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The world has a Hotel California problem, and it can’t seem to get out of it. Since late 2008, central banks have cut interest rates, and printed and pumped a huge amount of money into the global financial system, in order to keep interest rates low in the hope of driving economic growth. At the same time governments have borrowed more and upped their expenditure to pump prime economic growth.

All this money sloshing around has led to multiple financial and real estate bubbles across the world, something that central banks have stayed away from pricking. In fact, after covid started spreading, they have even actively encouraged these bubbles to grow bigger by printing more money. As Ruchir Sharma, chief global strategist at Morgan Stanley, wrote in a Financial Times column on 28 February: “Nearly 20% of all dollars in circulation were printed in 2020 alone."

The price to earnings ratio of the Dow Jones Industrial average, America’s most famous stock market index, stood at 31.47 as of 26 February. It was at 19.75, a year earlier. A similar story has played out through much of the rest of the world, including India. Clearly, stock prices have grown much faster than company earnings, thanks to liquidity.

However, in the recent past, investors and the market have hinted that they aren’t happy with things as they are. The bond yields across the Western world have been going up. This is investors telling governments that returns from their bonds are too low as inflationary expectations are setting in.

In order to hedge against expected inflation, investors are buying all kinds of commodities. Food and oil prices are up, and so are prices of various metals. Interestingly, the Bloomberg Commodity Index has risen by 9.25% since the beginning of January, clearly suggesting that investors are now diversifying into different commodities.

Given the palpable nervousness, will central banks try to prick the stock market bubble by allowing bond yields to go up? Or will they try and maintain the flush-with-easy-money status quo?

These lines from the Eagles’ Hotel California song give us an indication: “You can check-out any time you like; But you can never leave!"

Yield spike scare

The yield or the return on a ten-year United States (US) government bond has been going up for a while. It was at 0.93% as of 31 December. It crossed 1.5% on 25 February, and touched 1.53%, the highest it has been in more than a year. On 26 February, the yield fell to 1.41%.

The US government sells bonds in order to borrow money. The yield on a bond is the return an investor can expect by buying it on a given day and at a given price and holding on to it until maturity.

Why have yields risen rapidly this year? The large institutional investors who drive the narrative around such topics, expect inflation in the US and other parts of the world to go up, in the months ahead.

As the pandemic spread across the world and people practised social distancing, consumer demand collapsed. While the money central banks and governments pumped into the system has built up latent consumer demand, which is now expected to explode after people get vaccinated. The belief is that supply will not be able to keep up with the increasing demand and this will lead to more money chasing the same set of goods and services—in the process, pushing up prices or leading to higher inflation.

With investors expecting higher inflation, they were no longer happy with the extremely low interest rates being paid on US government bonds and bonds of other developed countries. Hence, they have been selling these bonds. As bonds get sold, the supply of bonds goes up, driving down their prices.

Once bond prices fall, the bond yield goes up. This is primarily because the investor earns the same rate of interest on the bond but has bought it at a lower price, pushing up the overall return from the bond.

The US government bonds are deemed to be the safest financial security in the world. If the yields or returns on these bonds go up, the returns expected from other financial assets need to go up. This implies that interest rates in general need to go up. Higher interest rates tend to spook the stock markets. The major reason for this being that higher interest rates make bank deposits and other financial instruments offering a fixed rate of interest, more attractive to invest in.

Further, higher interest rates make borrowing and spending money less attractive for individuals and businesses. Higher interest rates also mean that businesses and consumers have borrowed money will also see the interest cost on their borrowings go up.

All this is expected to impact future earnings. The stock market doesn’t wait for things to happen, it discounts on possibilities. And this explains why stock markets fell majorly on Friday.

Lessons from Japan

To understand how central banks and governments will react, we need to know a little bit of history and go back to Japan in the 1980s. The country was in the midst of a huge stock market and a real estate bubble. In fact, the story goes that the land underneath Tokyo’s imperial palace was worth more than the entire state of California in the US.

The stock market also matched the rise of the real estate market. The Nikkei 225, Japan’s premier stock market index, hit an all-time high on 29 December 1989, reaching 38,957.44. Around this time, Yasushi Mieno took over as the 26th governor of the Bank of Japan, the Japanese central bank, on 17 December 1989. Eight days later, on 25 December 1989, he shocked the market by raising the interest rate. Worse, he publicly declared that he wanted the land prices to fall by 20%, which he later upped to 30%.

