Bank stocks were hit hard by the 2008 financial crisis. Years of heavy borrowing left many banks exposed, and some of the most trusted names collapsed. Investors faced huge losses as governments stepped in with taxpayer-funded bailouts. In response, regulators introduced strict new rules to prevent a repeat. These measures weighed on profits for years, but the sector has now come through that difficult period. Today, banks are much safer than they were before the crisis. Big investors have returned, helping to push up share prices; some have even tripled in recent years. As valuations edge back towards more normal levels, an important question remains. Do these high-yielding stocks still deserve a place in a portfolio, or have the easiest gains already been made?

Bank stocks’ wilderness years

For more than a decade, the banking sector struggled to regain the confidence of investors. Most professional fund managers suffered significant losses in the 2008 crash and subsequently found the industry difficult to navigate. Investors discovered they lacked understanding of complex balance sheets. Consequently, their appetite for banks' shares vanished for a generation. Even today, many professional investors remain wary because they find the internal mechanics of a global bank difficult to decipher.

While investors remained cautious, regulators rebuilt the global financial architecture. There has been a substantial increase in banks' capital, the cushion that stands between bank assets and insolvency. Core capital ratios, which give the size of this cushion expressed as a percentage of the bank's total risk, were as low as 4% pre-crisis; today, they often exceed 15%. In the UK, the Vickers Report mandated a separation between retail and investment banking operations. This altered the nature of the business and kept valuations low.

Jamie Dimon provided the first credible signal that this era of stagnation was ending. In February 2016, the chief executive of JPMorgan Chase invested $26 million of his own money into his bank's stock. He purchased the shares at roughly $56 per share, which aligned with the company's book value at the time. Dimon realised that the regulatory clean-up was largely complete. He saw an institution that was well-capitalised and undervalued, yet still priced as if it was ruined. His investment marked the start of a decade-long rally that eventually saw the stock price rise more than fivefold. It would take several more years and a radical change in the interest-rate environment for the rest of the market finally to reach the same conclusion.

The return of inflation

The stagnation of the previous decade ended with the return of inflation. Central banks tackled inflation by raising interest rates from near-zero to 5% and, with that, the fundamental engine of banking profit returned to health. This engine is the “net interest margin” – the difference between the interest a bank pays to its depositors and the interest it receives from its borrowers. For years, the industry struggled to generate a decent return in a world where interest rates were near-zero. The shift to higher rates boosted profits.

How much banks paid their depositors played a big role in this windfall – that is, how much of a central-bank rate rise was passed on to savers. When rates went up, banks were slow to increase interest on current accounts. At the same time, they quickly raised the cost of mortgages and business loans. This delay helped to boost profits. In theory, this rise in profits should only be temporary. But it made it easier for a bank to manage future earnings through a “structural hedge”, allowing them to lock in interest rates for several years and smooth profits as rates fall. The result is a more stable and predictable income stream. This improved profitability has transformed how banks manage their capital. After a decade of hoarding cash to satisfy regulations, they are now paying a lot back to shareholders via a mix of dividends and share buybacks. Total shareholder yields, combining dividends and buybacks, now often exceed 10% a year.

Strong recent results from the biggest banks have cast doubt on the idea that upstart digital challenger banks will disrupt them. While the challengers achieved high user numbers and launched attractive software, they lacked the massive and low-cost deposit bases that the traditional banks enjoy. The incumbents used their superior cash flows to adopt the best elements of the digital revolution, investing billions in their own platforms while maintaining the trust and regulatory licences required to dominate high-value lending, such as residential mortgages.

The established banks were also better able to absorb the higher costs of regulation and cybersecurity. For a smaller challenger bank, the compliance burden is often a significant percentage of its total revenue. For a giant bank, it is a manageable operational expense. Some challenger banks, most notably Revolut, have grown to a large size, but the biggest effect of the new banks is a forced modernisation of the older ones.

This combination of rising margins, disciplined shareholder returns and the resilience of the established model has restored the sector's momentum. The banks have demonstrated that they are no longer just safe utilities. They are profit-seeking enterprises with the capacity to deliver high yields to patient investors. The current challenge for investors is to identify which institutions can sustain this performance as the interest-rate cycle matures. The market has recognised the recovery, but the divergence between the winners and the laggards suggests that selection remains critical.

How to navigate the banking market

There are at least three distinct types of banking. Retail banking is the familiar world of the high street, managing residential mortgages and personal savings for millions of customers. Corporate banking offers services to the commercial sector, extending credit to firms and facilitating international trade. Investment banking is a more volatile endeavour that involves mergers, debt issuance and investing in the capital markets. The latter depends on the shifting appetites of the financial markets, which introduces a level of unpredictability that many investors find unsettling. The market typically rewards the steady stability of retail lending with a higher multiple, while it views the inconsistent profits of investment banking with caution.

The main concern for investors is the progression of the interest-rate cycle. Banks generally benefit from rising interest rates because the income they generate from loans increases more quickly than the interest they pay to depositors. However, as rates plateau this advantage often diminishes. Customers eventually move their money from low-interest current accounts into higher-yielding fixed-term products. This shift increases the bank's cost of funding and can lead to a lower profit. Asset quality is another area of vulnerability. Extended periods of high borrowing costs can put pressure on both households and businesses, leading to a rise in loan defaults. The commercial real-estate sector is currently viewed with particular caution, especially in markets where office and retail property valuations have fallen. If a bank has a high concentration of lending in these areas, it may be forced to raise its loan-loss provisions, which hurts profits.

Political and regulatory risks are also a factor. Governments may consider windfall taxes on high bank profits during hard times. Regulators often introduce new rules on capital requirements or consumer protection. Such measures increase operational costs and limit the amount of cash that banks are able to return to shareholders through dividends and buybacks.

Finally, structural shifts in the financial system present long-term challenges. The rise of non-traditional lenders and private credit markets has introduced new competition for corporate lending. Furthermore, the development of digital currencies could alter the traditional deposit-taking model. If consumers begin to hold significant portions of their wealth in digital sovereign currencies rather than bank accounts, the industry's funding costs could rise substantially.

To assess a bank accurately, investors must look past the price-to-earnings ratios used for ordinary companies. Instead, they prioritise the price-to-tangible-book-value ratio. This metric compares the share price against the net value of the bank's hard assets, once intangible items such as goodwill or brand value are stripped away. It provides a realistic view of the bank's worth if it were liquidated today. A bank trading at a discount to this figure suggests that the market believes the management is failing to earn its way, or that the assets on the balance sheet are not as safe as they appear. Conversely, a premium indicates that investors expect the institution to generate superior returns for years to come. In this new higher-interest-rate environment, investors must distinguish between high-quality cash machines and potential value traps.

The efficiency leaders of the banking industry

JPMorgan Chase (NYSE: JPM) remains the undisputed benchmark for the global banking industry. It is the largest bank in the world by a significant margin and is valued at more than double its nearest competitor. This scale allows the firm to simultaneously dominate both investment banking and retail lending. Under the leadership of Jamie Dimon, the bank has maintained a return on equity of nearly 16% while investing billions into its technological infrastructure. While the valuation is high compared with peers, its operational dominance and so-called “fortress balance sheet” provide a unique safety net. It is the go-to investment for those who wish to gain exposure to banking.

Lloyds Banking Group (LSE: LLOY) is a direct bet on the British economy. Unlike its more international rivals, Lloyds Banking Group generates the majority of its profit from domestic retail and commercial lending. Its net interest margin has improved significantly in recent years as it benefited from the shift in interest rates. With a price-to-tangible-net-asset-value ratio of 1.5 times and a healthy return on equity, the bank has become a favourite for dividend-seekers. Its aggressive share buyback policy continues to support the shares even during periods of domestic economic uncertainty.

HSBC (LSE: HSBA) has focused its efforts on the high-growth markets of Asia, which now drive the majority of its earnings. The bank trades at 1.7 times tangible net asset value and delivers a return on equity of 13.7%. For the income investor, the appeal lies in consistent dividends and regular share buybacks. However, the heavy exposure of HSBC to Hong Kong and mainland China remains a double-edged sword. These regions offer superior growth potential, but also introduce geopolitical risks.

NatWest Group (LSE: NWG) has completed its journey from a government-controlled institution back to a fully private enterprise. Many investors will remember the bank as the Royal Bank of Scotland, which rebranded to distance itself from the reputational damage suffered during the 2008 crisis. The bank has shown remarkable profitability recently, with a return on equity approaching 20% in its most recent results. The shares trade at a more modest 1.3 times tangible net asset value, offering an attractive entry point for those seeking exposure to banking. Its focus on digital efficiency has allowed it to maintain a competitive edge.

The recovery candidates

Barclays (LSE: BARC) trades at a discount of 0.8 times to tangible net asset value, despite delivering a return on equity of more than 10%. The market remains cautious regarding its large investment-banking division, which requires significant capital and produces volatile returns, but management recently vowed to return substantial capital to shareholders by the end of this year. If the bank can prove its investment arm is no longer a drag on the retail business, the potential for a valuation re-rating is substantial. It remains an interesting candidate for those looking for value and who are comfortable with higher risk.

UniCredit (Milan: UCG) has emerged as one of the most efficient banks in the eurozone. Under a disciplined management team, the Italian giant has achieved a return on equity of nearly 17%, far outstripping many of its domestic and international peers. It trades at 1.5 times tangible net asset value, reflecting a market that has finally begun to appreciate its streamlined operating model. By aggressively cutting costs and returning capital, UniCredit has proved that a European bank can thrive without the tailwinds of a massive domestic mortgage market.

Deutsche Bank (Frankfurt: DBK) has historically been the sick man of European banking. After years of losses and scandals, the bank has finally returned to consistent profitability, posting a return on equity of 9.2%. Reflecting this, it remains one of the cheapest major banks in the world, trading at just 0.7 times tangible net asset value. The discount is due to its poor reputation, but the structural improvements in its corporate and private banking arms are undeniable. For the patient investor, it represents a bet that the final stages of its turnaround will lead to a revaluation.

The specialists

BNP Paribas (Paris: BNP) is the closest institution Europe has to a diversified American-style giant. It operates a massive corporate and investment bank alongside a stable retail presence across several countries. Trading at 0.9 times tangible net asset value, it offers a diversified stream of earnings and a healthy dividend yield. The bank has successfully used its scale to gain market share as American rivals pulled back from certain European markets. It is a solid choice for those who want exposure to European growth without the concentrated risk of a single-country lender.

Banco Santander (LSE: BNC) has exploited its unique geographic footprint, spanning from Spain to Brazil and the US, to protect itself from regional economic shocks. The bank trades at 1.7 times tangible net asset value and delivers a return on equity of more than 12%. Its diversified model means that when the European economy slows, its Latin American operations often provide a profitable cushion. This geographic spread is its greatest strength, although the complexity of managing such a diverse empire often leads to a slightly lower valuation than its simpler peers.

Standard Chartered (LSE: STAN) provides a unique way to gain exposure to the emerging markets of Asia, Africa and the Middle East. Unlike HSBC, it has a smaller retail presence and focuses more heavily on corporate and institutional banking. It trades at 1.1 times tangible net asset value and has recently exceeded its own profitability targets. It is a primary beneficiary of the rise in intra-Asian trade and is well-positioned to benefit from the ongoing economic development in its core markets. It remains an attractive option for investors looking towards the emerging economies.

Bank of America (NYSE: BAC) is the second-largest lender in the US and serves as a bellwether for the US consumer. It trades at 1.8 times tangible net asset value, a premium that reflects its massive deposit base and its leading position in digital banking. While it is highly sensitive to US interest rates, its diversified earnings from investment banking and wealth management provide stability. It is often seen as a more conservative alternative to JPMorgan Chase for those who want exposure to the American financial system.

Goldman Sachs (NYSE: GS) remains the premier investment bank in the world. Unlike the universal banks, Goldman Sachs is heavily weighted towards merger advice, trading and asset management. This makes its earnings more volatile and dependent on the health of the financial markets. After a period of strategic drift into consumer banking, the firm has refocused on its core strengths. It remains an option for those trying to gain exposure to pure investment banking rather than more traditional lines of business.

The best bank stocks to invest in now

The banking sector has transitioned from a source of risk to a reliable engine of shareholder returns. For those seeking stability, Bank of America offers a good balance sheet and direct exposure to the US economy. Its historical resilience provides a degree of security for investors prioritising long-term capital preservation. Barclays represents a more opportunistic choice. It remains priced at a discount compared with its domestic peers, and the successful execution of its current strategy should allow this valuation gap to narrow, rewarding patient holders. Finally, Standard Chartered serves as a unique vehicle for those desiring exposure to emerging markets. As a UK-listed entity, it provides a regulated gateway to high-growth regions in Asia and Africa.

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Five years ago there were lots of reports about how the finance industry was going to move from London to Paris, Amsterdam or Frankfurt. In the wake of Britain's departure from the European Union, the City would lose its role as the main hub in the finance industry and all the jobs and tax revenues it created. Deals would have to be made within the bloc, and trades would have to settle under EU rules, so there would be little space for a country outside the EU. The only real question was which major city on the continent would take London's place.

But traders and analysts can forget about freshly baked croissants for breakfast and two-hour lunch breaks. It turns out that the US mega-banks are not moving en masse to Paris after all. Last week, JPMorgan started moving some of its staff in Paris back to London. Its chief executive, Jamie Dimon, warned back in 2021 that the bank might well move all its European operations out of the City. Instead, it has been steadily increasing its headcount and building the biggest tower in Canary Wharf to house them all. Its plans to make Paris the centre of operations appear to have been quietly wound down.

It is not hard to understand why. President Emmanuel Macron's promises to carve out a special regime for global bankers have come to nothing. The “temporary” tax surcharge on anyone earning more than €250,000 a year – not much for a star banker at JPMorgan – has been extended for another year. With the government paralysed and a huge deficit to fix, France will have to put up taxes again.

Meanwhile, Amsterdam is about to become a no-go zone for investors. The Dutch city mounted a challenge to London that was every bit as serious as the one from Paris. With its long traditions in finance and a powerful stock market, it attracted a series of high-profile listings, including giants such as Universal Music. But now the Netherlands is planning to extend the capital gains tax at 36% even to unrealised gains. In effect, if your investments go up in value by 10% over the course of the year, you will have to pay a big chunk of that in tax, even if you have not yet cashed them in.

