UPDATE– Shortly after I completed this post, the BoE announced a 200 billion yuan ($32.6 billion) swap line with the PBoC, according to the Financial Times. This is the first time a G7 country has taken a step to provide funding for the PBoC, although Japan already has such a line, according to the FT. Might not the Fed be far behind? What a firestorm that would ignite. The headline, “Bernanke bails out China?” I can’t see it but it would certainly make things interesting if they did.
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The world’s major central banks are now working at cross purposes, creating massive crosscurrents that are making life extremely difficult for investors. This isn’t likely to end soon. In fact, conditions should get worse.
The 4 big central banks in the world are the Fed, ECB (European Central Bank), BoJ (Bank of Japan), and PBoC (Peoples Bank of China). The BoE, (Bank of England) is far smaller but important from a policy signaling perspective and because of who its counterparties are. They include not only the 3 mammoth British banks that are US primary dealers but all the other major players in world markets, who all have big operations in London.
The Fed, ECB, BoJ, and BoE all deal with the same banks and the securities dealers affiliates of those banks. For example, of the Fed’s 21 Primary Dealers who are the Fed’s sole counterparties, only seven are US domiciled. Three are Canadian banks. Eight are European, including three British banks, and three are Japanese. All of these banks are also major players in Europe and Japan.
These banks are all playing in the same sea of liquidity. When one central bank pumps, that action may impact not only the central bank’s home market, but any or all of the world’s markets. When central banks buy securities, those purchases cash out the counterparty banks and dealers, who then use the cash and the leverage it creates to buy other securities and push asset prices higher. What they buy is up to them. They deploy the funds where there money gets the love. Over the past 7 months, until last week, that was mostly US equities.
The situation with the PBoC is different. Its system is not fully integrated with the world financial system. China’s central bank serves only its domestic banks, and they in turn serve only domestic financial institutions, including the out-of-control shadow financial system. However, many of those institutions are significant players in the world markets.
US and European banks who were engulfed by bad loans and their own horrendous practices were bailed out by the Fed, ECB, and BoE. Unlike them, the major central banks are not there to bail out China’s miscreants. Apparently the PBoC has also decided, no more! It has slammed the door on them to put a stop to the wild speculative bubbles they have blown. Now that they are swamped with trillions in bad loans these players have no place to go and no means to raise the needed cash other than to sell whatever liquid assets they can, wherever they can around the world. If not the primary impetus for last week’s selloff, this selling was at least a major contributor to it.
While the PBoC doesn’t play directly in the world liquidity sea, it has dammed a major tributary and has inserted massive reverse flow pumps into the pool. As a result, the players along that tributary have not only stopped the flow of liquidity into the world sea, but in order to replenish their own liquidity which has run dry, they are pulling cash out of world markets that they had previously pumped in. These institutions are largely insolvent. The reverse flows going back into China aren’t likely to turn back toward the rest of the world again anytime soon unless the PBoC relents and prints money.
As it grew its balance sheet, the PBoC in the past provided funds to the world cash pool indirectly via its shadow financial institutions. This year it pulled the punch bowl. It shrunk its balance sheet early in the year, then has grown it by only 1.3% since April, hardly enough to prop up massive overhangs of bad loans in both the banks and shadow financial system. Its assets remain below the peak levels reached early in the year.
The Fed and BoJ are still furiously pumping cash into the world pool, and markets were responding accordingly until the last few weeks, or at least the equities markets were. However, the European banks have been pulling funds out of the pool to repay loans from the ECB. Some of them who did not want the funds originally but were forced to take them, had bought Treasuries. When the ECB opened the repayment window early this year the banks liquidated the Treasuries they had bought with the funds. Others sold other sovereign bonds they had bought. Still others who had reached for yield in emerging markets began selling those securities. The process began to snowball over the past few weeks.
The BoE has also stopped providing funds to the pool. After growing its assets by 50% from Q4 2011 to Q4 2012, it too has stopped supplying funds to the markets.
The Fed and BoJ are the last two major central banks still adding cash to the system. They are fighting the PBoC, BoE, and ECB. Unlike the other central banks, the ECB’s money printing involved mostly loans rather than direct asset purchases. The ECB is allowing banks to pay down loans, with the resulting liquidation pressures beginning to snowball. As those loans are repaid they create liquidation pressures in world markets. It started with US Treasuries and has spread to other sovereigns and emerging markets, and last week it hit US stocks.
Central banks working at cross purposes have generated liquidity crosscurrents that have buffeted the markets in recent months. Those crosscurrents are likely to turn more difficult to navigate as the Fed begins to wind down QE, assuming it does what Bernanke said that it would do. But until that happens, there should still be net liquidity growth overall as the Fed and BoJ continue to pump. It depends on just how bad things become in China and just how much selling and asset price decline the PBoC is willing to tolerate. China holds massive stores of assets around the world including US Treasuries, and it’s not clear how much pain it is willing and able to bear. It’s also not clear how much difference it will make if the PBoC does decide to print money.
As the world’s Last Ponzi Game Standing, the US is likely to see most of the benefit of whatever positive liquidity flows remain, particularly in equities where most of the recent funding has headed. The cross currents of liquidation will make the seas far more choppy and treacherous to navigate, fun for traders who strictly trade the charts both long and short, but longer term investors probably won’t be able to keep their ships afloat.
I’ve been watching the Fed’s operations every day ever since it started publishing them daily in 2002 along with its balance sheet and the commercial banking system balance sheet weekly. As the famous financial philosopher L. Berra wisely said, “You can observe a lot by watching.” I invite you to watch along with me, and observe a lot.
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