For years, many analysts have been warning about the dangers of the Fed’s unusually easy monetary policy, mostly fearing that inflation would suddenly begin accelerating, as it occasionally did in past dovish eras.
In the post Great Recession period, those widespread price increases have yet to truly materialise (though there are signs that is slowly beginning to change), which is why the Fed has been comfortable keeping rates low.
In a recent note, JP Morgan’s Jan Loeys, the bank’s head of global asset allocation, warns inflation is coming, but not in the goods and services where we may have thought. It will be in asset prices, in what he calls “financial overheating,” which will increase faster than consumer prices, which he calls “economic overheating.” This, he says, will create a “financial bubble” that will inevitably pop.
Here’s how it will go down:
Where do we go from here? To this analyst, still very subdued economic growth, both at the US and global level, implies continued easy monetary policy. The risk is that bond yields rise no faster than the forwards. Financial overheating (asset inflation) proceeds much faster than economic overheating (CPI inflation). Before CPI inflation has a chance to emerge, and before monetary policy is truly above neutral, a financial bubble will have popped up somewhere and will have corrected, pushing the economy down. That is what has happened in the past 25 years. The behaviour of central banks gives us no confidence that this time will be different: Central banks talk about financial instability, but appear to define this mostly in term of bank leverage. Each successive boom and bust is always in another place. A bubble can emerge without leverage. It is not possible to project exactly where this boom and bust cycle will take place as knowing where it will be would induce evasive actions that should prevent it from occurring. One possible ending, among many, is that ultra-easy rates having induced credit markets to grow much faster than equity markets, combines with reduced market making by banks (many of whom have become like brokers) to create a liquidity crisis when the Fed starts the first set of rate hikes. This could then be bad enough to close primary markets, and thus push us into a credit crisis.
The good news is this won’t happen for another two or three years. “We need blindness to risk, and some normalization of policy rates to induce a broad asset correction,” he says. As far as positioning, Loeys says it makes sense to steadily shift from less liquid to more liquid assets, namely from credit to equities.
Still, none of this sounds good.
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