Markets paying for the sins of central banks (The world economy and markets post central banks' stimulus)

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 Markets paying for the sins of central banks (The world economy and markets post central banks' stimulus)

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• QE during 2008: The US Federal Reserve began an unconventional exercise in 2008 - Quantitative Easing (QE) - to save the economy from collapse. Experts warned against it, including Raghuram Rajan. Now, no one even warns!
• Other banks did the same: Many central banks followed - the European Central Bank, Bank of England, Bank of Japan etc. They provided "stimulus funding" to their economies. Some slashed policy interest rates, taking them to zero or negative! Net result - credit flowed like mad, and debt accumulated with companies, households and governments. Asset prices (stocks etc.) zoomed to new levels.
• Unwinding the stimulus: It could not go on forever. So unwinding started. Asset prices went down.

1. A bad thing - financial markets started fearing the winding down, and hence the 2013 "taper tantrum", as also the 2018 last quarter decline in markets.
2. Political leaders started showing equity rallies as signs of economic success! A very bad idea, as that scared the Central Banks from normalising monetary policy quickly.
3. The 2020 market crash was long coming - High stock prices were due to 1 + 2 + 3 + 4 + 5
1. Easy money policy (QE) by central banks
2. Delay in normalising QE (due to political pressure)
3. Poor economic growth but high share prices
4. Threat of recession
5. Coronavirus

• The 2008 scenario: Central Banks did two things -

1. slash interest rates (RBI)
2. start quantitative easing (Federal Reserve)

• The US Fed's balance sheet grew by four times by 2014, and it was always aware of the dangers of it. So it informed the financial markets, and began winding down the QE programme + hiking rates from 2015. Sadly, once addicted to the drug of easy money, and with most economies not doing well, the Bank of Japan and ECB found it tough to normalise monetary policy.
• President Trump: His directly criticising the Federal Reserve forced the Fed to begin cutting rates after a while (from June 2019). It restarted QE (asset purchases) from Sept 2019. So a fresh and hollow stock market rally started in 2019, with no economic fundamentals attached. Markets assumed more central bank support, and bullish positions were built.
• IMF report Oct 2019: It informed that in the rich world, the monetary policy had reached a turning point,as amount of global bonds with negative yields crossed $15 trillion. So many investors have gone for stocks in other markets. IMF also found that debt in many countries had risen to very high levels, due to higher liquidity in global markets.
• Indian stock markets: While mutual funds were facing redemption pressures in India, the FPIs were pumping money in the markets constantly (2019 net purchase of equities - $14.3 b). Those trading positions are being unwound now.
• Euro joined the Yen: Due to very low interest rates, and due to ECB's printing of notes, euro and yen both were preferred currencies for carry trades over many years. Investors took loans in these currencies, and went buying shares across the world. Speculative derivative positions too were built.

1. As stocks collapsed from Feb 24, 2020, those holding speculative derivative positions financed by carry trades came under pressure to see their positions to cut losses, so they could replay the loans. (original cycle was -- take loans - get into carry trades - build speculative positions in derivatives)
2. Hence many currencies fell - rupee, USD and others.

• The last bastion fell: Till Feb 2020, most were hoping that global economy will ultimately pick up, thereby causing little harm when Central Banks would suck back the excess QE money they pumped in. But then COVID-19 arrived. So 2020 growth will be lower than in 2019. So those doing leveraged trading in markets will be under pressure.
• What next: Rich world Central Banks have little scope to do much, as rates are already low, and balance sheets huge. But other countries (India) still have many weapons left in monetary policy (and also counter-cyclical fiscal measures).
• Summary : The 2008 global recession forced central banks to adopt easy money policies, and they could not unwind that in time, leading to various problems in markets in 2020.

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