Central banks vs market forces: the global economy’s tug of war amid rising interest rates
Central banks and market players are struggling to adapt to an environment of rising interest rates and raging inflation.
Nobody asked for it but the world economy is now being tugged in two very directions at the same time.
On the one hand are the central bankers who are getting increasingly determined to get inflation down by pulling on the one big lever at their disposal – interest rates.
On the other hand, there are individuals, households and big systemic players like banks and major businesses that are coming under all sorts of pressure through the combination of rising interest rates and cost pressures.
The lightning-fast collapse of Silicon Valley Bank was just one symptom of these pressures as various market sectors painfully and slowly adjust from a lengthy period of falling interest rates and benign inflation to rapidly rising interest rates and stubbornly rising prices.
Bank collapses now, what next?
That makes for a very awkward and difficult investing environment, given that the next company or sector that has failed to adjust quickly enough could suddenly pop up out of the blue.
There were precious few people talking about a potential bank collapse in the US in the lead up to SVB’s lightning collapse but now the entire market is speculating and testing values to see who might be next.
The same applies to ailing Credit Suisse, which is also a victim of poor management for a protracted period and is itself a victim of corporate collapses such as Greensill Capital – a company effectively tailor made for super low interest rates that folded as soon as the tide turned.
Who is swimming nude?
To use the language of Warren Buffett, who else might turn out to be swimming without their bathers as the tide of free money subsides rapidly?
While the banking sector around the world is certainly not out of the woods, there could be unexpected problems in areas such as commercial office property where valuations have not yet factored in higher interest rates on borrowings and greater difficulties attracting tenants.
In a wider sense, any businesses packed to the gills with debt could be in trouble if their earnings fall or their liquidity is challenged in any way.
Similarly, any business that is forced to liquidate long term assets like bonds at a loss that were initially being held for the long term could be toast.
Collapses can happen very quickly
What this latest crisis has shown us is that such collapses can happen very quickly – one day a business looks fine and the next, it can be left flapping on the beach like a stranded fish.
On a more personal level, I suspect the pain being suffered in some households and small businesses is becoming extreme, even if there has so far been little sign of forced sales.
For example, despite rising rents, can you imagine what the balance sheet of some of the “how to buy fifteen properties in five years” crew looks like at the moment?
They might be hanging on by their toenails for now but highly leveraged property empires of all sorts are extremely vulnerable when interest rates rise.
We have already seen collapses of builders as they struggle to cope with rising material prices.
Into this already highly anxious investing environment you have to add the major central banks.
Last week with Credit Suisse once again flapping on the sand before another rescue was launched to land it back in the water, the European central bank nevertheless still jacked up official rates by 50 basis points.
This week the US Fed faces an acid test on whether if flows with market consensus to a 25-basis point rise or goes hawkish with a 50-basis point rise or super dovish by holding rates steady.
Central banks could keep lifting rates
At this stage, even though these big central banks have been seen as compliant and supportive doves in the past, I wouldn’t underestimate how determined they are to get inflation down as quickly as possible and then pause for a look around.
Here in Australia, the RBA has a more delicate task given the high percentage of floating rate housing loans compared to offshore markets that has greatly magnified the pain of many borrowers – particularly those who bought in the final stages of the property market boom during the COVID lockdowns and those coming off low fixed rate loans.
RBA Governor Philip Lowe might only have one or two 25-basis point rises left in him but even that could be the straw that literally breaks quite a few backs.
Time to boost cash like Buffett?
In that context, the direction of inflation is central to where rates will end up and how quickly but only the real optimists see a lot of hope there.
While inflation may have peaked, even here in tardy and difficult Australia, it is hard to see it coming down to the sorts of targets central banks have in mind in the short term.
All of which brings the dreaded spectre of a recession firmly into the picture – along with the odd flash crash or two in the corporate sector.
Warren Buffett, for one, has been boosting his already massive cash pile in recent days as he prepares to once again get greedy while others are fearful.
It is a model that is certainly worth considering as risks increase along with interest rates.