Deflating the Balloon Without Bursting

Views are my own. Broad macro thoughts. Not investment advice.

Sadly I feel that the credit issues for the market are just getting started. Higher interest rates expose weak balance sheets. They are not the cause of weak balance sheets. Balance sheets that were built on air like FTX or built without interest rate hedges like SVB. These balance sheets were already built on weak foundations. Higher rates just exposed that. They were shown to be swimming naked. What concerns me is that if this many people are being shown to be this naked. Then how many more naked swimmers are out there? The whole thing is starting to look like a nudist beach.

The market is starting to have the same concerns and this is where the next problem is. Uncertainty. Uncertainty leads to fear and that leads to a credit crunch. As liquidity dries up any other weaknesses will be exposed. Higher rates expose weak balance sheets but a credit crunch can cause weak balance sheets. As liquidity dries up balance sheets that were otherwise strong can suddenly become weak and the negative feedback loop feeds on itself. This appears to be happening today. Vulnerabilities are exposed in these kinds of markets, wherever they are hiding. I expect there will be other vulnerable businesses exposed over the coming weeks. Other central banks may need to follow the Fed by taking steps to calm the uncertainty and panic otherwise it is difficult to see how this turns around.

Central Bankers understandably needed to hike rates to stem inflation pressures. I have been a strong proponent of tighter policy to stem the kind of unruly risk taking that was taking place. The problem for policy makers is that deflating and overinflated balloon without bursting it is very difficult. Central Bankers allowed these kinds of balance sheets to develop under ZIRP regimes and now as rates moved higher those vulnerabilities are exposed. This leaves a very difficult tightrope for central bankers to walk as they need to maintain credibility in their fight against inflation whilst also maintaining credibility that they will maintain financial stability. Those two goals look apposing right now.

Uncertainty is about as high as it can be. It is extremely difficult to predict how central bankers will act from here and markets are extremely volatile as a result. I still maintain an extremely defensive position of long USD, XAU and CHF and short growth currencies. Sadly I think this gets worse before it gets better.