The previous year in the financial markets was definitely dominated by central banks. The most rememberable was the fact that they've changed their course in conducting monetary policy by 180 degrees, turning from tightening financial conditions to full easing. By easing I mean interest rates cuts in order to incentivize borrowing (lower costs of credit) as well as money injections into the financial system by any forms, which in effect increase the value of total assets on the central banks' balance sheets. Tightening, in simplification, is just the opposite, rate hikes and the total assets' value declines.

To give you some perspective see the chart below which is showing net global central banks hikes/cuts over the last two decades.


In 2019, global central banks net interest rate cuts (hikes minus cuts) has reached a level not seen since the Global Financial Crisis. The main reason behind that was the global economic slowdown. The most common measure of economic activity (although not the most accurate), the world GDP annual growth fell to 2.9% last year, the lowest rate since the crisis. I am referencing GDP to give some sort of perspective. The fact is that most central banks in conducting their policies focus on inflation rate or inflation expectations as well as the labor market conditions.

In any case, as a result of the slowdown, we experienced the most synchronized easing cycle in a decade. Are governors' fearing of the repeat of 2007-2009?


As it is shown in the above chart, almost 60% of global central banks have cut rates till the end of Q3 2019. As I mentioned in the first paragraph, they've also returned to massive money printing and its injections to the financial system. You can call it whatever you want (QE Infinity, QE4, Not QE, etc.) The reality is that the value of total assets of the four major Central Banks have started rising again.


As of November 2019, the total assets of the Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BOJ) and People's Bank of China (PBOC) have reached $19.7 trillion.

In this article, however, I would like to focus only on the US central bank (the Fed), its historical pivot at the turn of 2018/2019 and the following consequences. After analyzing the policy of the world's most powerful central bank, in the next take, I will look into Europe and Japan


Powell's "Autopilot"

To better understand what happened a year ago, let's go back in time to December 2018. Jerome Powell, the first Federal Reserve President for 40 years with no Ph.D. in economics but with abundant professional experience, along with his colleagues has probably gone one step too far in normalizing (rate hikes, bringing assets to pre-crisis level) US monetary policy or at least in its communication.

On December 19, 2018, the Fed hiked interest rate (Fed Funds Rate) by 0.25% from 2.25% to 2.5%, projecting two additional raises in 2019 (down from three forecasted earlier). That was a four rate hike in 2018.



In addition, while delivering speech during the press conference after the rate hike announcement, Powell said that the Fed balance sheet run off (reduction in the size of total assets, also called Quantitative Tightening) is on "autopilot".

"We thought carefully about how to normalize policy and came to the view that we would effectively have the balance sheet run off on automatic pilot and use monetary policy, rate policy to adjust to incoming data. I think that has been a good decision. I think that the runoff of the balance sheet has been smooth and has served its purpose and I don't see us changing that."

Those words together with the rate hike and further guidance have definitely exacerbated ongoing (since the beginning of October) market turmoil. For clarification, hearing that the non-tested policy, in the form of Quantitative Tightening, is on autopilot is rather shocking for investors and brings a lot of uncertainty, especially considering that the Fed was shrinking its balance sheet by $50 billion a month.

In effect, the Dow Jones Industrial Average (DJIA) recorded its biggest weekly loss in more than a decade. In turn, on 24th Dec the S&P 500 entered a bear market territory on an intraday basis (more than 20% loss) and closed the day just above that, technically avoiding a bear market.


The yellow line on the chart shows the S&P 500 index, while the gray the Dow Jones.

As a result of those declines, both indexes finished the year with the largest annual losses since 2008. It could be even worse if not the rescue from Trump's "Great opportunity to buy" speech as well as the historic call between Treasury Secretary Steven Mnuchin and the Plunge Protection Team. On the year the S&P 500 fell -6.2%, the DJIA -5.6%, while the Nasdaq Composite (technology index), lost 3.9%.


Powell Pivot

Fourth-quarter of 2018 has shown, therefore, the first clear signs that the Fed probably overtightened. Those signals was not only from the stock market which is widely believed that the Fed cares about the most but also from the bond market. I would like to emphasize that the bond market is the one that the Federal Reserve watches the most closely. I also think that its bubble is much bigger than in stocks and eventual massive defaults would lead to a complete massacre. Nothing surprising then that the Fed panicked and fully changed its policy course after Q4.

One example of what could hit the US monetary policymakers was the high-yield corporate bond market (high yield is below BBB credit rating - regarded as very risky) where there have been no bond issuances for 41 days starting in November, ending on January 10. That was the longest period of the high-yield bond market freeze in the entire history! The reason of that market drought was mainly the lack of investors' demand as the effect of high volatility and the Fed policy tightening.

While the junk bond market freeze continued at its best then came January 4, 2019, when three Federal Reserve leaders — current Chairman Jerome Powell and his immediate past predecessors Janet Yellen and Ben Bernanke were speaking and answering questions at the American Economic Association's annual meeting in Atlanta.

At the beginning of the conference, the host said interesting, half-joking words: "In short, if you believe that United States monetary policy has been good over the last 15 years, 20 years, you have them to thank. If you think it has been bad, you have these three people to blame."

Although very likely that the Fed's Powell had prepared his answers before the conference, he took some of these words to heart because what he said after would be considered as the historical pivot in the modern monetary policy. First, he said that the Fed "wouldn't hesitate" to change its policy if the balance sheet reduction was a problem. Thus, he simply pulled back the 'autopilot' comment made in mid-December. He also said that the Fed “will be patient” in terms of the monetary policy, putting further rate hikes on hold.

As a result of Powell's words together with the strong US job report, three main stock market indices (the S&P 500, Dow Jones and Nasdaq) in the US rallied more than 3% on that day.


