The latest piece for Australian Financial Review (AFR) is up. Since it’s behind a paywall I have posted it below. The links shown are to other related AFR articles. Subscribers can simply click the link or the link here for the full article.

Disinflation is over, deleveraging the financial system could be next.

All war is terrible, but sadly, it’s not unusual.

Indeed, in 2020 it was calculated that the US has been at war for 225 out of the previous 243 years. Similarly, virus epidemics are not unusual, especially ones with a 99 per cent plus survival rate.

Humans, and by extension financial markets, are adept at pattern recognition and as such the initial response to both the arrival of COVID and the Russian invasion of Ukraine was similar.

There was a sharp increase in risk aversion, involving a deleveraging by traders and buying of derivative protection by asset allocators, followed by a pause and then a reversal of some of the ‘new’ trades put on that didn’t generate further underlying activity.

That included shorts in equities that saw no follow through selling and were squeezed higher, or speculative longs in commodities that saw no follow through buying and thus fell back.

We are now at the second phase, which is trying to work out the implications not so much of the ‘event’, but of the policy actions made in its immediate aftermath.Advertisement

Over the last two years these policy measures have been the things that are, quite literally unprecedented and as such the markets have struggled to find any historic pattern.

The mass medical interventions in 2020 were unprecedented, but even more so the non-Pharmaceutical Interventions (NPIs) like masking, testing and lockdowns. Dramatic and previously unthinkable restrictions were placed on individual freedoms, many of which remain and will have to be hard fought to be removed.

The great bond bear market is long overdue

Centralisation and increased government power tends to work on a ratchet. Similarly, the immediate moves to not only sanction Russia but to freeze its foreign currency reserves are completely without precedent and threaten to have consequences far beyond the end of the conflict in Ukraine.

Markets and economies are thus in a renewed period of uncertainty as the policy measures of the last few years continue to put stress on the underlying economic and financial systems that we take for granted.

Most obviously this has appeared in the ending of this latest iteration of globalisation as first COVID disrupted the just-in-time supply chains that were already pressured from US/China sanctions and then, obviously, this has now been followed by huge disruption even further down the ladder, at the very basic level of input costs of energy and raw materials.Advertisement

While the debate may still be there about exactly how sustainable price rises are and to what extent they are simply a function of supply shortages, the key thing is that the period of dis-inflation associated with a long period of excess supply is clearly over.

The argument that zero or even negative nominal yields were still attractive in ‘real’ or inflation adjusted terms no longer holds water (if it ever did).

Importantly, in terms of policy response, this time something really is different, the central banks are not responding as they did in the past, by cutting interest rates or buying in fixed income securities. Indeed, they are now doing the opposite and that is one reason why bond markets have had an awful first quarter to follow on from an awful 2021.

Long-term investors need to look through short-term confusion

Fundamentally, if you don’t have to own bonds for regulatory reasons, it’s been difficult to see why you would bother and the near inversion of the yield curve also means that the carry trade of borrowing short and lending long is essentially dead for the rest of the cycle.

Another important factor that markets are trying to assess at the moment is the longer-term implications of the unprecedented decision by the US to freeze the foreign exchange reserves of Russia and in particular what it means for the US dollar, both as a trading currency and also as the sole Reserve Currency.Advertisement

Currently, global trade amounts to a little over $US6 trillion a year, the vast majority of which is done in US dollars, even if the US is not the underlying counter-party.

Far more importantly for financial markets, that $$US6 trillion a year supports $US6 trillion a day in the foreign exchange markets as the big global banks apply vast amounts of speculative capital on top of the trade flow. Switch even some of that trade flow out of the US dollar and the necessary deleveraging of the FX markets would be enormous.

The current crisis looks to have marked the end of the 50-year experiment known as the Petro-Dollar, where the US effectively recycled the world’s savings via the mechanism of pricing energy – and other commodities – in US dollars, although after several years of sanctions, Russia was already doing bilateral deals with China and India that cut out the US dollar and this is now simply accelerating.

Perhaps more important however is the near 80-year experiment in role of the US dollar as sole reserve currency; many are saying that this ‘exorbitant privilege’, as De Gaulle put it, of being able to print as much money as you like is not under threat because no other currency could take its place, but there is an interesting and highly credible alternative, the Special Drawing Rights (SDRs) held by the IMF.

This would not be a currency, but a unit of account similar to the Bancor suggested by Keynes after the war, but rejected by Bretton Woods. Perhaps now its time has come.

Disinflation is over, perhaps deleveraging the financial system comes next?

Mark Tinker is chief investment officer of Toscafund Hong Kong and the founder of Market Thinking. He blogs on behavioural finance and markets at Market-thinking.com.

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