Trainspotting provides today’s economic analysis. The movie is about a drug addict’s attempts to come clean.

It doesn’t go so well. Perhaps because he’s trying to do it in Scotland.

In the end, he steals thousands of pounds from his friends and escapes their drug-fuelled lives. Because being a thief is preferable to being a drug addict.

It’s much the same in investing today. The world is addicted to quantitative easing (QE). It’s been a fun few years too. US stocks are up 200% in nine years. UK stocks almost doubled from their lows.

But now we’re trying to go cold turkey. It isn’t so pleasant.

In coming years, the balance sheets of the major central banks put together are set to slowly shrink. They’ll go from quantitative easing to quantitative tightening (QT). The European Central Bank (ECB) is behind the curve a little, but others have their QT well underway.

In the movie, the struggle to go off drugs is depicted by a dead baby crawling along the ceiling above the addict’s bed.

In reality, it was far worse. A 10% correction wiped trillions off stocks in February. It ended one of the longest uninterrupted monthly runs in US stocks ever.

Just as in the movie, the solution is obvious. Just one more hit. For old times’ sake. To keep me going. To get me over the hill. Just one.

On cue, the Federal Reserve’s balance sheet increased by $14.1 billion in one week. Yes, the very week when stocks rebounded from their 10% drop.

It’s a nice little confirmation of the world we live in. There is only one player in the market – central banks. They’re still what matters. Even if it takes a 10% correction to bring them back in, there they are.

That was three weeks ago. Two weeks ago, the Fed went back to tightening. By the $23 billion reduction didn’t rout the market. Why?

Investors have now confirmed where the “Powell Put” comes active. They know at what level of a stockmarket plunge the Federal Reserve will act. Their new man in the Fed has their back.

The problem, as Trainspotting fans will know, is that this leaves you back where you started. An addict of QE.

And there’s something hollow about being an addict. It’s not your reality that’s pleasant, but your escape from reality. Eventually the truth does catch up with you. That’s how they discovered the baby had died at all.

Central bankers and the drug wars

These days, central banks don’t just deal in their preferred drug of government bonds. In fact, in the week which stocks recovered, the Fed continued to unload its government bonds.

But it bought a load of mortgage-backed securities instead. Not a surprise given the recent higher rates have caused trouble in the US mortgage market.

Over in Europe, the ECB clarified its stance on its own QE. The growth in the drug supply is falling and will cease to grow in autumn. But the price will stay the same until mid-2019, the date interest rates might go up. The idea is that if you signal the availability in advance, you drug addicts won’t fly into a frenzy when it changes.

It’s not a surprise the ECB still isn’t tightening supply. Inflation has slowed for three straight months. Then again, annual GDP growth is above 2.5%. How long can the eurozone be left behind on interest rate increases around the world?

What about the Bank of England? Governor Mark Carney is too busy moralising and philosophising to get caught up in drugs. As you might remember, there’s just such a character in Trainspotting too.

While the rest of the world’s central bankers are busy implementing monetary policy, here are the news lines we get for the Bank of England (BoE) governor:

BoE’s Carney: Bankers should not enter finance industry for the money
Financial Times (19 Feb 2018)

BoE’s Carney says Bitcoin has ‘pretty much failed’ as currency
Reuters (19 Feb 2018)

Mark Carney: People are earning 3.5% less than we estimated before the EU referendum
Business Insider (21 Feb 2018)

Brexit will knock 5% off wage growth, says Mark Carney
The Guardian (21 Feb 2018)

The founders of the Old Lady of Threadneedle Street would be horrified by the nonsense being spouted by their heir. Evading the public, shutting up and declaring their cluelessness was a big part of running the bank for hundreds of years. Directors were chosen specifically for their lack of knowledge of banking.

But back to the big player – the US.

Yesterday, the new Federal Reserve chair Jerome Powell finally took to the microphone. His prepared remarks went well. Then he was asked a few questions and got the answers wrong.

Stocks plunged. Bonds plunged. The US dollar spiked. Commodities including gold fell.

When the drug dealer sneezes, his dependents catch a cold.

Now you know why shutting up, declaring your cluelessness and knowing nothing is a good position for central bankers to take.

Withdrawal symptoms

Stockmarket corrections are a reliable sign of withdrawal symptoms. But they needn’t be a problem. The central bankers can just step in to save the day with another high.

At what point does being on the QE drug really start to become a problem? When central bankers lose control of something. But what?

There aren’t many ways for it to happen.

But there is one place central bankers could still lose control. It’s the same place they did in 2008.

When governments failed to rescue Lehman Brothers, they unleashed a crash far more devastating than the correction which preceded it. Even central bank lines of credit weren’t enough. Why? Because central banks only influence financial markets. In the end, banks have to lend to each other to remain alive.

The good news is, keeping an eye on pressure in the banking system is surprisingly easy. Introducing, the Libor-OIS spread.

Libor measures the price banks charge to lend to each other. OIS measures the rate at which central banks are willing to lend to banks.

They should be pretty much the same. Unless you’re expecting a bank to default. In which case Libor spikes while OIS remains the same.

That means, a divergence between Libor and OIS tells you the level of suspicion and perceived risk in the banking system. The difference between Libor and OIS is called the Libor-OIS spread.

Well, the spread has doubled since the beginning of the calendar year. Any higher and it’ll be at the highest level since the European sovereign debt crisis.

Mistrust is growing inside the banking system. And yesterday I explained your way out…

Until next time,

Nick Hubble
Capital & Conflict