Even worse, you won't be able to claim any kind of refund or allowance if those same investments fall by 10% the following year. In effect, the state will confiscate 10% of your winnings, but it won't share in any of the losses. It will be the most punishing system of capital-gains taxation anywhere in the developed world. It is impossible to see how Amsterdam can survive as any sort of financial or business centre under that regime. As for Frankfurt, there is absolutely no sign of any banks moving to the city and the German economy remains stagnant despite the huge rise in government spending to try and get it growing again.

How the City of London can reclaim the crown

Add it all up, and this is the perfect moment for London to reclaim its place as Europe's main financial hub. There have been modest moves in the right direction. Some of the listing rules have been relaxed, the cap on bankers' bonuses has been lifted and a new junior market in “unquoted companies” has been created. We are promised more reforms in the King's speech later this month. It is a start, even if only a very modest one.

But there are also obstacles: higher income taxes, the ending of non-dom status for finance staff moving from abroad, some of the highest inheritance taxes in the world, and now a higher rate of tax on interest and dividend payments as well. It may well get worse in the next Budget. None of that will do anything to persuade any more bankers to move to this side of the Channel.

The government should be doing a lot more to help. It could introduce a new version of the non-dom regime, perhaps modelled on Italy's flat-rate tax scheme that has helped create a boom in Milan. It could turn the stock exchange into a genuinely light-touch regulatory centre for new listings. Finance remains one of the world's largest industries and one in which Britain has huge residual strengths. Brexit has not damaged it nearly as much as everyone predicted. But the City will have to work a lot harder if it is to reclaim its crown.

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Major UK banks should be ready to join in a round of consolidation in European banking. The British economy is stagnant, competition from challenger app-based banks is intense, and the government is determined to tax businesses out of existence. A major takeover of a European bank would put each of them on the global stage, and if they got it right, could power their profits for a decade or more.

In the sector's biggest takeover offer for more than a decade, Italy's UniCredit tabled a $40 billion offer for Germany's Commerzbank, which it has been stalking for years. What happens next remains to be seen. It is very hard to win a hostile contest for a eurozone financial institution, and certainly one as large as Commerzbank.

UK banks should join a unified European financial system

A round of consolidation within European banking is inevitable over the next year. The EU has finally realised it needs a unified financial system if it is to improve its competitiveness. But hold on - surely the major British banks should be taking part in that process? True, Britain is no longer part of the EU. But it is still part of the wider European economy, even if officials in Brussels would prefer that it wasn't. If a major eurozone bank is up for sale, then they should be looking at it very seriously.

Firstly, it is the natural space for expansion. There is not much scope for takeovers within the British banking market, while the US is a very hard market to crack and Asia offers limited opportunities. By contrast, all the major European finance markets are geographically close. A takeover or merger would offer huge scope for cost cutting, while the leaner management that UK banks have perfected would mean it would not be hard to make their branches and loan books more profitable. Continental banks are not very efficient, so it should be possible to squeeze out higher profits.

Secondly, UK banks can afford it. All the major British banks have been racking up huge profits. Lloyds made £6.7 billion last year, a 12% increase on a year earlier; Barclays made more than £9 billion, a 13% rise; while NatWest, now finally fully private again, made £7.7 billion, an increase of more than 24%.

Commerzbank only has a value of £31 billion despite all the takeover speculation, and even Deutsche Bank is only worth slightly over £40 billion. There are plenty of banks across the eurozone that are now relatively small compared to the British lenders. They can be bought without taking on huge levels of debt, especially if a deal can be financed partly in shares.

Finally, the chance won't come again. The German banking industry has been struggling along with the rest of the German economy, but it will probably recover over the next decade if the country manages to restructure its industrial base. If you don't take over one of its major banks now, then soon it will be too late. You won't be able to afford them, and they won't be for sale anyway.

Likewise, the French economy has slumped, but it may revive, and so may the rest of the eurozone. Looking back, Switzerland's Credit Suisse was a major opportunity when it was rescued by UBS in 2023. The UK banks missed out that time around. It would be a shame to miss out all over again. This is a once-in-a-generation opportunity to double or more in size.

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How has monetary policy shifted?

Over the past 25 years, monetary policy in advanced economies has undergone an astonishing, unprecedented transformation – dramatically changing in both scope and scale, and blurring the boundaries with fiscal policy. When MoneyWeek published its first edition, there was a broad consensus on inflation targeting, operational independence for central banks and faith in the ability of short-term interest rates to stabilise output and prices. But those turbulent 25 years have seen a radical shift. From the “Greenspan put” to quantitative easing (QE – printing money to buy government debt), monetary policy has evolved in ways that are highly controversial and politicised. Central banks today have vastly higher balance sheets, in some cases manage entire yield curves (that is, use policy to influence rates across different maturities of government bonds, not just short-term rates) and openly coordinate with fiscal authorities in emergencies.

Why is this controversial?

Because, critics argue, the gigantic balance sheets held by unelected central banks as the result of QE, and their “unconventional” monetary policies, have inflated asset-price bubbles, fostered inequality, led to misallocation of capital, and masked unsustainable public finances. Long-term, the chief purpose of monetary policy is to inspire confidence in the value of money by encouraging price stability. In the short or medium term, the aim of policy is to keep the real economy stable – supporting sustainable growth and employment – and to contain risks. Since the turn of the century, however, independent central banks have radically over-interpreted that brief by consistently coming to the rescue of equities and debt markets in ways that have distorted business cycles and deferred pain. Emergency measures have become the norm, and central banks have ballooned.

How have central banks expanded?

For almost the whole of the 20th century, the central-bank assets of advanced economies, as a proportion of economic output, remained remarkably constant, at around 10%-13% of GDP. But in the aftermath of the great financial crisis of 2007-2008 – as governments everywhere turned to QE – that proportion surged, rising above 20% in 2009-2010. And rather than falling back to normal levels as the crisis stabilised, that proportion then doubled once more during the 2010s to 40% – before spiking up to 70% in the aftermath of Covid. Even by 2024, it was still 50%. That’s a revolutionary change in the size of central banks’ financial assets within a couple of decades. Historically, balance sheets merely reflected operations. Now, they are strategic levers shaping long-term yields and risk premiums – a fundamental conceptual shift.

Was QE justified?

Yes, in the immediate aftermath of the financial crisis, decisive action by central banks was vital in stabilising economies and preventing deflation, says Andy Haldane in the Financial Times. By contrast, “later-stage QE, including purchases made in response to Covid, is harder to justify. With fiscal policy highly expansionary, QE’s primary purpose was to placate fretful bond markets rather than boost inflation” – a worrying step towards “fiscal dominance”. Vincent Reinhart, the chief economist at BNY Investments, co-authored two research papers on QE with Ben Bernanke, chairman of the Federal Reserve from 2006-2014, who instituted QE following the financial crisis. “We did not include a section on how to get out of the policy, or the risks stemming from it,” he now says. “That was a mistake – it was a lot stickier than I thought going in and has opened up a range of complications and potential political influences on monetary policy.”

So it’s been hard to get out of?

Indeed. The current era of gigantic public debt has blurred the lines between monetary and fiscal policy, since rate rises (or quantitative tightening) put up debt-servicing costs and infuriate the likes of Donald Trump. In the UK, quantitative tightening triggers indemnities that require the Treasury – ultimately, the taxpayer – to cover central-bank losses. In addition, by pushing up gilt yields, it makes it more expensive to the Treasury to borrow and service its debts. That makes monetary policy more politically charged than ever, and the target of populists who regard central bankers as sources of unelected and illegitimate technocratic power.

What are the limits on monetary policy?

Conventional monetary policy is a famously blunt tool. It has become blunter in recent decades. Financial globalisation and the absorption of China into the global economy, technological change and demographic ageing have lowered real rates. There’s been a relative decline in floating rate debt, meaning rate changes do not necessarily feed through into the wider economy. And rate-sensitive capital-intensive sectors, such as manufacturing and construction, have diminished in favour of services, which are more labour-intensive and less responsive to interest rates, says Marco Casiraghi, director at Evercore ISI. All of this makes monetary policy harder to frame and execute with confidence.

A tough gig, then?

The Bank for International Settlements says that everyone, from governments to central banks to investors and consumers, needs to become more realistic about monetary policy. The idea that it alone can underpin growth is an “illusion”. And the trade-offs that monetary policy involves will “become unmanageable” without “more holistic and coherent policy frameworks in which other policies – prudential, fiscal or structural – play their part”. Central bankers may be even more powerful than 25 years ago. But in an ever more complex and turbulent century, even they recognise that they are not magicians.

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The gnostic utterances of Jerome Powell, chairman of the American central bank, are these days pored over ever more intently by investors and analysts seeking to divine the future direction of interest rates. And for good reason: the interest rate set by the Federal Reserve is the most important number in the financial markets. The US is the world’s most important economy and its markets set the tone for global asset prices.

What investors want to know above all is the likely future direction of the Fed’s “benchmark federal funds rate”, the rate at which banks borrow from each other overnight, which in turn is deemed to have a powerful influence on other interest rates, including those paid for business or personal loans or mortgages, or earned on savings. Globally it will have a big impact on whether money flows into or out of emerging markets, for example, with knock-on effects everywhere.

In short, the number the Fed comes up with has a big influence on whether the world is making as good a living as it could be. If businesses are going to make new investments to produce more or become more productive or make a venture into new products or services, they need households and other savers to supply the capital to finance it. Balanced, stable growth demands that total investment in the economy be equal to the pool of available capital or savings.

For that to happen, interest rates need to be high enough to convince savers to save and low enough to incentivise borrowers to borrow, as the Brookings Institution explains. The interest rate that achieves this over the long run is known as the “neutral rate”. The Fed sets the rate above the neutral rate if it wants to cool an economy it thinks is overheating or below it if it wants to stimulate a flagging economy. It’s vital that the price is right.

It would seem to be a bit of a problem, then, that central bankers and other economic experts can’t agree on what the neutral rate actually is. It has long been the subject of intense debate, one that heated up in recent years as economists disagreed over whether the higher interest rates introduced post-Covid to restrain inflation had gone too high and were hence holding the economy back. The neutral rate – also known as the long-run equilibrium interest rate, the natural rate, or r* – is defined as the short-term interest rate that would prevail if the economy were at full employment and inflation stable, and if monetary policy were neither contractionary nor expansionary. In the long run, it is determined by the supply of and demand for savings.

But it is a theoretical concept, not something that can actually be observed in the wild. The Fed does not set the neutral rate, it just tries to estimate what it is. Economists use different models to try to pin it down, and estimates of what it might be vary. Some even insist that it doesn’t exist – that it makes no sense to try to estimate a single, economy-wide interest rate. That would be awkward for the Fed, which bases its most important decisions on some measure of it.

All of which goes to illustrate a puzzle about our societies – that monetary policy, as practised in the US, the UK and many other countries, assumes that central bankers, as central planners, can do a better job than financial markets in setting rates that will maximise economic output and stability while keeping a lid on inflation, even if they are, as they must be, flying blind. Why? We don’t have a central authority to set the price of food or shoes. Why do we need one to set the price of money and retain monopoly control over the supply of it? Why not privatise money?

Is there an alternative to central banks?

The idea that central banks are a necessary feature of modern economies has long “reigned supreme and is virtually unquestioned” in economics, as Kevin Dowd points out in The Experience of Free Banking (IEA, 2023), a collection of essays reissued last year. Even economists who are generally sympathetic to laissez-faire, such as Milton Friedman, accepted that money and banking could not just be left to markets. The issue of the national currency was deemed to be a “natural monopoly” that was properly the responsibility of the state, or more recently of central banks under the auspices of the state. There has, of course, been plenty of controversy over how much power the central bank should have and just what it should do, as Dowd points out, but no respectable economist suggested that central banks should be abolished – until, that is, Friedrich Hayek suggested in 1976 that the only way to achieve monetary stability was to “denationalise money”.

The most extreme version of the theories that developed following his suggestion advocates the abolition of central banks and the introduction instead of a system of “free banking”, defined as a system in which private banks are free to issue their own money under competitive conditions, typically convertible into gold or some other commodity standard, and in a legal environment in which the public is free to accept or reject bank currency as they see fit. That might sound impossibly radical, but following Hayek’s suggestion a major research effort revealed that free-banking systems had existed in the past and that they had indeed a long and respectable history. Dowd’s book presents an overview of the world experience of free banking, with examples from Australia, Belgium, Canada, Chile, Colombia, China, France, America, Italy, Sweden and Switzerland.

Perhaps the best-known example, however, is Scotland prior to 1844, thanks in part to Adam Smith’s assessment in The Wealth of Nations that its free banking system had contributed in a major way to the country’s economic development. In 1745, says Dowd, per capita income in Scotland was about half what it was in England at the time. A century later – a century that corresponds to the heyday of Scottish free banking – Scottish per capita income had risen to almost English levels despite England’s own rapid growth, and despite suffering a number of disadvantages, such as greater distance to markets, inferior infrastructure and fewer raw materials.

Competition between the free banks was fierce, and the fight for market share honed bankers’ liquidity and capital-management policies, their entrepreneurial skills and willingness to innovate. Banks provided commerce and industry with easy access to credit that was both inexpensive and relatively easy to obtain, provided the public with loans and monetary notes that were more convenient and easier to hold than coins, and promoted habits of thrift by offering them higher returns on their savings than they could obtain elsewhere.

Walter Scott wittily defended the Scottish system against its detractors in a way that might remind you of those economists beavering away in the Fed: “Here stands Theory, a scroll in her hand, full of deep and mysterious combinations of figures, the least failure in any one of which may alter the result entirely, and which you must take on trust … There lies before you a practical System, successful for upwards of a century. The one allures you with promises, as the saying goes, of untold gold, the other appeals to miracles already wrought in your behalf. The one shows you provinces, the wealth of which has been tripled under her management – the other, a problem which has never been practically solved. Here you have a pamphlet – there a fishing town – here the long-continued prosperity of a whole nation – and there the opinion of a professor of Economics, that in such circumstances she ought not by true principles to have prospered at all.”

The historical experience of free banking, both in Scotland and around the world, shows that the conventional wisdom about what would result from such an experiment must be rejected, concludes Dowd. Free banking systems were not in fact prone to inflation, competition did not destabilise them, and there’s some evidence that interest rates were more stable. The banks had to be careful and prudent in their lending, reserve and capital policies because they could not expect others to shoulder their losses or bail them out. Banks did sometimes fail under these laissez-faire conditions, but the failures do not appear to have been seriously contagious and major crises were rare. Indeed, where such crises did occur, they could usually be attributed to state pressure for cheap loans from the banks, which undermined their financial health, or to other forms of state intervention. Free banking – as in Scotland, for example – generally ended, says Dowd, because it was suppressed for political, fiscal or ideological reasons, and not because of any inherent flaws.

