It’s been quite the start to the year: with stock markets beginning 2018 as they finished 2017, setting new records, then tumbling, then recovering a little, then falling some more. One underlying driver sits behind it all.
Banks create money – it is an aspect of the modern economy that is not commonly appreciated. The money supply grows when the banks lend. It is not central banks that boost the money supply. When, after the financial crisis of 2008, banks resorted to quantitative easing, it was heralded as money printing, but actually, that is not what it was. QE was launched because bank lending had virtually collapsed, and as a result, the money supply had begun to shrink. This had the potential to be a disaster, it is, after-all what happened after the 1929 crash, leading to the Great Depression.
So central banks tried to reverse the stem, not by printing money, but by forcing asset prices up, so that banks would be more comfortable with lending.
And as a result of record low-interest rates and QE, asset prices did indeed surge. House prices began to recover their 2008 losses, and then they rose some more. Bond prices, which have an inverse relationship with interest rates, rose to record highs, as a consequence, share prices looked cheap relative to bonds, and they rose.
There is another, more subtle, relationship between shares and interest rates. In theory, the value of a company is a function of its future dividends, discounted by a rate of interest to give a net current value. The lower interest rates, and expected interest rates, the less the extent to which future dividends are discounted, hence company valuations are higher.
And as a result of falling rates, and rising asset prices, borrowing across the world surged.
According to McKinsey, between 2007 and the first quarter of 2014, global debt rose by $57 trillion.
High debt levels are particular concerns in Turkey, Canada and China. It is worth bearing in mind, however, that household debt to GDP is still lower in the UK than in 2008.
The big fear relates to what happens when interest rates rise. Up until very recently, there was an assumption that when they rose, rates would rise only very slowly and peak at a much lower level than they had peaked at in previous interest rate cycles in the past.
On the back of this belief, not only did equity prices rise, but the so-called VIX index, also called the Fear Index, a measure of market volatility, saw unprecedented low readings.
This all began to change at the end of January, with news on US jobs, suggesting that inflation pressures were beginning to build at a time when President Trump was planning to boost the economy with tax cuts. Under normal circumstances, these are the classic ingredients for rising inflation and interest rates.
The situation was compounded last week when the Bank of England indicated that it would be increasing interest rates over the next two years at a faster rate than had previously been assumed.
No one is quite sure what will happen if rates rise faster and higher than expected – and such uncertainty has led the VIX/Fear index to surge, hitting its highest level since 2011.
So far, though, the levels of the VIX are not at scary heights, since the index was launched in 1990, there have been eight periods when the VIX has risen higher.
This morning, the FT quoted the boss of the world’s largest Hedge Fund, Bob Price, as saying: “There had been a lot of complacency built up in markets over a long time, so we don't think this shakeout will be over in a matter of days"
He may well be right, but it depends on what happens with interest rates. If evidence builds that they need to rise higher than had previously been expected, then more volatility will indeed follow.