Opinion – Helio Beltrão: Fed starts QT, and this worries more than interest rates

The favorable 40-year cycle of falling dollar interest rates was buried for good. Since 1982, the annual interest rate in dollars (a ten-year term) has fallen steadily from 15% to stabilizing around 2% from 2011 onwards, providing a lasting period of prosperity. However, the Fed has recently been raising the base rate to contain high inflation. As a result, the market interest rate has doubled to 4% per annum, and may rise further. The party is over.

Investors vacillate between hoping that inflation has already peaked — the “worst is over” and fears that the Fed is pushing the economy into recession. They are unaccustomed to making easy money in risky assets with abundant liquidity and demand a “pivot”, that is, for the Fed to turn 180º and stop tightening interest rates.

Will the Fed pivot? It does not seem likely, except in a scenario of great instability in the international financial system.

Although belatedly, the Fed is determined to fight inflation and says it will not change course even in the event of an eventual recession. When the Fed slams on the brakes, someone breaks through the windshield.

We haven’t reached that point, but worryingly, small cracks have already appeared in the financial system and the real economy: depreciating currencies (the Japanese yen is at its lowest level since the bubble burst in 1989); the UK pension crisis; China’s low growth (maybe it will grow less than Brazil this year); the energy shock, especially in Europe; and, additionally, geopolitical tensions and the Ukrainian War.

In a double maneuver, while stepping harder on the interest rate brake, the Fed will remove the protective airbag. It announced that it will deflate the liquidity created since 2008 (more than twice the Brazilian GDP). While many are focused on rising interest rates, few understand the effects of this “quantitative tightening” (“QT”), which starts in earnest from now on.

Since 2008, the liquidity cushion granted to banks has had a greater impact than the basic interest rate, as it generated the financial conditions that stabilized the markets, and collaterally boosted the prices of shares and other risky assets. That’s why your reversal worries. Risky assets may suffer the most.

QT can be the straw that breaks the camel’s back, as the Arab proverb says, the last straw that overflows the bucket, as we Brazilians prefer to say, or even the turning point, as Malcolm Gladwell says.

Note that while the base rate hike may be halted in 2023, the schedule is for downsizing to continue for the next two years.

We are watching the trailer for the movie of the paralyzed camel, starring the UK. The new government announced a deficit budget and shocked markets. Interest on government bonds rose. Defined-benefit pension funds, squeezed by rising payments to retirees, had been placing bets on government bond derivatives. Its public bond portfolio depreciated; were forced to sell bonds to make cash. In a diabolical loop, interest rates rose even higher…

With QT, the Fed and other central banks will stop buying government bonds. The market will have to finance governments with resources that would have gone into investments. Interest rates will tend to rise more and turn on the yellow light of public debt sustainability. The governments of rich countries can end up similar to those of emerging countries: saucer in hand.