Walter Bagehot deemed central banking irreversible. Economic historian Charles Kindleberger noted a “strong revealed preference in history for a sole issuer” of currency. But the preference that history really reveals is that of the fiscal authorities, not of money users, as Lawrence White and George Selgin, two of the authors in Dowd’s book, have pointed out. In some places, such as London, free banking never received a trial for that reason. “Central banks primarily arose, directly or indirectly, from legislation that created privileges to promote the fiscal interests of the state or the rent-seeking interests of privileged bankers, not from market forces.”

Could it happen again?

Does any of this have relevance to the modern world? The historical record, according to the free banking advocates, shows that free banking, unlike the system of central banks, is not prone to inflation or banking instability. Those are features that would seem to be worth having. And if it worked in the past, then why not now? In theory, it seems, none at all. But there’s the small matter of the real world. Free banking, as Dowd admits, is not in the so-called “Overton Window” – that narrow range of policy options deemed to be politically possible. But even were that window to shift – as happens especially during crises – the case for free banking to date has relied heavily on theoretical arguments and history drawn from the 18th and 19th centuries, as a 2012 paper from the Cato Institute by Gerald O’Driscoll pointed out. However persuasive the arguments, they would come up against institutional inertia. Even if we agree that it would have been better if central banking had never been, the cost/benefit calculation for abolishing it has not been convincingly made.

The world of old in which free banking thrived is simply not the one we live in. None of the examples in Dowd’s book, extend far into the 20th century. The world in the preceding centuries was not as deeply interconnected through the financial system as it is today, and any proposal that we change that system must start from where we are – which is not a blank page, but a world where the incredibly complex, regulated, scaled-up infrastructure of modern banking already exists. And it works: the world with central banks is in many ways a better place than it was just a few generations ago and it continues to deliver material progress. Is it really sensible to think now about beginning anew? How would the change be carried out, and at what risk? Which piece of this complicated Jenga of a system would you pull out? And once pulled, just how confident are we that what will result will be stable? Even if it wobbles and doesn’t fall, will we be left with a structure that is radically better than what stood before? Is it worth playing the game given the risks we can think of, not to mention the unknown unknowns?

Under the current system, for example, we have instant transfer of capital, and relatively unfettered global trade in goods and services, where we pay for goods in our own currencies into a foreign bank account and don’t even need to think about all the complexities. How would that work under free banking? Will my pound from NatWest be accepted in the US, and how many pounds from HSBC is it worth? Will each bank have different exchange rates? The system instantly becomes incredibly more complex, increasing trade friction and transaction costs. Imagine we did in fact live in such a world. Wouldn’t a simpler system, where there is centralisation and central banks, to help ease some of these issues, seem very attractive?

It’s far from obvious, in short, that it would be worth the bother and risk of switching from central banks to an alternative system that has not been tried in the modern world, and this fundamental problem is not one addressed very deeply by free banking advocates. Perhaps that’s why the Fed is still fumbling around in the dark for a number that might not even exist. There’s simply no alternative.

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Over the last few weeks, the outlook for many French companies has deteriorated dramatically. The Altice empire, put together by billionaire Patrick Drahi, is in big trouble, ensnared in a corruption scandal, and raising emergency cash to stay afloat. Among other assets, its 24.5% stake in BT may have to be sold off, and its shares are down by almost 60% over the past year.

Last week, shares in Worldline, the payments firm that is one of the biggest tech businesses in France, crashed by 60% as it warned about its profits for the year ahead. One of the country’s few high-tech champions, even if it dates back to the 1970s, is failing badly. 

It’s not looking much better at the drinks giant Rémy Cointreau. Over the last few months, its shares have slumped to their lowest level in 15 years due to poor sales amid a slowing global economy. Meanwhile, luxury goods empire LVMH is on the slide, with its shares down by a quarter in the last six months as demand from China slips. 

France has been riding an artificial boom
Add it all up and one thing is clear. France is starting to get into trouble and the Emmanuel Macron bubble has started to burst. In the six years that he has now been in power, the hyper-energetic French president has benefited from an artificial boom. France rode the rapid expansion of the Chinese economy better than any other major country. Sure, the Chinese bought some German cars and machine tools, but what its nouveau-riche entrepreneurs really wanted was high-status European luxury goods that allowed them to show off how rich they had become.

It was demand from Asia that made LVMH the largest company in Europe and also powered the likes of Hermès and L’Oréal. That generated vast profits, which in turn produced plenty of corporation tax: the state’s tax from companies rose by almost 50% over the last decade. But as China slows down, profits certainly won’t keep on growing the way they did and those tax revenues will dry up. 

Meanwhile, membership of the euro, and the backing of the European Central Bank as it printed vast quantities of new money, has allowed France to run up huge debts. When the euro was launched, France’s debt was just 59% of GDP. It is now up to 112%. That worked while interest rates were close to zero, and when the ECB was buying bonds. Investors have simply assumed that France is “too big to fail” within the eurozone and that in a crisis the other member countries will always bail it out, and so will the central bank. Even so, it has now reached the limit of borrowing. Its credit rating has been cut. The IMF is warning that spending needs to be reduced further. Bond yields are rising. If there is a loss of confidence there could be a rapid exit. 

Macron's close allies' companies start to unravel
Finally, a select group of tycoons close to the president, such as Drahi, built up debt-fuelled empires that are now starting to unravel. They created an illusion of a dynamic, fast-growing France. But companies that are based on borrowing cheap money are rarely solid. If a few of these close allies crash, it will be hard for the president to escape some of the blame. 

Macron has sold himself to the world as a radical reformer. He was the man who would modernise France. True, he has made more progress on shaking up its rigid labour market and burdensome welfare system than his last two predecessors put together. Still, progress has been very slow, and all the grand talk of change has disguised the fact that he has presided over a vast increase in debt and state spending, helped by the luck of a luxury boom and low interest rates. 

Through all of this, France remained stuck in a low-growth rut, with little sign of new industries emerging, and only modest reductions in a punishing level of unemployment. The luck has now run out. Money will be very tight over the next few years. With all his political capital burned up on a tweak to the pension laws, Macron has no space for any further reforms. Soon, it will be clear that the bust has arrived – and the French economy will get very messy.

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The interest rate hiking cycle has ended - or that’s what it looks like anyway following the latest decisions from the European Central Bank, Bank of England and Federal Reserve. 

In the past week, all of these central banks have announced they’re pausing one of the most aggressive rate hiking cycles in the history of independent central banks. The BoE’s monetary policy committee (MPC) held the base rate at 5.25% at their meeting yesterday, the second meeting they’ve kept rates constant. 

Only the day before, the US Federal Open Market Committee voted to keep rates on hold for the second time, at a 22-year high of 5.25-5.50% (unlike the BoE, the Fed sets a range for its Fed Funds rate). And last week, the ECB held rates at 4%. 

All three of these leading central banks have hiked rates from zero over the past 18 months, as they’ve tried to bring inflation under control.  

Inflation begins to fall  

So far, the medicine seems to be working. Eurozone inflation dropped to a two-year low in October of 2.9%, from 4.3% a month earlier. Meanwhile, inflation dropped to 3.7% in the US for the 12 months ended September. 

Here in the UK, inflation has proved tougher to control. Since CPI inflation reached 11.1% in October last year it has fallen by more than 4 percentage points, although it flatlined at 6.7% in September. Inflation has remained sticker in the UK due to the energy price cap, which works with a lag. 

Unlike the US and Eurozone, where lower energy prices have already filtered through to consumers and businesses, the price cap is preventing prices from falling as fast here in the UK.

As energy is a big component of the inflation figures, this is something policymakers will be taking into consideration when setting interest rates. 

Higher interest rates are starting to have an impact 

Inflation is just part of the equation for central bankers. While The Fed, BoE and ECB all have a mandate to keep inflation under control, they don’t want to crush their respective economies at the same time. So they have a tough balancing act to practise.

That said, coming off the pedal too early could reverse much of the progress they’ve already made in the fight against inflation. BoE governor Andrew Bailey has said rates must stay, “sufficiently restrictive for sufficiently long”. He’s also recently added, “It’s far too early to be thinking about rate cuts.” 

Across the pond, Fed chairman Jerome Powell has summarised the Fed’s stance as being “not confident we have reached sufficiently restrictive [financial conditions], but not confident we haven’t”.

The markets have a bit of a different view. The market is pricing in interest rate cuts starting in the second half of next year and is only assigning a slim chance to further rate increases from both the BoE and the Fed. 

There are signs on both sides of the pond higher rates are starting to have an impact on economic growth. In the UK in particular, activity in the construction sector has fallen off a cliff and consumers are pulling back on spending as higher interest rates bite. It’s also more appealing than it has been for over a decade to save rather than spend (one of the main reasons why interest rates are so effective at controlling prices). 

Higher interest rates mean it’s more expensive for companies and consumers to borrow money to spend and invest, which reduces demand, forcing businesses to lower their prices. While inflation remains high in the UK, shop price inflation has been falling, suggesting part of this equation is already playing out as businesses compete for customers’ shrinking spending power.  

An upcoming election  

The BoE will have this in mind when it’s thinking about interest rates going forward. If businesses have to fight for consumers' money, business activity in the economy will fall (as is already happening in the construction industry) and that could lead to a recession. Higher interest rates are already forcing the government, which relies of debt to fund the day-to-day running of essential services, to consider benefit and spending freezes. 

With an election coming up, the government may start putting pressure on the BoE to cut rates, or at least hold off on any further rate increases to avoid sending the economy into a recession or driving harsh spending cuts in 2024. 

All in all, there’s a chance the BoE could push rates higher in the coming months if inflation surprises to the upside, but with risks to the economy growing, and inflation falling in the rest of the world, (which will filter through to the UK over time) the central bank may decide to hold off on any further changes or even cut in 2024. 

We’ve picked out three stocks to buy that should perform well in a high interest rate environment as inflation remains stubbornly high.

Indeed, even though central banks around the world have raised interest rates to highs not seen since the 2008 financial crisis in response to double-digit inflation, it does not look as if inflation is going to fall any time soon, suggesting rates could remain high for some time.

In the UK the Monetary Policy Committee raised rates to 4%. In the US the Federal Reserve raised rates to between 4.5 to 4.75%, and the European Central Bank’s base rate sits at 2.5%.

A high interest rate environment spells bad news for investors. In theory high interest rates discourage spending and encourage saving. Reduced consumer demand doesn’t bode well for companies.

High interest rates also push up the cost of borrowing, meaning companies with lots of debt are likely to struggle. That said, there’s a few sectors that are more sheltered from broader conditions, and might even benefit from them.

Here are our three favourite stocks to buy in the current interest rate environment.

3 stocks to buy in a high interest rate environment

NatWest (LSE: NWG)

Banks benefit from rising interest rates because their net interest margin expands. This means they make a profit from charging a higher rate on products such as loans and mortgages, than they pay on deposits, like savings accounts.

The bank’s net interest margin, the difference between what it pays out and what it receives in interest payments, widened to 2.85% in 2022 from 2.30% in 2021. The wider the gap, the higher the bank’s profits.

NatWest predicts interest rates will hold at 4% throughout 2023. The bank recorded profits of £5.1bn before tax in its 2022 full year results, up from £3.8bn a year earlier.

Additionally the bank announced a £800m share buyback programme, as well as a dividend of 10p per share as a reward to shareholders.

But despite the positive results, NatWest’s share price dropped by about 9% after the figures were released. This is largely due to the bank’s subdued outlook for 2023, combined with uncertainty around the UK economy for the year.

Higher interest rates also mean more people are likely to default on their loans. The bank has set aside £337m to prepare itself for defaults.

Still, the lender thinks its customers “are so far resilient”, with bad debt losses coming in at 0.09% of the loan book, “and much of that was assumptions about what’s coming next, rather than loans that have already soured”.

The bank has come a long way since it was bailed out by the government in the wake of the financial crisis. Today it looks well poised to navigate future turmoil, and will continue to benefit from the high interest rates environment.

Diageo (LSE: DGE)

Odds are, if you drink alcohol, you’ve probably tried at least one of Diageo’s products. The spirit maker owns over 200 well-known, well-loved brands, including Guinness, Baileys and Captain Morgan rum.

Consumers turn to these brands because they’re well-known, and they might prefer them to a supermarket’s own brand, for instance. This gives the company pricing power, enabling it to pass costs onto consumers.

That’s evidenced in Diageo’s interim results, released in January. Despite price increases to its beers, net sales were up 18% showing consumers are willing to pay a higher price for their drinks.

Additionally a lot of its brands are considered premium, consumed by drinkers with more discretionary income. As such, demand is less likely to be affected by inflation and the cost of living.

In its interim results announced in December, Diageo announced it had commenced a share buyback programme due to return £500m to investors as well as a 5% increase to its dividend, which has grown consistently over the last few years.

The company has also caught on to the fact younger people are drinking less, so it’s investing in non-alcoholic drinks to expand its portfolio.

Diageo has a simple business model and solid products, which should support the business through these tough times.

AstraZeneca (LSE: AZN)

The need for healthcare is going to exist no matter the economic climate, so despite peaks and troughs, pharmaceutical companies will likely always have a level of demand for their products.

AstraZeneca is perhaps most known for its Covid-19 vaccine. But the company has a wide range of treatments, and a lot of projects in its pipeline.

Additionally, due to patents, it has a certain level of protection over its products. While other companies might be making similar drugs, these patents and strong relationships with health providers gives it a certain level of pricing power.

The vaccine boosted its share price throughout the pandemic, but it’s likely got further to go. Demand for its cancer treatment, which is a big and growing part of its portfolio, is strong and, unfortunately, unlikely to diminish.

Moreover, the world’s population is ageing, which means more people will require medical treatment.

It looks expensive, but shares could continue to grow as more of its drugs are released and approved. These processes take time, and patents expire, but long term investors will continue to benefit, regardless of what central banks are doing.

More on share tips:

• Share tips of the week – 24 February
• Are housebuilder stocks looking cheap for dividend yields?
• Law Debenture Investment Trust offers something for all investors

The Bank of England has raised interest rates by 0.5%, which means the central bank’s base rate now stands at 3.5%, the highest level since October 2008.

