all cases though, this equals rising real US rates.
The suggestion this could happen may be enough to get people worried about a potential “Minsky moment”. However, the entire driver for our magical moment is that Minsky no longer matters. Indeed, if central banks were to act otherwise right now, they really would be sawing market prices in half – at least. Indeed, if those magicians have to face a choice between rising real rates and levitating markets, which one do you think they will make disappear? Obviously rising yields, through outright yield curve control. At which point, almost all price discovery will follow through the hidden trap door.
Even so, it is again magical thinking to believe this trick can be pulled off without literally bringing down the house. Decades of inequality-driving neoliberalism followed by unlimited free money only for the people who drove that same policy to prevent a Minsky moment comes at a political price. While the US --as leading indicator for others-- is not likely to slip into outright revolution, it is seeing deep, bitter, and worrying polarisation. This is Red-Blue, but generationally the divide is even starker. That necessarily puts pressure on politicians to respond: and they are.
Everyone is now looking after their own national economic interests. In the US, the Biden White House is talking about US foreign policy for the middle class and “Buy American”; China is embracing “dual circulation” to keep money flowing at home; and even the EU just released a proposal on trade that plans to rebuild supply chains to create high paying European green jobs, and flags EU tariffs, to prevent green stimulus from “leaking” out to ‘dirtier’ (cheaper) producers, and “an EU export credit facility and enhanced coordination of EU financial tools”. This historical pattern has repeated itself - as if by magic!
Geopolitical consequences then flow from these political adjustments, which brings us to our Munich moment. That infamous 1938 conference saw Chamberlain appease Hitler and promise “Peace for our time” - which turned out to be 12 months. Last week US President Biden spoke there (online) and his tone was upbeat and yet bleak. He proclaimed: “America is back. The trans-Atlantic alliance is back,”; that “Historians are going to examine and write about this moment as an inflection point,”; and “We must demonstrate that democracies can still deliver for our people in this changed world. That, in my view, is our galvanizing mission. Democracy doesn't happen by accident. We have to defend it, fight for it, strengthen it, renew it.” This will naturally require a lot of economic changes that a lot of markets aren’t going to like very much. As one example, how about the ‘Uber mention’ of the UK ruling last week that the firm’s drivers are indeed employees? Mark up a point for labor vs. capital. (Which makes it about 1-100.)
Biden also stressed “We must prepare together for a long-term strategic competition with China….We have to push back against the Chinese government's economic abuses and coercion that undercut the foundations of the international economic system. Everyone -- everyone -- must play by the same rules. We must shape the rules that will govern the advance of technology and the norms of behaviour in cyberspace, artificial intelligence, biotechnology so that they are used to lift people up, not used to pin them down.” He added that he didn’t want a Cold War – but it was too late for Chinese audiences at that point. Moreover, both France and Germany shrugged Biden’s appeal off. Paris said it wants US help in Africa and the Middle East, but sees Russia as a potential partner and won’t ruffle Chinese feathers; Berlin did what Berlin always does with geopolitics – think about selling cars.
Only the UK backed Biden….then PM BoJo claimed to be a “fervent Sinophile” who wishes to deepen economic relations - maybe they will help construct the three undersea tunnels to Northern Ireland and the roundabout under the Isle of Man he now seems to be keen on? Meanwhile, the UK, as usual, wishes to stand alongside the US militarily even so – yet its own ex-generals claim planned troop cuts of 10,000 over the next decade will make it irrelevant. “The threshold below which our Army must not fall is our ability to field a single division into a new major conventional conflict. We could do this in the Gulf wars of 1991 and 2003 but we cannot today. If this remains the case the US will ignore the UK as a land partner in future. Is that what Prime Minister Johnson wants?” asks Lord Dannatt, who led the Army from 2006 to 2009. Perhaps typical budget lobbying: or perhaps it underlines just how little joined-up thinking is going on, and just how much money is going to be needed for defence all over the unwilling West as we head towards Munich redux territory of unstable geopolitics. After all, the UK was already set to increase defence spending by GBP16.5bn, but this is apparently not enough. Good job we have magical monetary financing available, eh? Except that’s only for financial assets, not national defence of course.
Like rising US yields, this geopolitical backdrop of either multipolar, divided interests --or trans-Atlantic unity under a rebadged Cold War-- will ultimately flow back to shape the global economy and markets, as Brexit shows us.
Ironically, however, in the near term this is likely to lead to even more magical market moments. As in the 1930s, no country wants to see a stronger currency and become a larger net importer of goods (and exporter of jobs). That includes China. To avoid excess FX appreciation on the back of its huge trade surpluses and the rising capital inflows from global markets happily shrugging off any Biden appeals to trans-Atlantic values, Beijing may not only allow easy access to the promised USD50,000 in per capita annual FX outflows, but permit this for buying foreign financial assets or property! Let’s see if this is actually delivered, but if it is, more levitation for all assets outside China seems assured. Ta-dah! Let’s just try not to think of the risks involved from the asset-liability imbalances as foreign capital flows into China, and those FX flow back out again rather than boosting its FX reserves – especially if that FX flows into US assets, helping to push up US real yields even faster.
Take a ‘moment’ to try to see how this all might fit together.