Uno reverse

In the world of finance, there is almost nothing more complicated than how banking actually works. From a very cursory view it is as simple as “borrow short, lend long”, meaning a bank takes money in on a deposit – say a bank account at almost 0% interest, and turns around and lends it out the back door on a mortgage for 5 years at a rate in or around 4.40%. The bank keeps the difference for matching up people who need to borrow with people who have excess funds.

Of course we all know it is far more in depth than this, and it seems to become more complicated every day. Ever since the 2008 financial crisis threatened to wipe the global banking system out of existence, the financial system has come up with a lot of ways, things, and tricks to keep the money flowing. Money needs to flow through the veins of the financial system for all parts to work correctly. If money stops moving through any part of the system, then that part dies, much like if your foot did not get blood pumped to it from the heart – you would lose you foot. When 2008 threatened to stop the flow of blood to the foot of finance – central bankers stepped in and created a new vein to flow the money around and stave off the amputation of certain sectors of finance. Ironically, the man that dealt with the central banking clean up of the 2008 crisis in Canada is now on the campaign trail to become the new ruler….I mean Prime Minister of Canada. Mark Carney was a brilliant central banker. So much so, that after leaving the BOC in 2013, Mr. Carney went on to be the Governor of the Bank of England – an institution almost as old as the world of finance itself. After helping the UK deal with Brexit, he went into private employment. While the financial world was reeling from the 2008 collapse, Mr. Carney served as the chair of the Financial Stability Board. Mr. Carney is smart, as most central bankers are. While most people view the world of central banking as dull an mundane, the feats they have pulled off in the past is what has allowed most people to live their lives with a lot less financial stress.

So why do I go on about a central banker form a by gone era? The reason I ramble on is because the thing I think a lot of people miss is that there are plenty of talented, smart people who work in central banks around the world, and with the world changing ever more frequently, they are coming up with new tools to fight new, modern day problems. As a society, we get very locked in on history, precedents, models that, much like Mr. Carney are from a bygone era, without thinking about what could be next. Below I am going to give you a great example of how group think can really paralyze people in our industry:

For months now, people have gone on and on and on about how tariffs would generate inflation. We know this apparently. We also know that if inflation is creeping up, then bond yields will creep up, especially the 10 year in the US and the 5 year in Canada. We know this, right? We are all sure that tariffs equal inflation, which equals higher rates. 1 million percent, right? Okay, so lets assume we are right about most of what we think, but wrong on the outcome? What if the events can happen differently than we come to think? The reason I mention this, is that I find when I speak with a lot of agents, they make their plans based on everything going one direction. That is well and fine, but the potential exists for things to go the other way sometimes. If everything in your life is hedged to 1 single outcome, anything that happens that isn’t the EXACT outcome, can cause a lot of problems.

Lets do some quick hypothesizing here. Let’s assume that everyone is correct and tariffs in the US increase inflation. Lets just assume that it happens for 100%. Now lets assume that inflation heating up gets Jerome and Co. to raise the overnight rate in he US ,and the short end of the yield curve starts to increase just like everyone thought. Next, everyone just knows that the 10 year yield on government bonds goes up, right? Well, the cool thing about these smart central bankers is that they could actually make the reverse happen if they wanted to.

A couple of weeks ago Bruno Valko sent out a great piece outlining why the 10 year yield is so important to the US economy. Basically, most mortgages in the US are priced at a spread over the 10 year yield, so the higher the 10 year yield goes – the higher fixed mortgage rates go in America. But, what if those smart central bankers saw the tariffs increasing inflation, saw their own actions raising overnight rates, and then saw the yield on the 10 year note climbing beyond a sustainable level? Could they do something? Well, the short answer is yes. The Federal Reserve could do a multitude of things to actually stop the 10 year yield from going higher. For example, the Fed could simply instigate a bond buying program where it bought 10 year US Treasuries, and sold either shorter dated or longer dated treasuries to balance out the purchases. If the US FED came into the market and started buying up all of the 10 year notes, then that would make price of the treasuries rise, and the yield fall, since price and yield move in opposite directions. Overnight, the US Federal Reserve could go into markets and buy up every single last 10 year note for sale, thus causing 10 year yields to plummet. Things like this have been done before during Operation Twist, and I have no doubt that something like this could be done again. Now, imagine if tariffs cause the economy to catch fire and boom, AND 10 year yields are falling at the same time. Talk about an economic renaissance!!! So even though you got the first 2 parts of the equation correct, your end result is completely wrong.

The above is only one small teeny tiny example of how things can change on a moments notice. Even though inflation is up, and even though we think we always know what will happen, central bankers can change the entire landscape with a simple policy tweak. We saw this happen in 2020. Remember March of 2020? Remember the economic collapse that was happening? It was all doom and gloom, until the BOC Governor – Stephen Poloz stood on stage alongside the finance minister and dropped interest rates to basically zero, and brought in QE. Within 60 days, markets went nuts and real estate started going to the moon. March 20th of 2020 every single person in the country was ready to fold it up and claim bankruptcy, and 60 days later, everyone and their brother was buying a pre con unit, and refinancing to buy a fricking cottage.

Things change fast in our business ,and things can go in 180 degrees the opposite direction of what you think, what everyone seems to know, or even what SHOULD happen. Make sure that your plans, business or other always leave a little possibility for things not working out like you thought. As the world gets into a more unconventional landscape, the tools we see brought out of central bankers tool boxes will become a lot more unconventional as well.