This is the ninth consecutive increase in the base rate. Last month the bank’s Monetary Policy Committee (MPC), which sets interest rates, decided to raise rates by 0.75%, one of the steepest hikes of the last few decades as inflation surged.

The central bank has been hiking rates to try and control inflation, but policymakers are now worried that hiking rates too far too fast will hurt the economy and they’re starting to take their foot off the pedal.

A month ago analysts were expecting the MPC to hike rates by 0.75% at its December meeting. The slower pace of growth comes as UK GDP shrank by 0.3% in the three months to October and the chancellor warned we are in a recession.

Other central banks are also scaling back their fight against rising prices.

Yesterday the US Federal Reserve announced a rate hike of 0.5%, taking the base rate in the US to 4.5% its highest in 15 years. However, it also said it would be slowing down on its rate increases to see how the economy was responding.

And the European Central Bank has also slowed the pace of hiking. After the BoE announcement, it raised interest rates by 0.5% after a 0.75% jump at its last meeting.

All three banks remain committed to taming inflation while trying to minimise the collateral damage to their economies.

Why did the Bank of England increase interest rates?

While the headline inflation figure fell to 10.7% from 11.1% in November, UK inflation is still running at over five times the BoE’s 2% target.

Higher interest rates increase the cost of borrowing, In theory, this should put people off spending and encourage them to save decreasing demand. Businesses then have to compete for the remaining business usually by cutting prices.

That said, the BoE has admitted its aggressive stance against inflation might be hurting the economy by increasing costs for borrowers and reducing spending.

Additionally, inflation is being driven by factors outside of the BoE’s control.

Food and energy prices have shot up this year largely due to Russia’s invasion of Ukraine, which the central bank cannot control.

How much further will interest rates rise?

This month’s inflation figures would suggest inflation has peaked, and that could mean interest rates won’t rise much higher.

It certainly seems as if that’s the case in the US. After announcing a 0.5% rate hike yesterday, Jerome Powell, the Fed’s chairman, said that though there was still “some way to go” to control inflation, the bank wanted to slow down the pace of rate hikes to see how the economy was responding.

Back in the UK, a couple of months ago analysts were forecasting peak interest rates of nearly 6%, but now it seems they don’t expect the BoE to go much further than 4.25%.

“With fractionally moderating inflation, the looming threat of recession and a slight tick up this week in the unemployment rate, the Bank of England rightfully voted for a more cautious approach to tightening," noted Victoria Scholar, head of investment at interactive investor.

“The Bank of England can feel justified by its counterparts stateside that it made the right decision. Both the BoE and the Fed adopted the same approach, voting for a more dovish 50 basis point hike, having both raised rates by 75 basis points at their previous meetings," Scholar went on to add.

The minutes of the MPC meeting, released after the rate decision, showed that the bank's outlook for the economy is starting to pick up, albeit modestly.

"There was much to like within the minutes," noted Nicholas Hyett, an Investment Analyst at Wealth Club.

"The rising value of sterling is good for our buying power as a nation – taking some of the edge off international inflation. This, together with historic price rises rolling out of the data, mean headline inflation will fall substantially next year," Hyett added.

"That should help ease demands for wage increases, reducing the chances current inflation becomes endemic. Further good news came in the form of easing global supply pressures."

What do rising interest rates mean for you?

Rising interest rates mean higher borrowing costs. This is the case for all debt – loans, credit cards, and mortgages.

Mortgage rates have fallen from their peak of 6.65% in October, but they remain high compared to recent standards. According to Moneyfacts the best two-year fixed-rate mortgage now costs 4.7% compared to 2% this time last year.

Rising rates are particularly bad news for those whose fixed rates end in 2023 – UK Finance estimates this is the case for around 1.8 million homeowners.

As Alice Guy, Personal Finance Editor at interactive investor explained, "rates rises mean someone with a £200,000 tracker mortgage could be paying an extra £326 per month which is an eye-watering annual increase of £3,912."

The effect of rising rates, coupled with the rising cost of living, has already begun to affect the property market and prices are creeping down after two years of fast growth.

Rising rates are also good news for savers. Providers are not obligated to raise rates in line with inflation, and currently, there are no deals out there that come close to helping savers earn a real return on their money.

Still, higher interest rates have been trickling down to the best regular savings accounts, so it could be a good time to look for a better home for your savings.

“Higher interest rates do not always translate to higher savings rates. It could take months for the increase in interest rates to trickle through to savers – if at all. The acceleration in the frequency of rate rises has meant that some savings providers may still be catching up to past base rate rises. Put simply, you may get a better savings rate in the near future – but there are no guarantees. The amount you are looking to save could guide your decision. An uptick in savings rates could mean the difference between pennies and hundreds of pounds depending on how much you have to save," noted Myron Jobson, Senior Personal Finance analyst at interactive investor.

They have also had a positive impact on annuity rates. Rates have hit a 14-year high, breathing life back into a product that for years has been overlooked.

Eurozone inflation jumped to a record high of 10.7% in October, outpacing analysts’ projections for an increase of 10.2% for the month. We explain what this means for your finances.

Like the UK, the EU is suffering from high energy and food prices following Russia’s invasion of Ukraine earlier in the year, which are pushing up prices of goods and services across the board.

Inflation in the UK hit 10.1% in September, rising back into double digits after a slight dip to 9.9% in August.

UK inflation figures for October have not yet been published. Nevertheless, they are widely expected to show inflation accelerating again following the increase in the energy price cap.

What is the European Central Bank doing to control Eurozone inflation?

Double-digit inflation is putting a lot of pressure on the European Central Bank (ECB) to continue increasing interest rates.

Here in the UK, the Bank of England has been acting aggressively to raise rates in an attempt to drive down inflation. However, across the Channel, the ECB is having to be more cautious.

The EU is in an incredibly precarious economic position and the central bank is wary of going too far too fast.

But despite these concerns, the ECB has raised its leading interest rate from below 0 to 1.5%. It is expected the bank will unveil another 0.75% hike in December, taking the base rate to 2.25%.

Some analysts believe this could tip the Eurozone into a recession. A recession in the EU would ultimately be bad news for the UK economy as lower demand will have an impact on imports and exports.

A recession may also hurt the value of the euro. This may make it cheaper for holidaymakers and importers, which could be a silver lining.

Will Eurozone inflation have an impact on UK inflation?

Higher inflation in the Eurozone is hardly good news for investors and consumers here in the UK.

It could be seen as a sign of things to come as higher energy and food prices are responsible for most of the increase.

Energy prices across the Eurozone rose by 41.9% in October, from 40.7% the previous month. Meanwhile, the prices of food, alcohol and tobacco rose by 13.1%, up from 11.8% in September,

More worryingly, core inflation, which excludes volatile energy and food prices, rose 5%, up from 4.8% in September. This number suggests that inflation is becoming more entrenched in the economy and is going to become much harder to contain.

What does higher Eurozone inflation mean for you?

Higher Eurozone inflation will ultimately lead to higher interest rates in the rest of Europe. Rising prices may also force the Bank of England to go further with its planned rate rises.

This will be good news for savers who will be earning more money on their cash. However, it will be bad news for borrowers as higher interest rates will increase the cost of borrowing.

If interest rates settle at a higher level here in the UK than in the Eurozone, the pound could strengthen in value against the euro.

That means holidaymakers may be able to get more for their money when travelling to the EU.

A stronger pound may also help reduce inflation here in the UK.

Unfortunately, rising prices across the EU may not mean much for most people in the UK, but it is going to have an effect here.

The EU is the UK’s biggest trading partner and higher prices will feed into exports from the region. That might mean higher prices for consumers here in the UK. With wages already lagging behind inflation, it seems negative real wage growth is going to continue.

Remember to get your tickets for the MoneyWeek Wealth Summit hosted by Merryn Somerset Webb, on 25 November 2022! – we’ve got some brilliant speakers lined up and, given everything that’s going on, we’ll have an awful lot to talk about.

Book your place now at moneyweekwealthsummit.co.uk

“The world has been hooked on cheap money for years. Now we’re witnessing what withdrawal looks like,” says Randall Forsyth in Barron’s.

Last week, central banks from Scandinavia to Mongolia and from South Africa to Indonesia raised interest rates. America’s Federal Reserve delivered its third successive three-quarter point interest-rate hike, while the Bank of England raised interest rates by half a percentage point to 2.25%. Switzerland became the last European central bank to end its experiment with negative interest rates, leaving Japan as the only big economy where rates are still below zero.

Markets have swooned, with America’s S&P 500 stock index falling to its lowest level of the year so far on Monday. Oil prices have hit their lowest level since January on expectations of weaker demand.

Bond-market pain

“We’re living through… the most truly global attempt to tighten financial conditions in memory,” says John Authers on Bloomberg. “With 2022 not quite three-quarters over, this is already the worst year for [US Treasury] bond investors in six decades.” The yield curve, a measure of the gap between yields on US ten-year and two-year government bonds, has reached its steepest inversion “in more than 40 years”. Previous inversions have heralded a recession.

It has been clear for some time that monetary policy would need to tighten, but traders are only slowly waking up to the implications for overpriced equities, says James Mackintosh in The Wall Street Journal. “Markets are doing what they always do, hoping against hope that there’s no recession, or at least a very mild one, right up to the last minute.”

Fed policymakers have made clear that more hikes are in the pipeline, says Aaron Back in the same paper. Fed chair Jerome Powell describes the US labour market as “extremely tight”, a sign that the economy is still running too hot. US central bankers want “to see the economy slow significantly, even if that involves some pain”. Yet the bulls may still have a point: “the inflation... Powell is contending with isn’t nearly as entrenched as that of the 1970s. So a recession isn’t a sure thing and, if there is one, it might not be very deep or prolonged by historical standards”.

Investors are struggling to accept that their lost wealth isn’t coming back any time soon, says Katie Martin in the Financial Times. “The five stages of grief are denial, anger, bargaining, depression and acceptance.” Markets spent much of the summer in bargaining mode, when they “briefly took seriously the notion that central bankers might be gentle with rate rises”.

The current mood in stocks is somewhere between depression and acceptance. The latest round of global rate rises “has demonstrated, as if it were not already obvious, that declines in asset market valuations are simply not going away”.

“You can’t buck the market”, Mrs Thatcher used to say. But her disciple, Liz Truss, has approved plans to do just that.

Admittedly, popular pressure and the media gave her little choice and the UK is only following most European countries, but hopes that this will end well may prove mistaken.

Tom Murley, a 30 year veteran of the renewable energy sector who founded that arm of Hg Capital and served on the board and investment committee, has profound doubts about the energy price guarantee based on the fiasco of his experience in Spain.

“The UK and Western Europe face an energy crisis; not so much of supply but one of price after decades of low costs,” he says. Truss’s £100bn solution, capping energy bills for up to two years, is not the answer. It does not solve the underlying problems of the energy sector – habitual underinvestment in UK energy supply and ever-changing UK energy policy. On top of this, this borrow-today-and-pay-tomorrow scheme has been tried before, and failed.

Spain’s failed energy price cap

In the early 2000s, Spain embarked on an ambitious renewable energy policy when renewable electricity was significantly more expensive than fossil fuels, which is no longer the case. Under that policy, Spain was to pass on the increased cost of renewables to all of its consumers. However, because the pace of renewables expansion was quicker than planned and successive governments were reluctant to pass on rate increases during election cycles, the consumer increases never happened. As a result electricity suppliers collected from customers less than it cost to run the system. This became known as the tariff deficit.

Between 2002 and 2007 the deficit was at manageable levels, so the suppliers agreed to wait for collection out of future price increases. However, as the tariff deficit widened they became nervous, so the Spanish government issued bonds backed by the future credit of the electricity system and a promise of tariff increases, with the proceeds paid to suppliers.

From 2008-2013, however, the tariff deficit exploded, reaching €30bn. The 2008 financial crisis and Spain’s deteriorating credit position (necessitating a bailout from the European Central Bank) made the issuance of more bonds impossible and tariff increases remained politically unpalatable. As the tariff deficit grew, the rating agencies began to question if the suppliers would ever be paid, and threatened a downgrade to junk bond status.

Not wanting to pass the cost on to voters, Spain opted to retroactively slash the rates paid to renewable energy providers by 30%-100%, effectively impairing over €100bn of equity invested in Spanish renewables based on Spain’s long-term promises. This cut the deficit and amounts due were paid, stabilising the system’s finances. The simple lesson from Spain is that systems which charge consumers well below the full cost of energy for an extended period (the Spanish tariff deficit was 3% of Spanish GDP) are not sustainable and doomed to failure. If the UK spends £100bn-£150bn on such a programme, it would amount to 3.1%-4.7% of 2021 GDP.

Truss’s plan contains too many unknowns

The UK is proposing to borrow the cost of the scheme, but is this the best or the fairest way to spend such a huge amount of money? Will the scale of it push up the cost of borrowing not just for the government but for the whole economy? How will it make the economy more efficient or productive?

As Murley says, “there is much about the current energy crisis that we do not know. How long will it last? When will new or resumed supply of gas come onstream and alleviate the price increases? Truss’s solution could end up looking like Spain – an already large problem that mushrooms into an economic disaster, resulting in a massive price hike after two years.”

The government does promise to allow UK gas production to be stepped up, to remove the blocks on fracking and to encourage new energy infrastructure, including nuclear, renewables and grid connections but planning and environmental objections could slow this down. It has ruled out a windfall tax on the sector (for now?), preferring to switch the generators now earning enormous profits onto lower priced, longer term contracts.

Reforming the electricity market is highly desirable and, it seems, universally accepted by the generators. But it will be complex and take time. With the massive profits that are currently being earned, the generators have an incentive to spin out the process.

There are some saving graces to the government’s proposal. The price cap of £2,500 should be high enough to encourage increased output and discourage consumption. Reducing the inflation peak by 5% will save on the cost of indexing inflation-linked bonds (though not in real terms) and may help reverse the upward spiral of inflation.

The best hope for the government is that energy prices fall quickly enough to make the price cap redundant long before the two years are up. The cost would therefore be far below that budgeted for. Their worst fear is that prices stay high, market reform takes too long to implement and the scheme becomes unaffordable. If so, windfall taxes will be back on the agenda.

Today at noon, we get the Bank of England’s latest interest rate decision.

