Call it a requiem.
Or a pseudo-lament.
Or maybe just an obituary dressed up as an FX strategy piece. But whatever you want to call it, Deutsche Bank’s George Saravelos penned a short critique called “the end of the free market” late last week that contains a series of poignant lines worth excerpting at a historic juncture for the global economy.
This little gem found its way to me on Monday evening, just after I put the finishing touches on “Against The Gods: ‘Historically A Losing Proposition’“, a post which essentially serves as a reminder that normative concerns aside, betting against central banks’ ability to corner markets, inflate asset prices and relegate price discovery to the dustbin of history, hasn’t generally paid off over the past decade.
The point wasn’t to glorify the power of the printing press or to otherwise suggest the current state of affairs is optimal. Rather, it was a descriptive piece more than anything else.
In his note, Saravelos doesn’t mince words. “There is no such thing as a free market anymore”, he begins. “All developed central banks have cut rates to zero and [are] buying trillions of assets”.
There really are no words to describe the scope of the easing measures unveiled across locales in March.
The Fed’s balance sheet topped $6 trillion, the ECB launched a massive pandemic program on top of expanding existing QE, the BOE restarted purchases and the RBA, RNBZ and Canada all unveiled QE programs.
The Fed’s bond purchases are unlimited and they’ll now buy corporate credit, both investment grade and junk. High yield ETFs are on the menu. So is everything else, either via outright purchases or programs that allow eligible banks to post whatever they’ve got as collateral. Here’s a snapshot of the various facilities Jerome Powell rolled out last month:
Deutsche’s Saravelos imagines a kind of dystopian future for markets, which I suppose would fit nicely with the increasingly dystopian vibe one gets from predictions about how society will function in the post-COVID reality.
“In a matter of weeks, policymakers have become a backstop for private-sector credit markets”, he writes. “At the extreme, central banks could become permanent command economy agents administering equity and credit prices, aggressively subduing financial shocks”.
Of course, that wouldn’t eliminate volatility in the real economy. Saravelos reminds you that the suppression of economic volatility has been the key goal of policymakers for decades, hence inflation targeting and employment mandates.
“It is natural to conclude that the exhaustion of conventional monetary policy space and a liquidity trap erodes central bank capacity to offset exogenous economic shocks”, he goes on to say.
Again, this is couched in terms of FX volatility, but it’s amenable to general audiences. Saravelos ends up contending that the read-through for FX is inconclusive thanks to a push-pull dynamic where larger economic shocks are offset by the suppression of financial shocks, which impact currencies through portfolio balance channels.
He asks you to consider what would have happened had central banks confined themselves to “conventional” policy tools after Lehman, during the Eurozone debt crisis and during the current pandemic. Spoiler alert: It would have been armageddon. “In any of those shocks the absence of unconventional intervention would have led to uncontrolled financial stress ultimately leading to the collapse of the financial system”, he says.
Instead, central banks are actively tamping down volatility in markets wherever it shows up and suppressing risk premia in order to avert a damaging spiral. In the current crisis, this has taken the form of “direct purchases of risky assets, indirect government guarantees and cross-border currency lending (swap lines)”, Deutsche writes.
As asset prices stabilize, so too do capital flows. That, in turn, short-circuits the portfolio flows channel of FX volatility, Saravelos says. Here’s the key point, which captures both the general thrust of the piece and also the FX angle:
With unlimited capacity to print money, central banks have unlimited capacity to intervene in asset markets too. Put simply, a central bank that pegs bond, credit and equity markets is highly likely to stabilize portfolio flows as well. We conclude that the impact of lower interest rate volatility on FX is ambivalent. On the one hand, real economy volatility is likely to rise. On the other, so is global central bank activism and financial repression in markets. The overall impact on FX volatility is not clear.
While the impact on FX is, as Saravelos puts it, “ambivalent” (and there’s a ton of nuance to that discussion in the full note), the broader ramifications are more clear.
A reality where central banks simply administer the prices of stocks and corporate bonds “would be a bi-polar world of financial repression with high real economy volatility but very low financial volatility”, Saravelos says.
It would, he writes, be “a ‘zombie’ market”.