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Fed and ECB happy to turn Japanese

By Sam Kerr
19 Sep 2019

The renewed dovishness of the US Federal Reserve and the European Central Bank (ECB) may consign both Europe and the US to the same fate as Japan when it experienced its lost decades of stagnant growth. Central banks will find the tools they’ve used since the financial crisis have simply worn out when the next one hits.

To assuage short term fears of market instability, the Fed and the ECB may have irreversibly set both the eurozone and US economy on a path to a longer period of structural deflation and little to no economic growth.

Both debt and equity markets have become addicted to monetary stimulus and used to the resulting low yields. It has been a honeymoon for European debt issuers in particular, some of whom have grown used to the notion that bond investors must pay to lend them money.

Low rates have also accelerated leveraged lending, with companies borrowing heavily to finance business activities, make acquisitions or pay dividends.

Rising leverage caused the Fed to warn in May that high levels of risk appetite had exacerbated corporate indebtedness. But the central bank then proceeded anyway with two rate cuts which have made borrowing cheaper still. 

Some firms are using this opportunity to raise debt and buy back equity, keeping an already inflated stock market at unnaturally high levels.  

A fall in stocks would cause short term pain, but equity investors have been calling the top of the market for almost two years. Huge reallocations away from equities by active managers suggest that many have lost faith in a prolonged run for stocks. This year’s rise in indices has been driven by corporate buy-backs and quant traders.

When the inevitable downturn arrives there seems to be no plan to deal with it beyond the old, tired methods. At first they were implemented to stop financial collapse. There is no obvious threat of that happening, and yet now these extreme methods are the go-to way to do mundane monetary management. It is hard to see how the Japanification of Western economies is anything but inevitable while the West stays this course.

By Sam Kerr
19 Sep 2019