The main UK interest rate is currently sitting at 1.25%. Markets expect the Bank to raise that to 1.75%. That half-point increase would be the biggest rise since 1995 (and the Bank wasn’t even independent back then).

(For perspective, they were starting from a much higher rate at that point – the Bank rate was above 6%, while inflation was sitting at less than 3%.)

The expectations for a half-point hike are driven mostly by the action of the Bank’s peers. The US Federal Reserve and the European Central Bank have both been raising rates more aggressively than expected. (The ECB raised them all the way to 0%!)

So some argue that the Bank should be raising rates aggressively, to keep up.

There’s a perfectly reasonable argument for all of this. Inflation is really high compared to interest rates. If it stays high, then inflation expectations go up too. If people expect inflation to stay high then it changes their behaviour. Same goes for corporations. Everyone starts acting as if inflation will stay high, and it becomes a self-fulfilling prophecy.

That’s the theory anyway. Personally speaking, I’m not convinced by the whole “expectations” idea, which falls into the wishy-washy “feelings” side of economics. People’s economic actions don’t stem from mood swings, they are bedded in “real” conditions and circumstances facing them on the ground.

If you start with that assumption, then the concrete problem with inflation being above a certain level is that it makes planning ahead much harder. This in turn makes decision-making throughout the economy more short-termist and therefore less efficient. You move from “just-in-time” to “just-in-case”.

And yes, that becomes a self-fulfilling prophecy too. But if you at least acknowledge that it’s based on what is fundamentally a mechanical problem in the real world, then you can think about how to address that problem. This explains why, for example, Walmart is struggling with inventory management right now, even though its expertise in inventory management must surely put it among the best in the world.

Central banks can no longer play the saviour

Anyway, there’s a bigger issue here.

The reality is that the Bank probably doesn’t have a great deal of choice. Having rates sitting at 1.25% when inflation is heading into double-digit territory is just untenable. And if the Bank doesn’t at least meet market expectations – no guarantee when Andrew Bailey is in charge – then that would send the pound lower, which would only exacerbate the problem.

But a rate rise to 1.75%, or 2%, or even 2.25% is not going to do a lot to make anything better for anyone.

The real problem is that, over the last 20 years or so, we have come to rely on central banks far too much to do all the heavy economic lifting. And during that period, they haven’t really been fighting inflation – they’ve been fighting deflation.

This means that when the economy has run into recessionary times, central banks have always been poised to cut interest rates, not raise them. None of that has stopped recessions from happening. But certainly during 2008 and the 2020 pandemic and countless brief market stumbles in between, cutting rates has been seen as a bit of a magic wand – not just for markets, but for the wider economy too.

We are now in a situation where central banks simply cannot help in this way. If they really want to stop inflation in its tracks, they’ll have to raise rates so high that they inflict a recession which is even harsher than the one which is more than likely already heading our way.

So what does all that mean? Well, once upon a time, we might have argued that you could just do nothing. Let the economy sort itself out. High energy prices will squeeze consumer demand. A recession will mean less competition for workers, which will keep a lid on wages. Getting interest rates to a point where they are a little more “normal” will help savings to balance out debt somewhat.

But after such a long time of getting used to someone coming along to “do something” when economic pain is on the horizon, I don’t think we’re going to see a laissez-faire attitude spring up now. Instead, the obvious candidate to “do something” is the government.

“Do something!”

The government, which will either be led by Liz Truss or Rishi Sunak, is definitely going to face calls to “do something” (indeed it already is) given how painful the energy squeeze is about to get.

As things stand, it’s hard to exaggerate how bad the shock looks like it could be. Households are facing a doubling of energy bills compared to what they’ve been used to. That is a huge amount of money and it will not be politically popular, to say the least.

Iain Martin in The Times (hardly a “big government” guy) goes so far as to argue that the pending energy crisis could “become a poll tax moment”.

So what does that mean in practice? In practice, it means intervention. On the upside, you might find that you get more help with your energy bills this year (and maybe next) than is already on the cards. On the downside, that money is going to have to come from somewhere.

You need only look at headlines in recent days as companies in the energy sector have reported record profits. You can debate the financial literacy of all this for days (there isn’t any). But that’s not really useful to an investor.

I suspect that further windfall taxes of some sort are likely to be considered (although they’re probably more likely under Sunak). And that’s under a right-leaning government.

It doesn’t mean you should avoid energy production – we’re going to need a lot more of it after all. But it does mean it makes sense to be diversified both within and outside of the UK. Dominic suggested some wide-ranging funds for playing oil here.

“Europe once again stands at the edge of the precipice, staring into the abyss below,” says Jeremy Warner in The Telegraph. The 2009-2012 eurozone crisis was centred on “tiny” Greece – just think what debt problems in a major economy such as France could do to the single currency.

French prime minister Michel Barnier’s three-month-old minority government has collapsed after being ousted in a vote of no-confidence on 4 December, following which Barnier resigned. Barnier’s “fragile” administration had been trying to close a fiscal deficit of 6.1% of GDP with €60billion in spending cuts and tax hikes, says Liz Alderman in The New York Times.

His plans have drawn the ire of opposition parties, with the far-left and far-right ganging up to vote him down. That leaves president Emmanuel Macron in a bind. France’s legislature is hopelessly divided, and Macron legally can’t call fresh parliamentary elections until June next year. The risk premium, or “spread”, between benchmark French and German government bonds has touched 90 basis points, the highest level in 12 years. In a further humiliation, financial markets have started charging France the same amount as Greece to borrow for a decade.

Talk of a Greek-style crisis is “for the moment... a complete exaggeration”, Éric Heyer of Sciences Po tells the Financial Times. At 2.9%, French ten-year yields are far below the 16% level that Greek bonds hit in 2011. Indeed, French borrowing costs are currently lower than Britain’s. Unlike with Greece, there is no doubt that European institutions will do “whatever it takes” to save France, says Andrew Kenningham of Capital Economics. Crisis-era Greece had a 15% deficit and plunging GDP, compared with a 6% deficit and modest growth in France today. Paris requires a relatively small fiscal tightening to sort out its budget. The problem is not so much economic as political – France seems “unable to give any government a mandate for deficit reduction”, leaving the issue of growing debt to fester.

The real risk for the eurozone will only come if Marine Le Pen’s far-right party takes power in a future election. While Le Pen no longer supports leaving the euro, her party will be “much less committed to cooperating with the EU” to keep the currency bloc functioning smoothly. If things do get out of hand, then expect the European Central Bank (ECB) to deploy its Transmission Protection Instrument (TPI), says Johanna Treeck in Politico. The TPI allows the ECB to buy up government bonds if it thinks bond markets have become “disorderly”. Yet the “bar for such intervention is high” – probably requiring French debt to hit somewhere above 200 basis points of spread over German bunds, compared with today’s 85 points.

What the crisis in France means for Macron

Macron has pledged to appoint a new prime minister within days and vows to stay in office until the end of his term in 2027. Macron has three bad options to resolve the political deadlock, says Pierre Briançon for Breakingviews. He could try to repeat the failed Barnier trick, appointing a “temperate centrist” willing to do budget deals with the far-left or far-right. Alternatively, he could pick a far-left or far-right administration, purely to demonstrate that the populists are also “unable to govern”. Finally, he could conclude that he himself is the problem and resign, plunging France into the uncertainty of a snap presidential election.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.

MoneyWeek has been around long enough to see several big trends recur. Most of them have been fascinating to cover. But one key theme of the past decade fills me with dread, because it was like watching a slow-motion car crash: the euro crisis. It may now be making a comeback.

The launch of the euro coincided with the start of a global upswing, so the currency’s intrinsic flaws were overlooked. Everyone was getting used to the conversion rates (an irksome 13.76 schillings to one euro in Austria). Because the eurozone encompassed most EU members it was trumpeted as a giant leap forward for European integration.

A sub-optimal currency area

Many analysts, however, pointed out that there had never been a successful single currency without a single government, and that the euro was far from what economists call an optimal currency area. The basic idea is that groups of structurally similar economies, who often tend to experience similar business cycles, are best suited to sharing a currency. A similar approach to money management helps too, as it pre-empts fights about any joint budgets and potential debt issuance.

Benelux, Germany and Austria would arguably be an optimal currency zone: wealthy manufacturing-based economies with a shared instinct for sound money. What we got instead, of course, was northern Europe plus the inflation-prone south’s less healthy balance sheets. The prospect of sharing a currency with people who can’t budget, and would probably need a bailout at some stage, unnerved many northern Europeans, but such objections were steamrollered by the integrationist tide.

When the financial tide went out after the crisis, investors’ fears over the sustainability of the southern countries’ debt duly proved justified and bond yields soared. Since bond yields are implied long-term interest rates, that exacerbated countries’ solvency problems.

In the absence of a central fiscal authority to send money to poorer parts of the currency area to temper the impact of a downturn, only painful reforms and a clampdown on prices and wages would restore competitiveness and fuel confidence in stricken states’ ability to grow out of debt.

Cue endless wrangling between the European authorities and southern governments, and a cascade of market panic attacks focused on different countries until ten years ago this week Mario Draghi promised to do “whatever it takes” to keep southern bond yields low. The prospect of the European Central Bank hoovering up enough bonds to keep the yields down kept the wolf from the door, and a similar mechanism, the Transmission Protection Instrument, was launched last week, again against a backdrop of turmoil in Italy.

The wolf is still there, however. There is still ample scope for market panics and political clashes between Brussels and the member states, while the EU’s construction of a fiscal union (with an incipient banking union and a Covid-19-induced recovery facility allowing the EU to borrow collectively) is proceeding at the speed of a hungover giant sloth. More broadly, the eurozone is still stuck with a structure that acts as a deflationary straitjacket for much of the south, a recipe for recession and rancour. Until there is a European government or the euro is dismantled, the eternal crisis can only be managed or fudged – never resolved.

The European Central Bank (ECB) raised interest rates for the first time in more than a decade yesterday.

The rate rise was also bigger than markets had expected. The half-a-percentage-point rise means the eurozone interest rate is now 0%. Negative interest rates, perhaps the weirdest financial phenomenon of an admittedly very weird era, are rapidly becoming extinct.

However, while markets were certainly interested in the rate hike, what they were much more interested in was the ECB’s replacement strategy for “whatever it takes”.

And, it has to be said, unlike the outsize rate hike, the new “transmission protection instrument” (TPI) didn’t do anything to beat expectations.

The eurozone’s fundamental problem is nowhere near being solved

Rising inflation and consequent rising interest rates are a problem for most parts of the world. But the eurozone has one big problem that sets it apart from everywhere else – the euro.

We ran through the history a couple of days ago, so you can read all that here. But the main problem for the euro can be summed up pretty quickly.

All four countries in the UK share a currency – sterling. But they also share the same government debt. No one looks at the individual creditworthiness of Scotland or Northern Ireland or Wales or England. The entity that does the borrowing is the UK. And in extremis, the UK can print more money to repay its debts. (This would have consequences – but it does mean that the UK never has to default on its debt, unless it explicitly chose to do so).

All 19 countries in the eurozone share a currency - the euro. But they each issue individual government debt. Germany borrows separately to Italy. German taxpayers and the German economy do not stand behind Italian government debt. The only thing that backs Italian government debt is Italy.

Also, in extremis, Italy cannot print more euros to repay its debts (and nor can Germany). So an actual default – where government bonds simply can’t be paid – is technically possible. As a result of this, if a eurozone country looks like it has a wobbly balance sheet, markets will drive up the interest rate on its debt, which makes the balance sheet even wobblier.

In turn, this all threatens the very existence of the single currency. Because if a country like Italy (or France) was in danger of defaulting on its debt, it would have to leave the eurozone. And if that happened, the euro would disintegrate.

The ultra-low interest rate world meant that none of this was an issue for a while. ECB interest rates were negative, and the ECB was also printing money to buy bonds, which enabled it to keep rates on the riskier borrowers under control.

That changes rapidly in a rising rate environment. Particularly because inflation not only heats up the economy but also heats up the political realm. Fuel price protests and the like put pressure on public finances (because people expect the government to spend money to “do something”).

Suddenly the threat of the riskier eurozone members seeing their borrowing costs driven up to unsustainable levels is becoming a danger again.

The TPI is designed to avoid this problem. However, as with most things in the eurozone, politics gets in the way.

The market is going to test the ECB’s resolve – again

The simple solution to preventing interest rates in the eurozone from diverging catastrophically, is for the ECB to just say it’ll print as much money as it likes to keep the yield on government debt issued by eurozone countries to within one percentage point (or whatever) of the lowest comparable rate paid by any member state.

In other words, “we won’t let Italian government bonds yield more than a percentage point above German bunds”. There are potential economic issues here, of course. (Just ask the Bank of Japan how tricky fixing interest rates can be).

But the main problem here is political. The moral hazard is that countries which really need to reform their economies, instead don’t do anything because they know that however much they spend, the ECB will bail them out. And whether this is fair or truthful or not, it’s how German taxpayers will perceive it.

So the ECB has to somehow tell markets that it will definitely not let anything happen to the euro – that it will still do “whatever it takes” – while at the same time not issuing anything that looks like an unconditional guarantee by German taxpayers to pay for Italian pension schemes.

That’s a really tricky line to walk. You have to be vague, but threatening.

So on the one hand, ECB boss Christine Lagarde said that the decision to intervene was at the ECB’s discretion and that any such intervention would be unlimited and could also extend to private sector assets. That sounds pretty aggressive.

But the document also mentioned a series of conditions a country would have to meet before getting this sort of assistance. This includes things like “sustainable macro policies” and several other lines which add up to an attempted reassurance to Germany that this is not a free lunch for non-German eurozone countries.

In short, it’s subject to all the contradictions that any eurozone policy is subject to. It’s an attempt to patch up the gaping holes left by a lack of political union using monetary policy by the backdoor.

Will it work? Markets were not especially inspired. The euro has barely shifted against the dollar, which given that the rate hike surprised on the upside, is not a vote of confidence in the policy. And the gap between the yield on Italian bonds and German bunds is still significant.

I think the long and the short of it is that this may not ever be tested out as there are other mechanisms with which to control the spread in extremis. But it’s also clear that the market is likely to test the ECB’s resolve over this.

And with the political situation in Italy getting more chaotic as Mario Draghi’s era comes to an end, and the wider eurozone economic outlook getting weaker and more stagflationary, it’s probably only a matter of time before another crisis erupts.

