The Vampire Stake has many splinters.

There are quite a few events competing for the vampire stake, including fear and uncertainty surrounding:

• The UK crashing out of the EU next year, with Theresa May stalling the Brexit deal vote in the House of Commons (with the Northern Ireland border ‘backstop’ still the main hot potato).

• Riots in Paris and Belgium and economic storm clouds again over Italy.

• Mario Draghi’s expected declaration that EU QE may be over.

• Arrest of Huawei chief financial officer, Meng Wanzhou on the same day as Trump and Xi agreed to a bizarre 90 day ceasefire on tariff increases.

• A flattening US yield curve that has been inverting, intermittently.

• Expectations for further interest rate hikes in the US this month, albeit with possibly one or two hikes next year, as opposed to 3 or 4.

However, there’s a fairly large splinter that isn’t getting much airplay.

Way less money is being printed.

The US is printing less money. The US Federal Reserve (Fed) is tightening the monetary base by running off its investment in treasuries. Less money sloshing around means less liquidity and less potential for growth.

The run-off started in the last quarter of 2017, and without getting into the weeds it works by the Fed ceasing reinvestment in treasuries at a rate of $10bn per month, i.e., only reinvesting in $40bn, with that cap increasing by $10bn each month until the run-off reaches $50bn per month (see here for further detail).

So, at the same time as the cost of money has increased through rate hikes, the quantity of money is decreasing - a double whammy for growth.

Strangely, this liquidity run-off has not been getting as much airplay as rate hikes, yet it may have a more profound effect on growth and capital flows.

Fed Chair Jerome Powell must be pretty happy that Trump has not challenged him on this, just yet. But that doesn’t mean he won’t.

If both the Fed and China ratchet down their buying, who will fund the US economy?

Prior to the GFC, the monetary base was circa $1 trillion. The Fed then bumped it up by $3.1 trillion, mainly through open market purchases of US treasuries.

Between the Fed and China, the US Treasury had ample buyers during the days of quantitative easing (QE) following the GFC. High demand outstripped supply. The effect was increasing bond prices and decreasing yields, making it attractive to be in US treasuries.

As interest rates decreased to 0% (with many countries following suit or going to negative rates such as in Europe and Japan) we witnessed investors stampede into global equities markets, causing a steroidal impact on multiples and valuations.

But then, QE stopped, and QT, or quantitative tightening started. Since then, we have been waiting for the inflexion point where demand for equities starts to splutter.

It appears the current mixture of 2-2.25% rates and a $600bn decline in the monetary base has been enough to cause some splutters and recalibration in global equities; with some help of course from tariffs and moderating growth out of Europe and China.

The S&P500 has slipped 11% in the last 3 months, and we can expect more volatility with some mini-rallies and further corrections.

How much more?

Since the run-off commenced, the monetary base has decreased by $600 billion, from a $4.1 trillion peak.

Latest figures on December 5 indicate a monetary base that is now closer to $3.5 trillion, and dropping.

If the run-off goes to plan, the monetary base would likely fall by another $1 trillion, to around $2.5 trillion.

That’s less potential for growth and a big dent in demand for US treasuries which will likely pose a challenge for Congress given the recent acceleration of the Government deficit.

Perhaps if a breakthrough is reached during the tariff ceasefire (as Trump appears to be tweeting today), China might also be persuaded to buy more US treasuries.

Still, the question remains whether Trump will see the run-off as a further growth killer - and whether the run-off becomes his next battleground with Jerome Powell. Will the Fed cave on its road to normalisation in 2019?

Mike.

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