Fed cuts rates, feeds markets’ liquidity addiction as bubble concerns rise

(Originally published Dec. 11 in “What in the World“) The central bank to the world’s central banks is getting even more worried.

The Basel-based Bank for International Settlements, fresh from sounding an alarm over the build-up of exotic derivatives bought with borrowed cash, is now concerned about a much more fundamental peril: a bubble in stocks and gold. “The past few quarters represent the only time in at least the last 50 years in which gold and equities have entered this territory simultaneously,” the BIS said. “Following its explosive phase, a bubble typically bursts with a sharp and swift correction.”

In its latest quarterly report, the BIS warns that retail investors have bid up the price of stocks—and stocks related to AI in particular—far higher than makes sense. No surprise there: the BIS’ alarm only adds its voice to what the IMF and many others have been saying for a while. While institutional investors have been selling off some of their stocks, retail investors have been buying more.

But the BIS also worries retail investors have been buying gold with a zeal also beyond reason. The World Gold Council says it’s seeing record inflows this year into gold ETFs. One reason investors are snapping up gold is concerns about growing government debt and how it could weaken the fundamental value of currencies, a concern made vividly real in the U.S. by persistent inflation. Combined with the likelihood that the U.S. Federal Reserve will need to cut interest rates to offset a weakening job market, thus lowering the return on cash, investors see gold as no-brainer.

Regular readers will recall that only last week the new head of the BIS was worrying about the level of hedge fund activity in derivatives for government bonds. BIS General Manager Pablo Hernández de Cos warned in a speech at the London School of Economics that authorities need to rein in the amount of leverage hedge funds are using in the market for government-bond derivatives.

De Cos warned that, with government’s ramping up their debt levels to buy more weapons to counter Russia and care for their ageing populations, they can’t afford to risk having the derivatives market crash the party. Reining in leverage among non-bank financial institutions, de Cos said, should be a “key policy priority.”

The Fed, while delivering another 0.25 basis point rate cut, also announced Wednesday that it would try to relieve the growing strain in money markets by launching a new, $40 billion program to buy short-term T-bills.

The new program follows the Fed’s announcement early last month that it was ending its policy of “quantitative tightening,” in which it sold U.S. government bonds it bought with imaginary dollars when the economy was struggling, or let them mature without buying new ones. That effort was slowly draining cash from the economy, exacerbating a shortage of cash among banks and raising the risk of sudden shocks.

But announcing the end of QT didn’t provide the immediate relief many thought it might. The Fed had been letting bonds it held mature without rolling them over, i.e. buying new ones to replace them. After ending QT, it started using the proceeds of maturing asset-backed securities from federal agencies to buy short-term U.S. Treasury bonds, or T-bills. Even though this would inject $15 billion into the market, a key gauge of liquidity continued to worsen. So now the Fed is tossing the market another $40 billion.

Maybe that’ll work. But with increasingly leveraged investors now worried the Fed will hold off rewarding them with any more interest-rate cuts until at least April, the market’s liquidity junkies may soon be baying for another fix.