High-yield bonds are finally living “up to their name”, says Randall Forsyth in Barron’s: yields on debt issued by companies with lower credit ratings plunged during the pandemic, as prices rose owing to ultra-low interest rates (yields move inversely to prices).

But now yields in the US high-yield market have soared by 4.2% since the start of the year to more than 8%, says Rachna Ramachandran of GMO. “There have been only two other instances in which yields have doubled so quickly” in the past 30 years: the 2008 financial crisis and the start of the pandemic in 2020.

The yield spike has brought painful losses for existing bondholders. The iShares iBoxx ETF, which tracks US investment grade debt, is down 15% this year, with a Bloomberg index of high-yield, or “junk” debt also falling 14%. Euro-denominated corporate debt is being similarly hard hit, says Sophie Rolland in Les Échos. Down 13% in the year to 20 June, the market slump far exceeds the 4% it lost in 2008, until now the worst year on record.

As well as feeling the effect of higher interest rate expectations, European debt is being hit by the European Central Bank’s (ECB) move to stop purchasing fresh debt with printed money this month. The ECB holds nearly 15% of all investment-grade euro corporate debt following previous rounds of asset purchases. Tightening credit conditions have seen “dozens of corporate bond deals” pulled from the European market, says Ian Johnston in the Financial Times. New corporate debt issuance fell 17% in the first half compared with a year before, with European high-yield debt issuance plunging 78%.

“Bond markets have had a rough year,” says Matt Grossman in The Wall Street Journal. “Red-hot inflation makes the fixed payments offered by most debt investments less appealing.” Yet as the yields offered by corporate debt rise, investors are “giving bonds another look”. Debt issued by blue-chip firms with reliable balance sheets is appealing: “it offers higher returns than government bonds but with relatively little additional risk”.

Will defaults spread?

The key uncertainty is to what extent defaults will rise. In past downturns investors could count on central banks stepping in to ease lending conditions, says Joe Rennison in the Financial Times. Yet now, with inflation soaring, they can’t.

Credit rating agency S&P Global Ratings thinks US corporate defaults will “rise to 3% by next March, up from 1.4% the previous year”, says Julia Horowitz for CNN Business. Still, most corporate balance sheets are reasonably solid after firms “took advantage of rock-bottom borrowing costs over the past two years to stash cash and… refinance their debt”. For now, “those who trade corporate bonds aren’t overly anxious”.

The eurozone sovereign debt crisis came hot on the heels of the 2008 financial crisis.

The main focus throughout was Greece. That’s where it kicked off, when an incoming Greek government revealed that the national balance sheet was in a much worse condition than anyone had thought.

To cut a long (and pretty boring) story short, the headline struggle during the eurozone crisis was “who carries the can for Greece’s inability to repay its sovereign debt?”

If the eurozone had been the US – with not just shared monetary policy, but also shared debt issuance and fiscal policy – the problem could have been solved easily. In effect, Greek debt would have been backed not just by Greek taxpayers, but also by the European Central Bank and the rest of the eurozone’s taxpayers.

But that’s not the way the eurozone worked (and still doesn’t). German taxpayers specifically were not keen to be on the hook for Greek debts.

So the answer largely ended up being a) Greek bondholders, who saw the value of their debt written down; and b) the Greek population, who endured a severe depression as Greece – under the duress of the single currency – deflated its way back to something approaching solvency.

How financial contagion nearly shattered the euro

So that’s the headline story. But during this whole process there was a much bigger underlying concern. That was the fear of “contagion”.

At the end of the day – although it took the eurozone authorities a long time to come to the conclusion – Greece was sufficiently small that it could have left (or been ejected from) the eurozone, without jeopardising the survival of the single currency.

By contrast, there were plenty of other countries with messy balance sheets too. And markets weren’t slow to pick up on this.

Investors had spent most of the early years of the eurozone (ie, the 2000s) driving bond yields closer across the region. The assumption was that the euro was just the start. Countries that shared monetary policy would eventually have to share fiscal policy too. So a Greek bond was just as good as a German bond, because they were all backed by the same thing.

That assumption was shattered by the Greek debt crisis. As a result, investors started to differentiate between eurozone countries. Bond “spreads” – that is, the gap between “safe” German debt and higher-risk countries – blew out. In other words, countries with the worst balance sheets saw their cost of borrowing rise.

The “peripheral” countries included, alongside Greece, Portugal, Ireland, Spain and Italy. Portugal and Ireland, being relatively small nations, basically knuckled under and imposed similar sorts of austerity packages to Greece. Spain’s finances were in fact not that bad - its main problem was a massive housing bubble.

But Italy – Italy was a problem. A sclerotic economy plus a heavily-indebted balance sheet. Moreover, it was too big to push around. Imposing a depression on Greece was possible. Not so Italy, one of the founding member states.

Faced with the risk that some countries, and Italy specifically, would in effect be locked out of borrowing in sovereign debt markets, the eurozone had to take action. That’s where Mario Draghi, then head of the European Central Bank (ECB) came in. In 2012, he said he would do “whatever it takes” to save the euro.

In the end, that eventually added up to an open-ended commitment to buy the sovereign debt of the most troubled countries, which would in turn keep spreads from exploding, and allow troubled countries to continue borrowing.

It worked. Contagion was halted. Greece continued to cause the odd spasm of fear, but with the risk contained to Greece itself, wider markets calmed down.

Italian political strife is rearing its head again

For a while, the fundamental problems of the eurozone faded into the background. The Brexit vote almost certainly helped – it’s always good for cohesion to have something to triangulate against.

But more important was the ongoing deflationary backdrop. High interest rates were not going to be a problem and central bank intervention was regarded as standard for most major economies.

Finally, Draghi – the saviour of the eurozone – went from being the head of the ECB to being the Italian prime minister.

But now everything is changing. And suddenly, existential fears about the eurozone are erupting again.

Firstly, inflation is back. That means interest rates can’t stay where they are. And put simply, if borrowing costs generally are going up, and the ECB is no longer printing money to funnel into the countries whose bonds are viewed as most risky, then spreads are going to start blowing out again.

Secondly, Italian political turmoil is raising its head again. During the Greek crisis years, the big bugbear was a left-wing populist party called Five Star. Now the most popular contingent in the country is a right-wing populist movement comprising three different parties, including one led by Silvio Berlusconi.

Now I’m no expert on Italian politics and given that I’m in my late 40s, I’m not sure there are sufficient years left to become one. But the upshot is that Draghi may end up resigning and that could result in elections, and while the various members of any prospective governing coalition have backed away from actively campaigning to leave the eurozone, they all have eurosceptic backgrounds.

How will the ECB stop the eurozone from cracking up this time?

So what’s the plan?

For now the ECB is going to keep raising interest rates. But it also intends to unveil an “anti-fragmentation tool” on Thursday. The purpose of this tool – whatever shape it arrives in–- will be to give the ECB a licence to tie eurozone bond yields together.

The problem is, they can’t be as overt as that when they unveil it. The lack of overall political unity means that the ECB faces very similar problems to during the Greek crisis.

Back then, they couldn’t bail Greece out because of the idea that it would incentivise “bad” behaviour on the part of Greece – in effect, you’re penalising German taxpayers with more inflationary monetary policy so that Greece doesn’t have to embark on much-needed reform (all of this depends on your point of view, to be clear, it’s not black and white – but that’s the nature of the argument).

So now they can’t say: “we want Italy to be able to borrow at a minimal premium to Germany” because that then looks like running profligate monetary policy in order to allow Italy (or any other country that ends up needing it) to duck reform.

In other words, it’s all a bit messy in the eurozone again, and we’re back here for the same reason as before: you can’t have a fully functional monetary union without having a political union too.

What happens next? I used to think the eurozone was inevitably doomed long-term. I’m not so sure about that now. For the euro to crack up, a member state (and one of the big ones) needs to pull out. That boils down to politics – you need a political party to argue the case, and people to vote for it.

The only country where that seems potentially possible is Germany, in that Germany may end up getting fed up with feeling like the bag carrier for the rest of the eurozone. But even then, I suspect that there is too much of a sense of obligation for that to happen.

So in the long run, I think the path of least resistance is to lean heavily on the ECB for support during crises; and to gradually introduce some form of common debt instrument (we’re getting there with the coronavirus relief package).

In the meantime, all of this stuff will continue to be a horrendous distraction and more than likely contribute to disappointing growth in the region. But individual companies will do fine.

Given that eurozone equities are among the most-hated in the world right now, I’m tempted to start having a look. You might want to do the same.

“Recession in the eurozone is priced in,” say analysts at Japanese banking giant Mizuho. On Tuesday the euro slumped to parity with the US dollar – the lowest the euro has traded against the US currency since 2002. The selloff followed growing concern that the shutdown of the Nord Stream 1 gas pipeline to Germany for annual maintenance could turn into a more permanent closure.

“The ECB [European Central Bank] is fiddling while the currency burns,” Neil Wilson of Markets.com told Julia Kollewe and Graeme Wearden in The Guardian. “Inflation above 8% and interest rates remain negative … it’s madness.”

The euro’s slump could be a foretaste of what is to come if a Russian gas cut does materialise, say Lynn Thomasson and Farah Elbahrawy on Bloomberg. Economists at UBS think that the single currency could hit €0.90 to the dollar in that scenario, with corporate earnings falling by more than 15% and a 20%-plus drop in the Stoxx 600 index of pan-European stocks. German equities are already feeling the chill after tumbling 11% since June. Shares in gas giant Uniper, which is seeking a government bailout, are down 77% this year.

Considering the circumstances – “the worst geopolitical crisis in Europe since the World War II” – the euro isn’t holding up all that badly, says Ambrose Evans-Pritchard in The Daily Telegraph. This is not so much a story of euro weakness as of the dollar’s strength against nearly all other big currencies.

Note that the Japanese yen and the Swedish krona have fared even worse against the greenback this year. The dollar index, which tracks the US dollar‘s value against a basket of six major trading partners’ currencies, “has gone mad as the US Federal Reserve engages in frenetic triple-decker rate rises, belatedly scrambling to contain the inflationary blow-off of its own monetary creation, and to rein in the greatest fiscal expansion since Roosevelt’s New Deal”.

Economic logic

The dollar’s rally is a matter of “economic logic”, says James Mackintosh in The Wall Street Journal. At a time of soaring global energy prices it makes sense for investors to head for America – a country that is “self-sufficient in energy” because of fracking – rather than Japan or Germany, which need to import oil and gas from elsewhere. At some point the current dollar bull trade will flame out, but “without a trigger – a peace deal in Ukraine [that] might restore cheap gas to Germany, or perhaps a dovish turn by the Fed – it is hard to see what could prompt the dollar to turn”.

The dollar looks to be trading somewhere “between 10% and 20% north of fair value” at present, say Themistoklis Fiotakis and Sheryl Dong in a Barclays note. In the medium term that overvaluation should unwind, but don’t bet on it happening anytime soon. The dollar’s current strength rests on its role as a haven in uncertain times. Another “Covid-19 flare-up in China” or “more disruptions to the flow of Russian natural gas to Europe” could yet drive the greenback even higher.

Bridgewater is one of the biggest money managers in the world, and its founder Ray Dalio has been proved right more often than not. It managed to call the sub-prime crisis correctly slightly over a decade ago and it has consistently outperformed the market since then. Even in the ruthlessly competitive world of hedge funds it is a class act, with a long record of success.

When it takes a major position, most of its rivals quite rightly take notice. In the past couple of weeks it has emerged that Bridgewater is targeting a collapse in European stocks. Earlier in the month, it was revealed it had taken a $6.7bn short position against the continent’s largest businesses and only a week later that had grown to more than $10bn.

Fault lines reopen

That is a lot of money to wager on a fall in the market, especially as the major indices have already corrected sharply since the start of the year. Germany’s Dax has fallen by 17% since January, France’s CAC by 16%, and the Euro Stoxx 50 that covers the continent’s biggest companies by 18% (although the FTSE 100 is only off by 2%, mainly because it is so dull). Most people might well think it is time that equity prices bounced back. There are three big reasons why Bridgewater’s bet is going to pay off.

First, Russia’s invasion of Ukraine is turning into a long, brutal war of attrition. There is no sign it is ending any time soon. Sanctions will remain in place for many years to come, hitting exports to Russia. More importantly, Europe is going to have to find a way of living without Russian oil and gas. That might be just about possible, but it will be expensive (the reason we imported it from Russia was because it was relatively cheap).

In Germany, some form of energy rationing now looks a certainty over the coming winter, and if that includes factory closures or shortened working weeks, it will tip the country into recession. Worse, the major European economies will all have to raise defence spending, as well as paying for the arms they are shipping to Ukraine, and sooner or later pay for reconstruction as well. It will take a huge toll on the economy.

Next, inflation is about to reopen the fault lines in the single currency. We already knew from the crisis of 2011 and 2012 that the euro was dysfunctional and open to speculative attacks. European Central Bank chief Mario Draghi just about managed to paper over the cracks with printed money. But now? The reality is that the euro has never faced serious inflation before and is heading into a crisis as the ECB has to choose between controlling prices or bankrupting Italy and Greece. There have already been sharp rises in bond yields in the peripheral countries, and the ECB has promised to come up with a mysterious sounding “stabilisation tool” to control those, although there is not much detail on how it will work yet. The real test will come when interest rates start to rise next month – what happens then is anyone’s guess.

Finally, Europe’s trade deficit is soaring. Whatever their other problems, the major EU economies always managed to run a big trade surplus. That has now switched. The eurozone countries recorded a deficit of €16bn in March, and that is rising all the time. In part that reflects the cost of importing more energy. But it also reflects its declining competitiveness. That deficit will subtract from growth and at the same time put pressure on a currency that has already fallen close to parity with the dollar, but can still go down a lot more. From here on, trade is going to subtract from growth rather than help it – and that is a big change.

True, the British, American and Japanese economies are hardly in great shape either. Inflation is still dangerously high, political leaders don’t have the will to control it, and central banks are still trying to work out what level of interest rates will be needed to stop it running out of control. There will be recessions in most of the major economies. The only real question is how deep they will be. But Bridgewater is right: Europe is the weakest of all the major regions, and its economy is heading into a steep downturn – and its huge bet against Europe will prove very shrewd.

European Central Bank (ECB) president Christine Lagarde was a synchronised swimmer as a teenager, says Jill Treanor in The Sunday Times. Now, she is “struggling to keep her head above water” as the eurozone’s periphery feels the pressure from tighter monetary policy and Italian and Spanish bond yields soar to eight-year highs.

