Addicted to the Fed’s Liquidity Injections, the Stock Markets Will Not Appreciate the Withdrawal.
An analogy with the addictive phases of a drug addict allows us to better understand the current behavior of the markets.
The parallel between investors in the financial markets and drug addicts is not new. I do not want to refer here to the scenes of exuberance that films like “The Wolf of Wall Street” leave in our minds, but rather to the analogy that can be made metaphorically.
For several years now, it has become clear that investors have become addicted to the liquidity with which central banks are flooding the markets. All indications are that investors no longer know how to live without it.
What the market experienced on Wednesday, April 6, 2022, the day of the release of the minutes of the previous FOMC Meeting of the Fed, strongly resembles a phenomenon experienced by any drug addict: the descent.
Judge for yourself:
For those who don't know what it's all about, the descent is a phase of acute depression fueled by feelings of withdrawal and helplessness. It is an event that was completely predictable for anyone who has ever read books about drugs and addicts. The reason I say predictable event here is because the financial markets have gone through all the different phases of an addiction over the last fifteen years:
Use
Addiction
Euphoria
Withdrawal
The descent
Use begins in 2008
It was at the end of 2008 that the financial markets discovered the principle of monetary drip. In the middle of the subprime crisis. This crisis paralyzed the financial sector. It then led to another one: the European debt crisis in 2011.
To get things moving again, central banks, such as the Fed and the ECB, began injecting billions of dollars of liquidity into the financial markets. Better yet, central banks started to play the sorcerer's apprentice by creating experimental drugs: negative interest rates, Quantitative Easing (QE), Long Term Refinancing Operations (LTRO), ...
The most surprising thing is that it worked. Slowly but surely, the economy has rebounded and so have the financial markets.
Dependency takes hold in the mid-2010s
It is in the middle of the 2010s, from 2015 onwards, that the stock market indices gradually return to their pre-crisis levels. Many people then start to consider that the patient is cured. However, the patient is not stopping the medication. On the contrary, this is where the dependence of the markets on monetary perfusion comes to the fore.
Every new little problem is an excuse to ask for more money. The reason for this is that there is no apparent side effect.
The result is clear: in 2020, more than ten years after the subprime crisis, when financial markets are at their highest, when the US is almost at full employment, the Fed and other central banks continue to inject billions of dollars of liquidity into the financial markets.
If you think about it, it was during this period, even more than during the crises themselves, that the patient became truly addicted.
The euphoria comes next
In March 2020, the COVID-19 pandemic hits the world. A new crisis begins. What is the first reaction of investors? To throw themselves at the feet of their dealer, the central banks, because only new injections of liquidity can save the economy.
Nobody has the will to look for other solutions, other remedies to the crisis. The dependence is total.
The central banks are doing their job and flooding the markets with liquidity, as are the governments. Spectacularly, all the old taboos are shattered. Everyone is entitled to a dose of monetary infusion. Even those who did not ask for anything were served. The financial markets rebounded immediately.
In two months, whereas it took more than 5 years for the subprime crisis, COVID-19 is history for the financial markets. We are in the middle of the euphoria phase. Everyone starts to think that we have finally found a miracle cure for economic crises. Logically, investors feel invincible.
The harmful effects of the addiction appear, which leads central banks to think about withdrawal
All things too good to be true come to an end. So, after the euphoria, we always start to feel the harmful effects of the addiction. Overconsumption always pays off. Sooner or later. It is only a matter of time. For the financial markets, the first negative effects of the monetary infusion will be felt in the second half of 2021.
Inflation is showing signs of picking up. Jerome Powell, the Fed chairman, pretends not to believe it when he talks about temporary inflation. But hoping that things will work themselves out is unfortunately not enough.
In 2022, the price of raw materials explodes with the war in Ukraine. Central banks are now forced to wean themselves off liquidity injections. This is when investors enter into something akin to a detox phase.
Obviously, in order not to panic the patients, the central banks are planning to reduce the drips gradually, very gradually even. In any case, inflation should only be limited in time. Central bankers are no longer talking about temporary inflation, but about the causes for this high inflation being temporary. As you can see, central bankers like to play with nuance.
However, they reassure us by saying that at the slightest sign of difficulties, the injections can be resumed. Investors regain confidence and the markets take off again. This is a kind of crisis denial.
Withdrawal accelerates the descent, and volatility in the markets
A person in withdrawal is a nervous person. When investors are told they need to accelerate withdrawal, which is what the Fed is saying if you read the minutes of the previous FOMC meeting, they start to panic.
That's what happened on April 6, 2022, in the stock markets. All it took was the release of the Fed minutes and a simple speech by Lael Brainard, a Fed governor, who advocated a rapid reduction in the Fed's balance sheet starting in May 2022, to the tune of $95 billion per month.
This simple comment, which is not even a concrete decision yet, made all markets panic and see red. They then stabilized, but you can already imagine what could happen in the months to come.
Final Thoughts
It was illusory to think that the financial markets could live forever on monetary drips. Central banks are faced with new challenges, having to manage liquidity-hungry markets on the one hand and rampant inflation on the other. That's when we said to ourselves that it's a shame to have waited so long before adjusting the Fed's ultra-accommodating monetary policy.
The next 12 to 18 months are likely to be extremely volatile. This is normal, as detox is never easy. There are always phases of positive withdrawal, and phases of descent. So be prepared for several down days in the coming months like the one on April 6.
Unless the US economy falls into a recession, which would justify the reconnection of the monetary drip ... But that's another question we'll talk about in the future.