Risk: Is This The Big One? Part II
Breaking Unconventional Monetary Policy (B.U.M.P.) and its impact on liquidity is beginning to be felt. The current stock market correction has deeper roots than the market is crediting and it is time to consider hedging positions.
Readers will know that CheckRisk has been reporting on the recent stock and bond market unease since the beginning of January. Market risk in our Early Warning Risk System (EWRS) has been rising since January 15th and is at the highest level in over a year, with relatively high rates of change. Our overall system indication is still showing reasonable levels of economic growth and therefore risk is not at a level that is indicative of a potential crisis, as of yet. That being said we are beginning to see that some significant indicators are combining and therefore the risk of this correction developing into the “Big one” has increased over the past few days.
As a reminder B.U.M.P is the driver; a graphic representation of the risks associated with the unwinding of QE and other liquidity measures. Some $72tn of new debt has been created since 2008. The management of the withdrawal of that liquidity is encapsulated by B.U.M.P, Central Bank Policy Error risk. The Fed has been cutting its balance sheet by $20bn a month, a drop in the ocean compared to the debt levels concerned, however, even these small levels of liquidity flattening are creating tremors. The Fed is planning to lift this to $50bn in withdrawal by September of this year.
Source: CheckRisk HedgeBrunch talk – Is this the big one
CheckRisk believes that a recession is due in the USA in 2019, broad money supply indicators are indicating that this is the most likely period. In the US M3 has recently dropped to a six-year low, while the Fed is continuing to tighten the interest rate reins. It is clear why this contradictory path is being followed. The Fed needs 350bps of interest rate margin to offset a typical business cycle recession.
CheckRisk has recognized that Central Bank Policy Error is a significant B.U.M.P. risk and the Fed is tightening too quickly. So the question is how much of an impact will the Fed tightening have and at what stage will the Fed reverse its position and either lower interest rates and, more damaging for the long run, recommence QE?
Similar slowdowns of money supply in Europe and China are mirror images of the slow down in the USA; the same is the case in the UK. All of them are a result of the rise in the Fed funds rate to 1.75% (as reported in our last note) So far all Central Banks appear to be making the same policy errors by tightening too fast.
It is, of course, a Hobson’s choice. Central Banks have to raise rates or face the consequences of a recession without any ammo. The problem is so many central banks are at the limit of what they can do. The Telegraph quotes Prof. Congdon of the Institute of Monetary Research saying “The ECB has already pushed its balance sheet to 42% of GDP and is near the technical and political limits of QE.”
Central Bank overleverage is something CheckRisk has already discussed at length. Getting off the cross of QE is going to be a very tricky manoeuvre.
What most economic observers have failed to recognize, however, is the linkages of B.U.M.P. across the system. Geopolitical Risks, Currency Wars and Trade Wars, Synchronisation risks and Global GDP are ALL directly affected by the flattening of liquidity. They are, in many cases, the human behavioural response to the discomfort of leverage that exists across the system. All of these risks are inextricably linked because global debt has soared.
Early Warning Risk System
CheckRisk ran our EWRS financial risk model this morning. We see the following anomalies:
1) High Rate of Change in the Ratio of Interbank Lending Assets / Commercial Bank Assets
2) A significant rate of change in open interest for 3month Eurodollar, 2yr notes and ten-year bond
1) A high rate of change in Money Market Fund assets vs. Total asset
2) Spikes in the spread between French and German covered bonds
1) Spike to PBOC in Survey of Banker’s Confidence
2) Spike in the spread between China sovereign and quasi-gov index
1) The flow of funds to household asset loans has declined since mid-Feb.
2) Japan Risk – spread between 3 month – 1-month repo rate is increasing since mid-March.
US Market risk, as stated earlier, has been rising with rates of change that are making us notice. All are linked back to the tightening or liquidity flattening that has been occurring.
CheckRisk has been clear for over five years that the risk of a major financial market correction is focused on the period 2017-2020. Our belief remains that the period 2019 is one of highest risk. So how will Central Bankers and Politicians react when they realize that they are caught in a trap? The most likely response will be the line of least resistance, and a return to monetary policy largesse. This may, and we emphasise “may,” offset a crisis in the short term but it only increases the long term risk. What it would do to CheckRisk’s forecast of risk would be to prolong the period beyond our 2019-2020 timeframe. It may also, however, already be too late as the risks we have previously highlighted are combining and building.
The bottom line for investors is now is NOT the time to be taking a risk. For those that have not reduced exposure we recommend either doing so now or at least hedging positions. To be clear the situation is not yet critical, we feel the current correction is just that, but it can become something much more significant now if the Trade War between the USA and China picks up or if a whole host of Geopolitical Risks takeoff.
Our base case remains that markets will try to discount a late 2019 recession six months to nine months ahead of time. In other words, the underlying economic activity we see at present is sufficient to stop the current malaise for the moment. We recognize that risks are rising across our models and while below the levels seen in 2008 they are highly indicative of a change in underlying risk and the start of risk clustering.
For more information do not hesitate to contact the Team at CheckRisk.