Mid Cycle Adjustment

The remaining part of the year was related to more monetary easing by the Fed as the economy was slowing further. On March 20, 2019, the Fed announced that they plan to finish their experiment called Quantitative Tightening (QT), the process of unwinding the central bank's balance sheet in September. So, it became clear that the US economy is not able to handle shrinking financial conditions anymore in this cycle. It is stunning that it just took three months from being on "Autopilot" to end the policy. However, that was just the beginning.

Four months later, on July 31, the Fed announced first interest rates cut since December 2008 from 2.5% to 2.25% as well as the end of QT, two months earlier than they previously claimed. Actually, the latter was not surprising. It would be a policy absurd to cut rates while decreasing the value of assets on the balance sheet - that would be easing and tightening at the same time. As the result of those actions, the level of balance sheet eventually stood at $3.76 trillion at the end of August, red circle on the chart.

source: St. Louis Fed

Therefore, after roughly $3.60 trillion assets increase as the response to the Financial Crisis, the Fed was able to unwind only $0.75 trillion. Easing is easy, normalizing is not.

After the announcement, there was also the press conference with the Chairman, Jerome Powell. In his remarks, the Fed president said that there is no guarantee of additional cuts. However, what stuck the most in the heads of investors and observers was this sentence

“We’re thinking of it essentially as a midcycle adjustment to policy,”

He emphasized that it is not the beginning of a rate cut cycle (a series of several interest rate changes in response to economic slowdown or a recession). In that sense, then, a midcycle adjustment was referred to just 2-3 rate cuts and as a result a continuation of economic expansion, or simply avoiding a recession (economy soft landing).

That was a time when recession worries were the highest since a decade, and even mainstream media was intensively issuing those type of warnings. The most relevant and at the same time the simplest example, in my opinion, is a probability model used by the New York Fed to calculate a recession odds in the next 12 months which back then was at the highest level since 2009, or the last financial crisis, showing almost 40% probability of US recession.

source: New York Fed

Historically, every reading above 30% has preceded a recession.

Coming back to Powell's words, I think that was a really brave call. If the Fed manages a soft landing and avoids a recession, then Jerome Powell could be partially spared by the Fed critics, despite significant side effects, especially in the financial assets' land. On the flip side, if the US falls into recession in 2020, then the current Fed President will be painted with the same brush as the previous Chairmen as the one who contributed to asset bubbles creation and made the rich richer. Undoubtedly, however, he has already gone down in the history.

In the next months, the US central bank has again cut rates on September 18 from 2.00% to 1.75% and from 1.75% to 1.50% on October 30 whereas on December 11 meeting they decided to keep the rates on hold. Do you still remember the Fed's two rate hikes projections from mid-December 2018? You got three rate cuts instead.
As the summary, see the chart below showing the fed funds rate level over the last three decades.

source: St. Louis Fed

Grey areas show previous US recessions. As you can see, the Fed has managed to achieve two soft landings between 1994 and 1999 which preceded a massive technology companies' stock market bubble in 1999-2000.


REPO CRISIS

It would be great neglect not to mention what has happened on the US money market over the past four months and what the Fed did as a result. I will not go into technical definitions but if someone is interested there is a good theoretical study about the topic:
https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/1-what-is-a-repo/

In layman terms, on the repo market financial institutions lend cash to each other in exchange for some kind of collateral (safe assets) such as US Bonds (Treasuries), for different periods of time, usually overnight (24 hours). In turn, the repo rate is the interest rate paid to borrow cash in exchange for those assets overnight.

In mid-September, the repo rate suddenly jumped as a result of a shortage of cash (dollars), or the so-called liquidity. In other words, financial institutions to some extent have stopped to lend the money between themselves, so the cost of lending jumped. It sounds ridiculus, how on earth after 10 years of flooding the markets with more than $15 trillion of money (major central banks) there is a shortage of it? Well, I am not gonna answer this question now. There are many reasons behind that, enough to write the next article. Anyway, in effect, the Fed stepped into the market and has started to inject billions of dollars into the system in order to bring relative calm back. That money somehow had to be created, so the Fed's print presser has been brought back to life.

At first, the Fed tried to fix the glitch by temporary injections. However, when they realized that's not a transitory issue, on October 8, they announced that they will start buying treasuries again. This time only short-term, and it should not be confused with the previous massive asset scale purchases or Quantitative Easing (QE1, QE2, QE3) conducted to support the economy in the aftermath of the financial crisis. QE or not QE, the amount of assets on the US central bank balance sheet has started to increase again.

$405 645 000 000 ($405,6 bn), this is the amount of digital money the Federal Reserve has created out of thin air to rescue the money market over exactly four months.


The above chart shows the monthly changes in the central banks' balance sheet. As you can see, the Fed is pumping money into the system at the fastest pace since the financial crisis. There is an ongoing debate, whether the US central banks' actions have juiced the stock market or not. The fact is that, after the announcement, the S&P 500 has increased more than 10% over 2.5 months. Furthermore, every 1% increase in the central banks' balance sheet coincided with an average 1% rise in the S&P 500.


On the above S&P 500 chart, I also included the Fed Balance Sheet and its level projections by mid-Jan conducted by the largest financial institutions. If that materializes then the entire assets' reduction sluggishly made within 20 months will be reversed in just 5 months. It brings only one conclusion, the market is addicted to the Fed's money like a druggy man to heroin.


SUMMARY

In conclusion, 2019, as well as the entire decade in financial markets, has been a period marked by the Fed and its global counterparts. I will not be tempted to forecast the future but one is certain, unconventional, extraordinary and unique has become conventional, ordinary and common. I expect then a continuation of tremendous central banks market interventions at all costs. Unfortunately, as a consequence, we will have "these three people to blame".


Spread awareness and take care.

Seb