THIS event could crash markets big time

But relax: it is a low probability event!

As I explained in several past posts, ultimately the Central Bank of any country can stabilize market conditions when the shit hits the fan under ONE very important condition: inflation is under control or at least tolerable. This is the case now, as can be seen by the graph of the inflation in core personal consumption expenditure:

FRED tool of Federal Reserve of Saint Louis

In a rare and quite low probability event, something extreme happened in short term government debt (“Treasuries”) in March 2020: lots of sellers started selling their T-bills en-masse to get the cash for short term payments and for other reasons. The market froze: there were way more sell orders than buy orders and this caused the bid-to-ask spread to spike and caused a liquidity squeeze.

Why did this happen? Large banks and other commercial financials had already loaded up on US money market debt instruments in early 2020 and the extra sell orders were hard to “digest” by the market. It’s like having a huge meal to the point of feeling really stuffed and someone comes along and wants you to eat some more: you’ll be like “I just can’t!” … and so “someone” must absorb that new food (debt)…

Prices of t-bills plunged, hence yields spiked, causing credit stress in the money market.

Enter the Central Bank!

When this happens and when potential consequences are severe, the Central Bank of any country can step in to save the day: type in “+1000 billion” (or any other desired amount) and use that free cash to buy bonds galore. This effectively removes t-bills (or any other assets the Central Bank is buying) from circulation, this increasing their price (fall in market supply) and decreases yields (interest rates). This restores normalcy in the market and life goes on.

The impact of the shock and of the Fed intervention is best viewed with the TED Spread (T-bill to Euro-Dollar Spread):

Things got crazy in March 2020, the Fed stepped in… and life goes on…

What would happen if the CB (Central Bank) did NOT intervene like this? In one word: HELL! Credit markets would contract ridiculously, every large, small and medium institution would quickly become cash strapped, debt rollover stress would rise considerably, everyone would sell assets in a scramble for cash, asset prices would plummet permanently, negative wealth effects would kick in, the housing and commercial real estate markets would be hit and on and on… The real economy would tank and fall into depression, and the probable outcome would be social tension, unemployment, chaos and just not a fun place to be.

A saturated market?

What can go wrong? The combo of 2 things:

  1. Inflation.

If markets were already saturated in March to the point of needing Fed intervention to restore liquidity conditions and prevent interest rate spikes, then the NEW conditions after all this fresh bond supply could just become truly saturated indeed. We have had a LOT of new debt added to markets since March-April … and there is a new round coming to the order of 2 trillion+ in 2021–2022, regardless of who wins the Presidency.

That’s a LOT of new debt! Fear not: the market seems to be absorbing all this no problem AND inflation is not only “low”, but the Fed suggests it will be tolerating more inflation also…

Why is inflation important? Well, you need to read my many many past posts, but in a nutshell: if inflation remains low / tolerable, the Central Bank can create more money, hence buy more bonds and other assets when markets freeze up… and that prevents the “hell scenario” from happening.

If inflation rises, say, above 4%, then Central Banks will be in a very tough spot: don’t “print new money to buy assets” and you get an epic crash… DO print new money and you could start eroding confidence in monetary credibility, hence a drop in demand for your assets… and for a country that is a net global borrower (negative International Investment Position that is relatively “high” in % of GDP), that is generally quite catastrophic, as foreign holders of domestic assets dump those assets, thus starting a chain of events that causes asset crashes, capital flight, negative wealth effects and major feedback loops that get very ugly on a grand scale.

How likely is it?

For a general drop in monetary credibility and a significant drop of global demand for US assets, asset managers would need to have alternatives for the use of their funds… I will let you ponder this now:

  1. What currency is broad and credible and liquid enough to replace the USD right now and in the future?

I see none. The Euro is mired in LOTS of complexities and issues with its structural problems, China is simply not an open free market with credible data or institutions, and Japan is stagnating and not large enough. For these reasons, although it is “theoretically possible”, I do not see this catastrophic combo of 1) falling demand for US assets and 2) intolerable US inflation to be a real risk… but you never know, especially with the crazy politics we have seen in the US in recent years and quite a divided election and country…

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Pascal Bedard

www.pascalbedard.com

I fell off this cliff in my first attempt to climb it in Quebec, Canada

Sharing thoughts on economics, finance, business, trading, and life lessons. Founder of www.PascalBedard.com

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