These moves punctured both the stock market as well as the real estate bubble. The stock market fell by 50% from its peak, with the Nikkei 225 closing below the 20,000 level in October 1990. More than 270 trillion yen of wealth was destroyed. The real estate prices fell slowly over the next decade.

But most importantly, the Japanese economic growth collapsed, and has not recovered to pre-1990 levels since then. This is something that the central banks and governments across the world haven’t forgotten and want to avoid at all costs. It has influenced their behaviour since then.

Alan Greenspan, the Chairman of the Federal Reserve of the United States, between 1988 and 2006, believed that bubbles couldn’t be spotted at all. He told the US Congress in June 1999: “Bubbles are generally perceptible only after the fact."

Further, Greenspan kept the dotcom bubble of the 1990s and the real estate bubble of the 2000s going. At the slightest sign of trouble, Greenspan would cut interest rates and at the same time ensure that there was enough money going around in the financial system. This ensured that the stock market never fell for an extended period of time. This formula was followed by Greenspan’s successors Ben Bernanke and Janet Yellen as well.

In fact, on 27 August 2008, before the financial crisis had broken out, the total assets of the US Federal Reserve stood at $910 billion. As the crisis broke out, the Fed started printing money and buying government bonds and mortgages-backed securities, in order to pump in money into the financial system to drive down interest rates. This process was referred to as quantitative easing.

This is what Fed did for the next few years and the total assets on its books, as it kept buying bonds, shot up to $4.52 trillion as of 14 January 2014. This slowed down post January 2014 and the Fed even started selling some of the bonds it had bought, in order to pump money out of the financial system. By 21 August 2019, the size of the Fed’s balance sheet was down to $3.76 trillion. This pushed up bond yields and threatened to push up interest rates as well.

The balance sheet started growing again and it exploded post covid and it stands at $7.59 trillion as of 24 February 2021. In fact, in the last one year, the US Fed has printed and pumped more than $3 trillion into the financial system.

The Bank of Japan, the Japanese central bank, has also carried out a massive amount of money printing since the financial crisis broke out. As of August 2008, its balance sheet size stood at 108.4 trillion yen. As of January 2021, it stands at 709.5 trillion yen.

A lot of this money has found its way into the stock market and real estate markets all over the world. Companies have also borrowed money at very low interest rates in order to buy back their shares, reduce the number of outstanding shares, increase their earnings per share and, in the process, push up their stock price. Clearly, this money has helped stoke more than a few asset bubbles.

The next steps?

Given unsuccessful attempts in the past to suck out a part of the money from the financial system, it is more than likely that central banks and governments will want to ensure it continues to remain flooded with money. Hence, it is hardly surprising that Reuters reported on Friday: “The world’s financial leaders agreed they would avoid a premature withdrawal of fiscal and monetary stimulus."

This is governments signalling to the investors as well as the markets that the era of easy money will continue in the days to come.

On Saturday, the House of Representatives in the US passed President Joe Biden’s $1.9-trillion American Rescue Plan to stabilize the economy. Some of this money will seep into the stock markets and keep the bubbles going. Some of this will end up in the banking system, keeping interest rates and bond yields low.

Further, as the Wall Street Journal reported on 23 February, Jerome Powell sees easy-money policies staying in place. Powell is the current chairperson of the Federal Reserve. This means that the Fed will continue to print money and buy bonds. The chief economist of European Central Bank (ECB), Philip Lane, has made comments similar to that of Powell. He told the Financial Times that by March 2022, the ECB plans to spend up to €1.85trillion in order to buy bonds.

Meanwhile, commodity prices seem to be on their way up, building up inflationary expectations (see chart). The increase in commodity prices is not just because of an expected increase in consumer demand as economies recover. It is also because investors are trying to hedge against inflation by buying hard assets (even though in their derivative form).

The funny thing is that investors hedging against inflation can lead to even higher inflation. As investors buy commodities, in order to neutralise inflation, the commodity prices can go up further and create more inflation.

So, will the market and investors buy the story of the governments and the central banks this time around as well? Or do they really think higher inflation is around the corner?

I would watch the markets very closely, while humming Hotel California.

Vivek Kaul is the author of the Easy Money trilogy

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