Last week, the spread between German and Italian ten-year government bond yields spiked to 250 basis points (2.5%). That is well short of the 500-plus basis points that it reached at the height of the 2011-2012 eurozone debt crisis, but it was enough to force the ECB’s governing council to assemble for an emergency meeting in Frankfurt.

The central bankers unveiled a new “anti-fragmentation tool”. The suggestion that the ECB will act to keep spreads down “buys time”, Silvia Merler of Algebris Investments tells the Financial Times. But with details still scarce, it “does not take them out of the corner yet”.

Italy’s debt challenge

Italy – whose €2.759trn stock of debt is worth almost 150% of GDP – is the key concern, says Jérôme Gautheret in Le Monde. A debt crisis in the eurozone’s third-largest economy would pose an existential risk to the single currency.

The spike in yields leaves the Italian treasury paying interest rates of roughly 4%. For now Rome is maintaining the confidence of markets, thanks to the leadership of its prime minister, Mario Draghi, Lagarde’s predecessor at the ECB. Yet his “grand coalition” government “is showing increasingly obvious signs of running out of steam” ahead of elections due next year. “The personal aura of ‘Super Mario’ may no longer be of great help in protecting Italy from market storms.”

Comparisons with the eurozone debt crisis are overdone, say Martin Arnold and Amy Kazmin in the Financial Times. Things have changed over the past decade. Italy stands to receive €200bn in grants and cheap loans from the EU’s post-pandemic recovery fund. That will provide an economic boost worth 12.5% of GDP over five years. That help is tied to structural reforms that might drag Italy out of its long economic stagnation. The ECB also has a clearer plan for how to fight eurozone break-up risks – something it sorely lacked in 2011.

Still, the ECB’s recent behaviour doesn’t inspire much confidence, says Jeremy Warner in The Daily Telegraph. Why it is still persisting with asset purchases and negative interest rates when inflation is at 8% “is anyone’s guess”. Perhaps it is because while other central banks can just balance between the twin threats of inflation and stagnation, the ECB must also try to hold the euro together. “Europe’s monetary union is a bit like a bumblebee; aerodynamically it shouldn’t fly, yet somehow it does. For how much longer must again be in doubt.”

Earlier this week, the Federal Reserve raised interest rates by three quarters of a percentage point. (That’s 75 basis points, or bps, in the financial jargon – so now you know what that particular acronym means).

That wasn’t a surprise for markets, but only because the surprise had been sprung a couple of days earlier, when inflation hit a new 40-year high and markets were primed – via well-connected journos – to expect a big rise rather than just half a point.

The Bank of England needs better communication skills

Yesterday, the Bank of England declined to copy its larger peer.

It raised interest rates by a quarter point. Six of the nine-member Monetary Policy Committee (MPC) voted to raise rates by the quarter point, while three wanted to go further with the half point. So the Bank of England rate is now 1.25%.

Markets had half-expected a bigger hike in reaction to the Fed’s big rise. But the Bank of England right now is in a major quandary, one only rivalled by that of the European Central Bank (which has a lot more countries to take into account).

Yes inflation is high and only getting higher (the Bank now reckons it’ll go above 11% in October, and bear in mind, this is using the consumer prices index (CPI). Under the Bank’s previous target measure – the retail prices index minus mortgage interest costs (RPIX) – inflation is already sitting at more than 11%, so presumably that’ll be pushing 14% by then.

However, the UK is also flirting with recession. While the Bank became gloomier on inflation it also became gloomier on growth prospects. So you can see the argument for not raising rates too fast. The problem is that the Bank isn’t great at communicating or conveying any sort of confidence.

As Simon French, chief economist at Panmure Gordon pointed out on Twitter, “for good economic governance the hard work is explaining why an undersized move vs developed market peers. There is a narrative about balance of risks/confidence in policy path, but must be credible”.

In other words, the Bank needs to demonstrate more conviction in its lack of conviction.

Anyway, this divergence from the Fed saw the pound slide rapidly in the aftermath of the decision, although sterling rebounded later in the day after several US economic data releases turned out to be very disappointing (implying that perhaps the Fed is already tightening too much).

The Swiss turn hawkish but the Bank of Japan sticks to the plan

Flipping back to the hawkish side, the Swiss National Bank – Switzerland’s central bank – decided to surprise markets too yesterday, when it raised interest rates. Swiss rates were increased all the way from negative 0.75% (yes, negative) to negative 0.25%.

It may come as a surprise to anyone who doesn’t obsessively monitor global interest rates that Swiss rates are still negative. However, note that Swiss inflation is still only running at a bit below 3%. So in “real” terms, UK rates are a lot more negative than Swiss rates.

But back on the dovish side, we had the Bank of Japan (BoJ) this morning. The BoJ is probably the single most interesting central bank on the planet right now, which is not always the case by any means.

The BoJ put in place “yield curve control” (YCC) about six years ago. It declared that the ten-year Japanese government bond would essentially be fixed at 0%, and not allowed to move more than a quarter of a percentage point around that band.

In effect, the BoJ said it would print as much money as necessary to buy bonds if the yield went above 0.25%, or that it would sell bonds if the yield went below negative 0.25%.

When the BoJ did this, negative 0.25% seemed a much bigger risk than positive 0.25% (indeed, the latter would have been welcome). The point of YCC at the time – or at least one of the reasons for doing it – was to give the Japanese banking sector at least some way of generating profits by making sure there was at least a bit of “spread” (that is, gaps between the cost of borrowing over different lengths of time) in the system.

But now, with inflation rising – yes, even in Japan – and global bond yields doing likewise, the market is challenging the BoJ’s resolve. And so far the BoJ is not backing down.

At its latest meeting this morning, it said it will stick with YCC and it won’t be allowing the ten-year to rise further.

The tricky thing then though, is that this pressure has to come out somewhere. And that somewhere is in the currency.

Historically the Japanese yen has been a “safe haven” currency. It’s somewhere that investors used to run to in a market panic (partly because the yen was also a “carry” currency – big investors would borrow it at low rates to invest elsewhere in the good times, then have to rush back and buy yen back during “risk off” periods).

But that’s no longer the case. The yen is now trading at around 134 to the US dollar, the sorts of levels unseen in about 20 years.

Here’s why the 1970s is such a good analogy for today

What does all of this mean for investors?

No one has a crystal ball. But most of us have spent our adult lives investing in a market which relied on central banks to anchor it. The global political situation was benign. We’d enjoyed a “great convergence”. European countries were converging to form the eurozone. Once-communist countries were waking up to the benefits of capitalism, and democracy surely couldn’t be far behind. To use the much-abused term, it was the end of history.

Politicians basically agreed on everything. Markets were the only game in town. And, underpinned by central banks, embodied in the “maestro” Alan Greenspan, they could really only go up.

This was largely an illusion, and one which spent most of the 2000s becoming steadily thinner, with significant ruptures in 2008 and 2016. Now it’s pretty much out in the open.

Politics is no longer benign. Countries are diverging, rather than converging. Capital is no longer free and easy and can no longer expect to be treated well or welcomed with open arms in every destination.

Central banks cannot fix this. Whatever options they take will exacerbate one problem or another. And political “solutions” – whatever they are – will not be driven by the best interests of investors.

This, more than anything else, is why the 1970s is probably the best analogy for today. Politics, not markets, is pre-eminent. And that means anything can happen.

We’ve got more on that analogy in this week’s MoneyWeek magazine. If you don’t already subscribe, I suggest you do now. You’ll get your first six issues free.

“The eurozone is on the brink of stagflation,” says Eric Albert in Le Monde. Annual inflation hit 8.1% last month, a level unprecedented since the creation of the single currency. Energy prices, which rose at an annual rate of 39% in the past year, were the main cause, but “gradually the phenomenon is spreading to the entire economy”. At the same time, growth was just 0.3% in the first quarter. Industry is holding up reasonably well for now, but households are being “strangled by the sudden rise in the cost of living”.

Few economists “expect an outright recession” in the year ahead, says The Economist. “Many services firms are still reaping the rewards from reopening,” especially in the euro area’s tourism-reliant south. A cushion of pandemic savings and “plentiful” jobs should provide a backstop for consumer confidence. Yet the European Central Bank (ECB) finds itself in the tricky position of balancing soaring energy prices and a weaker growth outlook. In America loose government spending has contributed to rocketing inflation, but Europe’s price rises come mainly from the supply side, which a central bank can do little to control.

This week the ECB was poised to announce that it will stop buying bonds imminently. That should pave the way for interest-rate rises next month, say Dhara Ranasinghe, Tommy Wilkes and Saikat Chatterjee for Reuters. The bank’s deposit rate is currently at -0.5% and hasn’t been raised since 2011. There is growing speculation that policymakers might even opt for a 50-basis point rise (rather than the expected 25-point rise) to get inflation under control.

Earnings can’t beat the gloom

The pan-European Stoxx 600 index is down more than 9% since the start of the year. Even so, corporate earnings have been robust, says Ian Johnston in the Financial Times. “Earnings per share grew by 42% for the 452 companies in Europe’s Stoxx 600 share index that reported first-quarter numbers,” compared with 9% for US stocks. About half of European blue-chip earnings come from outside Europe, so the weak euro is also juicing earnings.

Strong earnings have been powered by the commodity-price boom, says Société Générale. Commodity-linked sectors account “for close to 10% of the market capitalisation in Europe, but almost 20% of total earnings”. As of the end of April, the Stoxx 600 was trading at a forward price/earnings (p/e) ratio of 13.1, below historical averages. Yet that discount comes from historically low valuations for commodity firms. “Looking at the Stoxx 600 excluding commodity-linked sectors… the forward p/e is at 14.5 times, so still above the ten-year and 20-year historical averages.”

Still, on a long view, it might pay to look at Europe’s smaller stocks, says Ollie Beckett of Janus Henderson. European small caps returned 301% in the decade to the end of 2021, compared with 194% for large firms. “The European economy has been criticised for being sluggish, but the universe of smaller companies continues to produce dynamic and innovative businesses that are well-placed to benefit from… factors such as the energy transition, or the changing healthcare landscape.”

There are a few contenders for the title of “most important price in the world”.

The most important is probably the US ten-year Treasury yield – that is, the interest rate that the US government has to pay to borrow for a decade.

This is generally regarded as the global “risk-free” rate. It’s not too much of an exaggeration to say that every other asset in the world is priced with reference to this slab of US government debt.

But a close runner up is the US dollar.

A strong US dollar sucks money out of risk assets

The US dollar is one of the most important prices in the world.

It’s the global reserve currency – everyone needs US dollars. As a result, when the price of US dollars goes up, you can view it as monetary policy getting tighter around the world (that’s an oversimplification, but it’s quite a useful one).

This is at least one reason markets have struggled in recent months; the Federal Reserve, America’s central bank, has been ahead of other economies in terms of raising interest rates, while the US economy has also looked relatively resilient. The US dollar is also a “safe haven” asset, which means that it benefits when investors are feeling jittery.

As a result of all this, the dollar has shot up in value against other major currencies. And risk assets don’t like that one tiny bit. As my colleague Dominic pointed out earlier this month, “if the US dollar keeps rising from here, it’s going to hurt”.

The good news is that after a burst higher, the dollar is now a little lower than it was when Dominic wrote that piece.

One key reason for that is the European Central Bank (ECB) – we’ll explain why in a minute. First, what’s the ECB done?

Well, yesterday, ECB chief Christine Lagarde came out with a blog post in which she – unusually for a central banker – was really quite clear about what the central bank will be doing over the next couple of quarters.

To summarise, she said that the ECB will stop printing money soon, it will start raising interest rates in July, and by the start of October rates will be back to 0% (ie, out of negative territory).

That’s quite an emphatic change for the ECB. As Marcus Ashworth says on Bloomberg, “I struggle to recall any central banker, certainly not one from the ECB, ever having been this definitive about the monetary policy outlook.”

There are probably two reasons for it. One is that the ECB has been lagging somewhat. Inflation has taken off in the eurozone too, but unlike the US, the economy has looked weaker so it’s been a tougher juggling act. But now it looks as though the hawks (for want of a better word) have won.

The second reason is that the euro was threatening to hit parity with the US dollar. In pure market terms, parity is just another number, no more or less significant than 1.01 or 0.99. But of course, it’s not actually just another number; it’s a big scary round number and one that grabs headlines. It’s probably best avoided if possible.

Part of a central bank’s role is to act as the guardian of the currency. That’s even more important in the eurozone than elsewhere because the euro is young and the lack of full political union between all of its member countries means there are still serious fault lines that could threaten its existence.

This risk has retreated greatly. During the sovereign bond crisis of the 2010s, the ECB, under Mario Draghi, effectively won the right to print money to suppress national bond yields – and thus underwrite the solvency of individual eurozone nations – where necessary.

But it’s better not to get to the point where markets decide to test your resolve on that front.

Why a stronger euro might be good news for markets

So why is this good news from a strong dollar front?

Because the euro is the “other” global reserve currency. It’s miles behind the dollar in terms of being stockpiled by central banks around the world, but it is the biggest component in the “DXY” index which measures the dollar’s strength against a basket of rival currencies. It is probably the most widely-watched barometer of dollar strength.

As a result, when the euro bounces against the dollar, DXY tends to fall.

And what with this being quite a hawkish turn for the ECB, the euro rallied from falling as low as $1.03-ish last Friday, to heading above $1.07 now.

Meanwhile, on top of that, it helped that one of the monetary policy setters at the Fed – Raphael Bostic, the head of the Federal Reserve bank of Atlanta – said that it might make sense for the Fed to pause for breath in September on interest-rate rises.

That’s hardly a wildly dovish statement (it implies half-point increases in both June and July), but with the market currently sweating that Fed boss Jerome Powell hopes to inherit the mantle of inflation destroyer from Paul Volcker, any sign that the central bank might relent is welcome to investors.

A weaker dollar would be good news for investors, as it implies that the rush for safe havens will ease and investors will start seeking risk again.

That doesn’t mean it’ll happen. However, one feasible scenario in which this might continue is one in which inflation ebbs (even while remaining high) and other central bank policies start to converge with that of the Fed.

That’s certainly possible over the coming months. Does that mean you should be piling in as if everything is back to the tech bubble days? Not at all; the environment has changed and the winners over the next phase will differ from those of the last.

But it does imply that the “crash-y” behaviour we’ve seen since the start of this year might be due a breather. Fingers crossed.

