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The Central Bank Put

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April produced the largest rally in equity markets since 1987. The US markets retraced roughly 60% of their losses from the highs in February, as did many other countries equity indices. Governments in G20 countries are implementing fiscal stimulus packages the size of which we last saw during the times of the Great Depression and Second World War. To add to this cocktail of do whatever it takes, Central Banks have committed to QE Infinity.

 

With the floodgates open wide and a sea of liquidity being flooded through the financial system we are again confronting the age old investing question, do we go with the long term trend of buying the market when we have the central banks writing an effective put. That is they are saying they wont let the markets collapse we will do whatever is necessary to keep the markets rising.

 

Let us look at a chart showing the central bank intervention over the last 35+ years. On the chart I have plotted the S&P500 with M2 Money Supply. As you can see there is a very strong relationship between these 2 charts. Which once again brings up the question whether the Central Banks can continue to successfully intervene with the equity markets?

 

 

 

My response to this tricky question lies beneath a complex set of relationships.

 

When you look at the above chart you see clearly a very strong trend of growth in money supply and you similarly see a strong growth in US equity prices. However you can also see that the growth in equity markets has been far more volatile with some significant market drops along the way. I have circled the major market crashes of 1987, 2008-2009 & 2020 (which still looks like a drop in the ocean). During these difficult times the Central Banks have eventually come to the rescue and markets have recovered and some. However like trend strategies you only know if you are wrong once you have given back a large portion of your profits. We have a very small sample of data points to infer what the likely behaviour of the market will be through economic history and therefore it becomes an exceptionally dangerous game to believe the Fed has your back. A buy and hold strategy through these market pullbacks witnesses exceptionally large drawdowns on an investment portfolio, so large that most people managing other peoples money would suffer enormous withdrawals and leveraged investors would go bankrupt. This at least makes the game with a Central Bank Put somewhat exciting. The problem is just because we haven’t seen a complete breakdown in the central bank liquidity induced market boost over the last 100yrs doesn’t mean it wont happen in the future.

 

In my humble opinion we are currently witnessing a decoupling of this once sacred relationship. In the chart below we see long term interest rates in green close to zero. There really is very little room for interest rates to drop further to create more market fuel. We also witnesses the velocity of money (blue line) working its way through the economy in complete free fall. What this means is that it is taking more and more money in the system to produce marginally decreasing economic output. Just like you can eventually eat too much ice cream so that you don’t want any more, the same applies to central banks intervening with money creation that nobody wants.

 

What we are seeing is a deflationary cycle starting to overwhelm the central banks proving their omnipotence is limited to an environment conducive for economic growth, not one manufactured at a printing press. The seeds were already sown for deflation long before Covid-19 entered the scene. We have already seen in Japan that 20+ years of zero interest rates and central bank intervention of epic proportion still leaves the Nikkei Index some 48% below its all-time high.

 

In summation: correlation doesn’t equal causation, and even if it did, it suffers from diminishing marginal impact. Finally we may be witnessing the Central Bank ability to control the world financial system put-less.

 

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