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 Nerve shake on Wall Street

The sensitivity of heavily indebted financial markets to the slightest hint of an interest rate hike or a “thinning” of asset purchases by the Federal Reserve (Fed) was highlighted last week after the meeting of its Monetary Policy Committee.

Nerve shake on Wall Street
A sign for a building on Wall Street, Wednesday, May 19, 2021, in New York. (AP Photo / Mark Lennihan)

Two main conclusions emerge from this meeting: the majority of its politicians believe that rates could start to rise in 2023, while the previous forecast was 2024, and the US central bank is now talking about reducing its purchases of financial assets. .

The Dow Jones Index had its worst week since October 2020, losing more than 500 points on Friday, down 3.45 percent for the week; the S&P 500 index fell 1.3 percent on the day, losing 1.9 percent on the week, ending three weeks of gains.

After the Asian markets fell - Japan's Nikkei 255 index fell 3.3 percent - Wall Street rose on Monday as the indexes recovered most of their previous losses.

Last week's pullback occurred despite the Fed taking no action at its meeting, simply indicating that it might be willing to do so in the future, and its chairman Jerome Powell either shown reassuring. He said the rate hike forecasts, contained in the dot plot where the Decision Committee members indicate where they think rates might go, did not constitute a political commitment and should be taken with a "big grain of salt."

Nerves increased on Friday when Federal Reserve Chairman James Bullard told business broadcaster CNBC he could consider hike in interest rates in 2022 rather than 2023.

Bullard, who is not currently a voting member of the Federal Monetary Policy Committee but will be next year, told the channel that there is "more inflation than we expected" and that 'it was "natural that we leaned a little more on the hawk side here to contain inflationary pressures."

Bullard has indicated that by the end of 2022, inflation could hover around 3 percent over a period of two or two and a half years. This would fit with the Fed's new framework of allowing inflation to exceed its target rate of 2 percent for a period of time, after which it would take steps to try to lower it.

In the midst of these gyrations, the big question remains: what effect will a rate hike, however small, or a reduction in asset purchases by the Federal Reserve have on heavily indebted companies and financial markets?

Since the market collapse in March 2020, where the $ 21 trillion US Treasury market, the bedrock of the global financial system, froze, the Federal Reserve has bought financial assets at the rate of 120 billion dollars a month and kept interest rates at virtually zero. The result is that the central bank has increased its balance sheet from around $ 4.5 trillion in early 2020 to more than $ 8 trillion, with that level expected to reach 9 trillion by 2022.

This has resulted in an explosion of debt across all sectors of the US financial system, with non-financial corporate debt alone now amounting to over $ 11 trillion, the equivalent of about 50 percent of US GDP. .

The general sentiment in the market, as in all speculative bubbles until they burst, is that the "good times" will persist as the Federal Reserve continues to inject more money, allowing enrichment without precedent of the financial oligarchy to continue.

The Bank of America's latest monthly survey of fund managers found that investors were "optimistic about permanent growth, transient inflation and a gradual and smooth reduction of the Federal Reserve."

But some are issuing warnings. Moody's Analytics chief economist Mark Zandi told CNBC that a significant market correction could take place: between 10 and 20 percent. According to him, "the Federal Reserve must change gears here, because the economy is very strong."

Zandi maintained, however, that this would not lead to a recession as the slowdown would be due to excessively high asset prices, rather than more fundamental issues. But that optimistic outlook ignores the fact that the economy at large - as the rising debt ratios indicate - has become entirely dependent on the flow of ultra-cheap money from the Federal Reserve.

The truth is that in the event of a significant fall in the financial markets, no one, and especially not the Fed, knows where it could end.

In remarks reported by the Australian Financial Review last week, Matt King, global market strategist at [investment bank] Citi, said major market instability could occur later in the year.

“The classic view is that if central banks slowly exit and slowly reduce activity, you should be fine. I think it's more difficult than that, and that we are now seeing the same underlying paradox that we saw at the end of 2018 ”.

In December of that year, markets fell sharply by 20 percent when the Federal Reserve said it was forecasting further interest rate hikes for 2019, after four 0.25 point hikes. percentage in the previous 12 months; and that it would continue to gradually reduce its holdings at the rate of $ 50 billion per month.

By this time, King noted, the U.S. economy was growing at 3 percent, there had been a big boost in tax cuts from Trump, and the S7P was breaking records.

“But suddenly there was a 20 percent drop in the S&P 500 that threatened to destabilize the economy. And the Federal Reserve was forced to change its mind ”.

Following the market collapse, Powell backtracked, did not raise interest rates and announced their reduction in July 2019, well six months before the pandemic arrived, and ended the reduction. actives.

King said the paradox was that "the more effective policymakers were in pushing up valuations, the more the markets became dependent on the continuation of that same stimulus."

As a result, they have become vulnerable not only to shrinking central bank balance sheets or rising interest rates, "but also to slower stimulus."

These remarks highlight one of the central contradictions of the financial system. The more money is poured into it - which drives up the price of financial assets - the lower the rate of return on those assets. Investors are therefore forced to invest in increasingly risky assets to obtain the desired return, which creates the conditions for a crash in the event of a reduction in the money supply.

King noted that, according to classical economic theories, markets are an effective mechanism, which anticipates future dividends and then discounts them, to establish the current value of an asset.

It was “simpler than that. It's all about the flow of money, ”he said.

However, even a small reduction in these flows can precipitate a major crisis.

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