After the interest rate surged in the dollar repo market in September, the US Federal Reserve stepped in with US$260 billion to bring down the rate, essentially bailing out the distressed borrowers behind the move. They were probably from the shadow banking system.
This new quantitative easing has led to the US market setting record highs again, and for good reason. If the Fed could bail out the shadow banking system, why not the stock market? So, speculators should not worry.
Ever since the US-China trade war began, the financial world has been in constant fear of the world order crashing. China and the US have accounted for most of the growth in the global economy in the past 10 or 20 years. Their symbiotic relationship has sustained global growth.
The US economy is based on debt-financed overconsumption, while China's is based on debt-financed overinvestment. They lean on each other for balance, like two one-legged men walking along with interlocking arms. The renminbi's peg to the dollar is both the symbol and substance of this mutual dependence. If this relationship breaks, the world is likely to go into a prolonged adjustment to reach a new equilibrium.
The uncertainty in the world order is occurring amid the biggest bubble ever in the global financial world. Quantitative easing by China and the US in response to the 2008 crisis led to massive debt build-up and asset appreciation along the way.
As asset markets have become so large, relative to the real economy, their turbulence determines the economic outlook and not, as is normally the case, the other way around. This is why the Fed has cut interest rates during the trade war, even with unemployment at historic lows. It views the ensuing market turbulence as a threat to the economy. The Fed has gone from the financial bubble's hostage to its guardian.
Two decades ago, financial markets were talking about the "Greenspan put" - the belief that the Fed, led by then-chairman Alan Greenspan, would ride to the rescue in the event of a downturn.
Similar expectations for the Fed are much stronger. It has essentially underwritten the market rally since 2008. Its QE has financed rapid growth in corporate debt that has gone into stock buy-backs. This money has basically gone into the stock market.
The Fed still insists that it is targeting 2 per cent inflation. But, it is doing so by inflating asset prices. As most people don't own stocks, such an approach has caused a massive stock bubble without lifting inflation much.
Debt-fuelled asset inflation is vulnerable to confidence shocks. The latest trouble in the repo market is one example. The trade war has increased market volatility. Most macro funds make a living through so-called "long volatility", that is, betting the Fed will always keep markets calm. As their trades are highly leveraged, if a significant shock hits and the Fed fails to come to the rescue quickly, the whole system could blow up.
During the year-long trade war, both Beijing and Trump have been feeding the market with false hope for an amicable ending. Trump wants to keep the market up. His life depends on it.
Why Beijing does so is more difficult to understand. A blow-up may force Trump to compromise, which may be the only path to what Beijing wants. As I have mused before, Beijing's main concern may be domestic confidence. So its incentive for sugarcoating the dispute is similar to Trump's.
The reality may catch up with the market's hallucination soon. It has panicked over missing deadlines a few times already, but recovered on false promises of a "fabulous" deal soon. Beijing would only accept one type of deal: purchase of agricultural commodities for eliminating tariffs.
The US hope of structural reforms in China is out of reach. Beijing's willingness to talk about it is merely a negotiating strategy. For negotiations to succeed, the US would have to climb down. Yet Trump is too thin-skinned to accept defeat. Besides, it could kill his strongman image - very bad for his re-election chances.
Trump will compromise only if the stock market crashes and stays down. If he can talk it back, nothing real will happen. The current deadline is for a phase-one deal by December 15. The odds are it won't happen, meaning the market will swoon again. If Trump can talk it back, we will experience another cycle of false hope. If he can't and we don't, a real solution may be possible.
The Fed has become an obstacle to ending the trade war. If it helps Trump to boost the market every time, the trade war becomes like Groundhog Day. Is it possible that the combined force of Trump and the Fed won't be able to keep the bubble from deflating?
If a financial crisis breaks out outside the China-US axis, it may trigger fatal whiplash. For example, the European banking system could go into crisis again if the global slowdown sees doubts return about the solvency of some southern European countries.
Private banking is another dangerous area. In competition for market share, private banks have provided leverage to speculators on a massive scale, often backed by low-quality collateral. When a slowing global economy decimates their collateral, some aggressive private banks may be in trouble.
Highly leveraged property financing is another danger. For example, Hong Kong has relaxed mortgage financing rules for first-time homebuyers, allowing them to borrow up to 90 per cent of a property's value. While the city resembles a battlefield, its property market remains the world's most expensive. A crash, like in 1998, is a distinct possibility. This time, it may take the banking system with it.
Central banks like the Fed have become very good at keeping up financial bubbles. This is why the current one has been around for so long. But as the bubble gets bigger, it causes stresses in unexpected places. Trump, Brexit, the yellow vests in France, the trade war and Hong Kong are all partly due to this bubble. We may never know when the last straw will land. But that time is surely getting closer.
Andy Xie is an independent economist
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