Taking the Easy(ing) way out.

It has become quite apparent over the last couple of weeks that the days of interest rate cuts have started. Uncle Tiff was first to the party in June of this year with 25 bps, followed by another 25 bps in both July and September. Jerome Powell and Co. brought a gun to a knife fight last week and chopped 50 bps off the overnight rate, and the European Central Bank ( ECB ), Bank of England ( BOE ), and a laundry list of other central bankers have been cutting and trimming rates as the global phenomenon formerly known as inflation quietly dies its death.

Everyone from mortgage brokers to real estate agents have been busy celebrating the return of lower rates, and I am too old and too tired to bring up the fact for the 164th time that lowering rates means all is not well in the economy. While lower interest rates get all the attention lately, there is some other things we should be paying attention to.

While everyone is watching central bank announcements like the newest hot movie release, we seem to be completely ignoring what is actually going on in the world of finance. I don’t mean things like drab old boring bank earnings, or what company is buying what, but there are some pretty big signals flashing right now, and no one seems to really be paying attention to them. Let’s see what we are missing:

1. Gotta loves those curves……I mean the yield curve of course. For the first time in a very long time the yield curve is no longer inverted. The yield curve just came off of its longest inversion in recorded history. An Inverted yield curve is a problem in finance. The basis of the yield curve are that the longer the term, then higher the rate. Since going farther out into the future adds unknown risks, then the investor must be compensated for taking a longer bond. When we see a yield curve inversion it means that shorter term bonds are yielding more than longer term bonds – hence the term inverted. When investors are demanding a higher rate for a shorter term, it signals a recession is in the making. While an imperfect indicator, it is usually a precursor to dark storm clouds on the economic horizon. However, the recession and the economic problems generally don’t arrive until the curve un-inverts – which we saw late last week. If you weren’t sure if a recession was coming, we can be now. Once the curve un-inverts, it usually means we tip into a recession within weeks. The general rule is that the longer the inversion the worse the recession, but we have never seen a yield curve inversion this deep or this long, so no one really knows the final verdict. And for those out there that always ask what I follow, I generally follow the 2/10 yield spread for my inversion signals, as it provides the best basis for a short vs. long bond, and has the greatest impact to financial company balance sheets.
2. Chinese Take Out: In a very non covered press release last night, China announced it is further easing bank requirements. China has decided to drop 50 basis points off of required bank reserves. While Basel III is looking to increase bank reserves in the G7 and G20, China is dropping the amount of money banks need to keep on hand. In case you are wondering – this never happens when things are moving along tikkity boo. This is usually a sign of stress in the financial community. Now, you may also think that China really doesn’t matter, but I can promise you that what happens in China will be felt – eventually – all around the globe. This is the second time in 6 months China has dropped the reserve requirements for banks in Mainland China. This is effectively quantitative easing by another name.
3. Speaking of quantitative easing, last week we had the Government of Canada announce the increase of the insurable mortgage and the addition of 30 year amortizations. While I am sure we will see some spin around “affordability”, this is nothing more than a QE move to prop up housing by a government desperate to win a re election. Never mind how you feel about the politics, but this is QE3 in Canada. Basically the government is trying to stimulate money movement and prices by making something more accessible to more people. At the end of the day though, it shows us once and for all that the government will do almost anything to stop the housing market from going down. This used to be called the ‘Fed Put‘ in the USA for the stock market, but Canada has put its own spin on it, and re invented the wheel to focus on housing.

No matter how you slice it, governments around the world are starting to make subtle changes to effectively bring in a version of QE. No government or central banker will stand up and announce ” We are screwed “, so they will subtly announce new programs, more easing, and a whole host of changes that they will ultimately convince everyone are good things. Somehow, every time I see an announcement made by some politician it feels like a timeshare pitch – it all feels too good to be true, and we have to wait for the details to see where the ‘ gotcha’ is. After 2008 and 2020 the public is more aware than ever of what QE is, and what the dangers of cheap money can be( ask anyone who bought 4 pre con condos in Toronto in late 2021 ), so governments have to somehow introduce QE into the environment without calling it QE. A rose by any other name would smell as sweet.

So why are governments doing this? Why pull out all the stops? Is it simply to get re elected? Probably not the only reason, even though there is a pretty big election stateside in the next 50 days, and Canada’s government is one bad idea from a non confidence vote. However, the reason we are slowly introducing all of these measures is that governments – more specifically government advisers, see the writing on the wall. The cycle of inflation and deflation can all be linked back to one thing, and one thing only – China. China basically controls whether the world will have inflation or deflation based on the prices they charge for things. Almost everything we buy today has some component of Chinese origination, and so the price the Chinese charge for products have a massive effect on the end price that consumers in North American and Europe pay. China plays the long game and can change import and export controls and prices seemingly at the drop of a hat. China exports either inflation or deflation in the prices they charge. China is now exporting deflation around the world. Recently the Chinese economy has started to suffer, and as such, China has lowered prices which will help start the deflationary cycle, much like we saw from 2010 to 2019. China started exporting inflation from mid 2022 until mid 2024. Interestingly enough, inflation seemed to skyrocket from mid 2022 and just recently started coming down. I will get a lot of blowback on these statements, but the truth is the truth. China can basically turn inflation on and off like a tap to North America. Based on the fact China is now starting to export deflation, I think we will start to see the recessions in advanced economies start to pick up speed. Oh sure, governments will change terms, or paper over them, or change the ‘official’ definition, but recessions are going to become a way of life.

For all the people who love to see rates falling – the next 12 months will be your time to shine. Deflation will lead to rates coming down, so best get those Tik Tok dances ready. Deflation will be a good thing for governments trying to slay the inflation dragon, until all of a sudden the deflationary prices lead us into a recession.

In Ernest Hemingway’s novel, The Sun Also Rises, in one conversation an interlocuter questions another on how he went bankrupt, resulting in the now well-known response: “Two ways. Gradually, then suddenly.”

Deflation will show up gradually, then suddenly. This gradual slip will require governments and central bankers to slowly and surely add more rounds of QE to the system. Of course the BOC is still working on quantitative tightening which they predict will be wrapped up mid way through 2025. Personally I feel that timeline might get sped up a bit, and we will see a full 180 from a QT to a QE.

No matter how you slice it, deflation has been and always will be a bad news bears event. Nothing good comes from deflation – even though we all want lower prices. Central bankers around the world have found a way to stop inflation – simply raise rates. No such easy solution exists for killing deflation. Japan tried to cure deflation in the mid 1980;’s and still wrestles with it today. Sure, some of Japan’s issues revolve around population and an aging society, but a lot of what killed Japan’s dominance was deflation. QE given out before deflation becomes entrenched may help solve the problem, but it has never been tried.

I guess we are all part of an experiment now.