A Normal Emergency

October 1, 2022

Over the past three quarters, the best advice to readers here has been to stand aside from markets and let the world of normal return from the frenzied search for returns that has become the investment world.

That advice may have seemed inappropriate because it sounded so similar to the advice in 2020 while COVID caused severe dislocations and markets plummeted and then sailed ever higher to the high which was reached on January 3, 2022. If you could get that timing right every time, wealth would be yours!

Despite the human failing of not being able to predict the future, it is easy to see that the world we live in is not a ‘normal’ world. It is highly partisan to the wealthy, excessively prejudiced against those with below average means and on an unsustainable path. There was some hope early in the year when the central banks around the world announced (and began implementing) policies that would turn the pendulum of finance away from the extreme and back toward the centre.

On Tuesday, the price of prudence became clear in the UK as the Bank of England was forced to intervene to stop nascent panic in the UK bond market. The most stable of holders (pension funds) of the most stable of financial instruments (UK bonds) were forced to sell assets to cover margin calls. If this isn’t clear, this is the modern equivalent to a run on a bank. It’s a systemic risk. It’s trouble.

Liquidity in markets improved for a few hours on Wednesday, but by Friday the realities of the situation were coming further into focus and markets had continued their declines.

Currently, it all points down!

Is This An Emergency?

One of the reasons I remain negative on markets is because the liquidity that has driven the gains is being removed at the same time as interest rates are increasing. That is a lot of pain all at once and the systemic risks experienced in the UK markets last week are likely in plenty of other markets, and the USA is a leading contender.

Further, the rise in US rates is causing a US dollar rally that is powerful and is causing massive strain on other economies around the world. There is incentive for the US to adjust their policy as a matter of being a good neighbour, economic partner, and avoiding destabilizing some of their greatest ‘friends’.

On Friday, it seems that the Federal Reserve called for an emergency meeting of the FOMC on Monday for a ‘review and determination … [of] … rates to be charged by the Federal Reserve Banks’. For those who don’t follow the arcane processes of the central bank, that means they are going to review their lending rates.

A significant body of evidence related to the few circumstances of modern inflation suggests that it is important to stop inflation early, or it gets entrenched and gets worse. On Friday two governors for the Federal Reserve gave public speeches and both highlighted the importance of increasing rates and holding the line on stopping inflation. So what should be expected from this meeting?

There are three areas to consider:

The Federal Funds Rate – The Federal Funds rate is the ‘benchmark’ rate that is used to set interest rates by banks. This rate has been rising quite dramatically as the Fed tries to ‘normalize’ rates and slow the economy down. It is the cause of the strong dollar, the declining markets and is likely to come under intense scrutiny during the meeting and for many months to come.

The Federal Reserve Balance Sheet – When things were particularly tough during the housing market collapse in 2008/2009, the Federal Reserve began using it’s balance sheet to ‘ease’ financial conditions. In September of 2008, the balance sheet was less than $1 trillion. By 2014 it had ballooned to $4.4 trillion. Notably in 2018 when the Federal Reserve began to shrink their balance sheet, US markets declined sharply. By the fall of 2019, the Federal Reserve began buying assets again, causing a dramatic rise in markets. The Federal Reserve balance sheet is currently at $8.8 trillion. Again, notably the decline in the balance sheet started on February 23, 2022 and market declines have been largely ongoing since January 3, 2022.

Like the Bank of England, stopping asset sales, or restarting asset purchases will act immediately to stabilize the financial system. This may be a short term path for the bank to reduce stress without appearing to renege on their inflation fight.

Asset purchases reflect higher stock indices, asset sales reflect lower stock indices

Open Market Operations – Using open market operations is really a subset of the asset purchases and sales that show up on the Federal Reserve Balance Sheet, and can be done tactically without much fanfare to solve problems in the system. Historically, when all of the numbers in the financial system were smaller, this was a meaningful way to impact the financial system. With the broad range of participants who all want equal disclosures, transparent actions along with the very large dollar amounts being used, this may not be possible, but also allows the Fed to reduce stress without stepping away from their broad goal to fight inflation through higher interest rates.

While the meeting is being held on an ‘expedited’ (that’s an emergency) basis, it is not clear that it will result in a lowering of interest rates, or a reduction or stoppage of asset purchases. Another outcome could be that they raise rates even further but include messaging that further rate increases will be unlikely for some extended time. (The market currently expects rates to rise until there are signs that the economy will return to the bank’s 2% inflation objective.)

One of the key issues facing central banks around the world, and the Federal Reserve in particular, is that they have lost credibility. Changing their stance just two weeks after the last meeting would not be helpful regarding arguments of credibility. On the other hand, the ‘breaking’ of important financial players in the UK during the past week is a window into what can happen when liquidity is drained from the markets too quickly.

The need to view poor portfolio management and excessive risk taking on the part of market participants, as an emergency is too easy. The need to step in and stop market routs, simply encourages further excessive risk taking among participants and propagates the need to rescue those with very, very large asset bases. Perhaps this isn’t an emergency, but it looks to be just another ‘normal emergency’.

For most investors, there is a risk that you ‘miss out’ on another bounce in the markets if the Federal Reserve eases policy this week, however any easing is likely to simply increase the duration of the stresses on the system, not resolve them. Asset prices remain too high, earnings estimates are likely to drop in the coming three weeks and markets will take some time to absorb the information and find a footing. When stability does come into the market, further asset sales are likely to take place by central banks to normalize the economy and the process will repeat. There is a little hope that the objective can be achieved without breaking the market completely.

For now, stay the course. By contrast, if you are a nimble and risk tolerant trader, then be prepared for a bounce on Monday afternoon!


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