Entering the Deflation Danger Zone

As deflation looms, weaknesses could be exposed.

The Federal Reserve is forging ahead with its balance sheet reduction, as the chart below shows. This reduction in the central bank’s assets which were paid for by money created out of thin air constitutes disinflation, and deflation (when the balance sheet is contracting on an annualized basis) will likely come by the end of the year.

The monetary tightening seen this year across the globe is changing the financial environment and liquidity is becoming an issue. The Bloomberg U.S. Government Securities Liquidity Index measures the deviation in yields from a fair value model in order to gauge how smoothly the Treasury market is operating. The index currently shows the most extreme level of illiquidity in its history, even more illiquid than March 2020 when the Covid lockdowns panic coincided with a dysfunctional market and caused the Fed to step in and print money big time.

Also, something curious is happening in Switzerland where the last few weeks saw banks (not just Swiss, but global banks with a Swiss presence) tap the U.S. dollar swap line that the Swiss National Bank (SNB) has with the Fed in the largest amount since the Global Financial Crisis of 2008. That was when this facility was established, as part of the bailout of the financial system. If banks are gorging the swap line again, is something wonky in the plumbing?

Not necessarily. It could be that banks are taking advantage of an arbitrage opportunity whereby they can borrow U.S. dollars from the SNB, swap into Swiss francs and then lend those francs back to the SNB using the repurchase (repo) facility to lock in a profit (the arb itself evidence of cracks in the global financial system). But it might not be this and could be pointing to liquidity issues at banks. As always, Elliott waves will anticipate future movements and we have previously shown that the KBW Bank index has a bearish structure anticipating further declines ahead.

It appears that the financial system is entering a dangerous period where the consequences of all the central-bank-induced distortions that have happened over the past two decades are finally being evened out. It will pay to stay alert over the next few months.