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The Third Eleven
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                                                                                    Friday, March 11th, 2022
Dear Chris,

It is 11 years since the Tohuku earthquake of March 11th, 2011. A decade earlier another 11, September 11th, 2001, provides a start date for an incredible twenty years.

Over this period the world and global markets have seen the ‘War on Terror’ and its failure, a real estate boom Part I and now Part II and the near collapse of the financial system, with central banks rushing to support a creaking system. This is on top of the aforementioned natural disaster and the immediate Covid pandemic.

The markets gasped but soon started to live on ever increasing rounds of Quantitative Easing. The final covid related QE comes to an end this week. Risk assets, over this period, have responded to this money-printing largesse with jubilance, benefiting from the tsunami of cheap and never-ending credit.
This colossal credit boom has left markets exposed and extremely susceptible to ‘event risk’. Beginning in this third decade the omnipotence of the central banks, especially the Big Five (Fed, ECB, BOJ, BOE, SNB) plus one (PBOC) is suspect and possibly waning. Added to this is the recent defenestration by the central bank brotherhood of one of their own - the Central Bank of Russia - by confiscating $350bn of assets that were in Euro FX swaps on the balance sheet of the ECB. Suddenly, all smaller central banks are now looking at each other and their balance sheets and asking “could we be next?”. Why place their assets in the Reserves of other central banks if they can, at a stroke of pen, be confiscated.

The Big Five have created a ‘reliable counter party’ problem for the future. They need to continue to convince other brethren bankers that their assets are safe, and that maintaining FX reserves with each other for the smooth functioning of the market is vital. This will be an ongoing mission, as the speed and size of the Russian ‘money grab’ was unprecedented, perhaps the only previous similar action was when the United States took the Empire of Japan’s reserves, under ‘Trading with Enemy Act’, 85 years ago. Institutional memory of the consequences of that last action have, no doubt, been lost.

Added to this PR problem is the market fragility created by the decade long engorged balance sheets of the Big Five. What must they do to maintain their credibility? Increase interest rates which will effect the physical economy, along with the interest costs of their key customer, the government? Or alternatively do they substantially reduce their balance sheets that will instead have direct effects on ‘risk assets’? This is a stark choice between the central banks’ two main customers: the government, whom they need to support in times of war and pandemic versus private finance, whom they need for the smooth functioning of prices and settlement of payment. This is a choice between inside money (the government) or outside money (the markets). We shall see which customer has greater ‘pull’.

The Big Five will soon decide which path to take over the next decade - interest rates or balance sheet. However, events will continue to limit its choices. And like all ageing entities, the Third 11 enters this decade a little heavier and bruised. 

See you next week - Mustafa


 
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