For more see:

If the US dollar keeps rising from here, it’s going to hurt

The tech bubble has burst, but I still want a Peloton

It has been “a crazy year for the Bourse de Paris”, says Quentin Soubranne on BFM Bourse. France’s CAC 40 gained 29% in 2021, making it the world’s best performing major stockmarket. The gain is the index’s best annual performance since 1999, as a strong economic rebound and easy money from the European Central Bank (ECB) pushed it to record highs.

The pandemic has changed the composition of CAC 40, says Bastien Bouchaud in Les Echos. Once the preserve of banks and oil companies, today the index is increasingly dominated by luxury and industrial firms. Between them the four big French fashion groups (LVMH, Hermès, L’Oréal and Kering) have generated “more than half of the index’s gains over the past two years”. Unable to travel, the world’s wealthy have been splurging on luxury goods instead. Green energy industrial firms and France’s handful of tech companies are also growing fast.

European stocks have had mixed fortunes

Elsewhere in Europe, it was a good year for Amsterdam’s AEX (up 27.5%) and Italy’s FTSE MIB (up 23%), says Danilo Masoni on Reuters. Germany’s Dax (up 15.6%) was less impressive, while Spain’s Ibex lagged behind, managing to climb just 7.4%. The pan-European Stoxx 600 index finished up by more than 22%, its second-best showing since 2009 – although this still lagged the near-27% gain of America’s S&P 500 index.

The big question for 2022 is whether European stocks can finally beat the S&P 500, which has delivered superior returns for most of the past decade, says Nikos Chrysoloras on Bloomberg. Strategists at Deutsche Bank and Jefferies think they might. While the US Federal Reserve is poised to start hiking interest rates soon, the ECB has indicated that it is in no hurry to do likewise. That should provide more of a cushion for European stocks, as easy money usually finds its way into markets. Valuations in Europe are also less stretched than in America. US price-to-earnings multiples are now 10% above pre-pandemic levels, but those in Europe remain 20% lower.

Inflation risks

The outlook for the first part of the year is encouraging, says Martin Skanberg of Schroders. Eurozone corporate profits rose roughly 50% year-on-year in 2021, with companies able to protect margins by passing price rises onto consumers. The continent boasts plenty of “market leaders” in the popular green themes of “renewable fuels, electric cars or metals recycling”. The big risk is that with inflation running at 4.9% in November, the ECB may yet be forced to tighten monetary policy more quickly than expected. As elsewhere, that could spell the end of the stockmarket party.

A new variant of Covid-19; a scandal swirling around Boris Johnson – there are lots of things that we can be sure will happen during 2022. Investors will have already taken them in their stride, but what are the unexpected twists, the surprises that no one saw coming? With an obvious pinch of salt, here are five events that might rock the markets over the next 12 months.

Bezos will be back at Amazon

First, Jeff Bezos returns to Amazon. In July when the world’s most relentlessly driven entrepreneur stepped back from day-to-day management of the company he founded to spend more time with his space rockets, the share price hit an all time high of $3,800. It was a fantastic achievement. How has it done since Andy Jassy took over? Well, it has hardly been a disaster, but it has been gently declining since then, with a steady fall to $3,400.

There have been worrying signs that the company is not quite as remorseless as it was with Bezos at the helm; labour costs have been rising and sales growth has slowed. It would hardly be a shock to anyone if Bezos decided to take personal control again – he is not the kind of person willing to sit back and watch the company he created lose its edge.

A change at the top of the ECB

Next, a change of leadership at the European Central Bank. Christine Lagarde, a lawyer with no formal experience in banking or finance, was always a very political choice. That would be fine if she just needed to run a steady ship, but the ECB is about to enter the stormiest waters of its short life. Inflation is already up to 5% in Germany and will go a lot higher still (just take a look at the price of natural gas).

This will be unacceptable in a country where most savings are held in the bank and there is a pathological fear of inflation. If it breaches 8%, Olaf Scholz, Germany’s new chancellor, will demand Lagarde is replaced to placate domestic public opinion.

Russia and China strike a deal

Thirdly, a Russian-Chinese pact. The Russian president Vladimir Putin’s massed troops on the border with Ukraine will turn out to be just a bluff; by the spring, he will have extracted the concessions he wants. Ukraine will stay out of Nato and he will get the pipeline to take Russian gas straight into the German market.

The real action will be elsewhere. While the West is distracted, Putin and China’s president, Xi Jinping, will strike a wide-ranging geopolitical partnership. The two countries will commit to working together, militarily, economically, financially and diplomatically. The West, led by the United States, will have to work out how to respond to the most serious threat it has faced since the end of the Cold War.

France will have a new president

Fourth, Emmanuel Macron loses the French presidency. The markets have complacently assumed that the centrist Macron is a certainty for re-election in April next year, but no sitting president has won a second term since Jacques Chirac in 2005. It would be rash to assume that Macron will be the person to break that record.

The National Rally leader, Marine Le Pen, is fading, and so is the Trump-like TV personality, Eric Zemmour, but the centre-right candidate, Valérie Pécresse, is a real threat. The polls are starting to suggest she can edge out her far-right rivals to make it into the second round.

If so, she will shift Macron to the left, and she stands a very good chance of beating him. There is nothing very radical about Pécresse, and she won’t make any huge shifts in policy, but France is now the largest debtor in Europe. Any sign of political instability will make the debt markets very nervous.

A bust-up at the US Federal Reserve

Finally, Jerome Powell quits as chair of the Federal Reserve, America's central bank, after a bust up with the White House. Inflation in the US has already hit 6.2% and will go much higher. Powell will press for far higher rates, US president Joe Biden will resist and Powell will walk away.

That will trigger a collapse in confidence in Biden, a spike in bond yields, and falls on Wall Street that will send shockwaves through the global economy. Biden will have to appoint someone even more hawkish on inflation to restore confidence – and the battle to bring inflation under control will be a lot harder.

Investors have long despaired of Italy, says Miles Johnson in the Financial Times. The economy has barely grown since 2000. “Anyone who purchased Italian equities at the start of 1999… has lost a fifth of their investment.” But now things are looking up under prime minister Mario Draghi’s unity government.

Italy’s government debt-to-GDP ratio of 155% is the second-highest in Europe, behind only Greece. For now, massive bond buying by the European Central Bank (ECB) is keeping borrowing costs low: at 0.85% Italy’s ten-year government bond yield is barely higher than the UK’s. But a brief spike in the gap with German bond yields earlier this month was a reminder that Italian debt is underpinned by the ECB’s stimulus. To solve its debt problems Italy needs growth.

Reform in Rome

Draghi’s government is shaking up Italy’s sluggish bureaucracy and courts, says Anna Momigliano in Foreign Policy. “By far the slowest in the European Union… civil proceedings can often last up to seven years,” which scares away international investors. The government is giving extra resources to the overwhelmed judiciary to help clear a backlog of cases and is imposing a new timetable to accelerate legal processes. Rome will receive the biggest slice of the EU’s pandemic recovery fund over the next five years: €191.5bn. Spending priorities include insulating buildings and rolling out new digital and rail infrastructure. That money should provide a steady tailwind for the economy. Italy’s FTSE MIB index has returned 23% so far this year, more than double the FTSE 100’s performance over the same period.

A country that has had seven prime ministers in the past decade is enjoying a rare moment of political calm, says Tom Rees in The Daily Telegraph. But another storm may not be far away. The Italian president’s term ends next February and Draghi is tipped to replace him. That could lead to early elections the far right is well placed to win. Investors have long feared that outcome, but Italy’s right is not the threat to the euro that it once was after toning down its criticisms of Brussels in recent years.

A key concern is that a new government could unpick Draghi’s reforms, says Nick Andrews of Gavekal Research. Yet Brussels has a “trump card… it can pull the plug on recovery fund transfers”. That should encourage Italian politicians to keep reforms on track. Italy’s debt woes date back to the 1980s, a period marked by excessive spending and overmighty trade unions.

Rome has done a better job at balancing the books since it joined the euro, but a lack of growth has kept debt levels high. Turning around the economy is a formidable task, but for “the first time in decades Italy does look to be headed the right way”.

Yesterday, the European Central Bank (ECB) re-affirmed that it has no intention of raising interest rates for the foreseeable future.

Markets didn’t especially care.

The euro’s value against the dollar – probably the best barometer of whether anything about the move came as a surprise – was barely changed.

And yet, I think it’s more important for investors in the long run than they might realise...

Central banks are spelling it out for us – they will tolerate higher inflation when it comes

The ECB recently moved to follow the US Federal Reserve by swapping to a new inflation target. It went from targeting “below, but close to 2%” to having a target that centres on 2% instead. In other words, it’s like the Bank of England – 1% or 3% is equally good/bad, as opposed to 3% being much worse than 1%.

Yesterday, at its latest meeting, we got a view of what that actually means in practice.

As Cedric Gemehl points out for Gavekal, it means that interest rates are going to be stuck where they are for a very long time indeed.

Without getting bogged down in details, the ECB raised the bar on what it needs to see or expect from inflation before it will actually raise rates – or importantly, stop quantitative easing. Put simply, the new framework “virtually guarantees no rate hikes until 2024 at least”.

You might think: “So what?” And on one level you’d be right.

It’s not as though inflation has been an issue up until now. Indeed, deflation has been the bigger threat for a long time. So why does it make any difference if the ECB says that it will tolerate higher inflation for longer, if inflation is nowhere near being a problem in any case? It’s not as though it promised to do anything new to create more inflation either.

So why does this matter?

Mainly because it’s a massive signal. Right now, markets are undecided about what’s going to happen as far as inflation goes. Is it “transitory”? Will central banks jump in and stop it in its tracks if it turns out not to be?

The reality is that central banks are spelling it out for us.Why do they keep saying that inflation is transitory? So that they don’t have to do anything about it.

Why do they keep saying that they will tolerate higher inflation or a longer period of time? Because they will! They don’t intend to do anything about it, even as and when it erupts.

This is just yet another signal as to the direction of travel. It’s another whopping great clue for markets – yet they still seem unconvinced.

Why are markets still so confused?

What’s going on? It’s quite likely that all that’s really happening here is that markets are struggling to recognise a trend change, because the previous trend has been in place for so long. Bond yields have been going down for about 40 years. Betting against that has been a losing battle.

The central bank legend is that Paul Volcker, head of the Federal Reserve in the late 1970s and most of the 80s, beat inflation by driving interest rates to devastatingly high levels.

This is true, but Volcker did it because, politically, inflation was a serious problem. Think about it: in what other context could you put interest rates up to double-digit levels without causing a revolution? It was a painful decision – and even a bold decision – but in many ways he had no choice.

Inflation was regarded as the enemy then; Ronald Reagan has that famous quote comparing inflation to a mugger. That’s just not the case today. It’s not a campaigning issue for politicians.

Anyway, Volcker’s actions mean that central banks have become synonymous with crushing inflation. Central bank independence has then bolstered that reputation.

And yet, maybe the causality is the other way around. Just as Volcker crushed inflation because it was ultimately the least politically painful option, making central banks independent was politically convenient at the time.

The whole point of making central banks independent was to protect monetary policy – and the national currency – from politics. The temptation to cut interest rates to add a bit of buzz to the economy ahead of an election was always going to be too great. So making them independent was a great way to make politicians seem like disciplined, transparent technocrats.

But the reality is that we were also living in a hugely disinflationary environment. From the internet to the fall of the Soviet Union to China joining the global economy – all of those things have relentlessly driven down costs (including wages). In effect, we had massive new capacity over that period (which – because the downsides were essentially unacknowledged or swept under the carpet – helped to create a lot of the tensions that gave us the politics we have today).

So it’s no coincidence that central banks gained their independence at roughly the same time as our biggest political concern was that there was little difference between the parties in power. They were made politically independent because independence had no actual bite to it, because there was a clear consensus on how the economy should be run.

It’s a good illustration of how good human beings are at applying a cloud to every silver lining. Today we whinge about polarisation; back then we whinged about consensus. Maybe we’re just always whingeing.

Anyway, for more on all of this, you really should listen to Merryn’s recent podcast with Russell Napier, in which he traces many of our current structural problems back to the Asian financial crisis, and central banks’ reactions to it.

But getting back to the point in hand: politically, inflation is now the goal. Not only that, but the underlying conditions are clearly far more inflationary than they have been for decades. Meanwhile “independent” central banks are changing the rules right in front of us. Tracing the exact causality of all of this is not easy, so I’d just suggest that you see it all as a symptom of one thing – the trend is changing.

The reason that markets aren’t reacting is because they’re already somewhat financially repressed, and also because trends are like supertankers – shifting them takes time.

This is probably a good thing, because when it does turn around, it will have an impact on virtually every aspect of most people’s financial lives.

I’ll be writing in more detail on the drivers of inflation and how to position your portfolio for its resurgence in an upcoming issue of MoneyWeek magazine. If you’re not already a subscriber, click here to get your first six issues free.

Until tomorrow,

John Stepek

Executive editor, MoneyWeek

The most important divide in the governance structure of our secular era – the theoretical separation between independent central bank and state – is being eroded on a daily basis.

It’s growing ever harder to tell the difference between fiscal and monetary policy.

And that matters, because you get to vote on one of them, and you don’t get any say at all on the other.

Once again, the Bank of Japan is leading the way.

Central banks are getting into industrial policy

The Bank of Japan is launching a “green” lending facility. The mechanism will be used to provide cheap funds to infrastructure (and other) projects that contribute to Japan becoming carbon neutral by 2050.

So how will this work? The Bank of Japan will offer interest-free funds to banks for “climate-linked loans or investments”, reports Bloomberg. There will be “no limit” to “rolling over the funding” – in other words, these are effectively permanent loans.

So commercial banks will have an incentive to make sure they are lending to “green” projects because they’ll get the money for nothing from the central bank, meaning they should be able to make bigger profit margins on their loans or investments. They’ll also get charged less for holding money with the central bank.

The Bank of Japan also said it will buy “green” bonds that are denominated in foreign currencies (it already buys overseas bonds).

This is a pretty interesting development. Central banks have been talking about getting involved in “green” finance for a while. The Bank of England has been told to take “green targets” into account when looking at which corporate bonds to buy. And the European Central Bank (ECB) has been talking along similar lines.

The idea here (as with ESG – environmental, social and governance – investing) is to drive up the cost of funding for companies that engage in carbon-intensive activity. In some ways, it’s a “nudge” along the lines of sin taxes.

However, this is also pretty controversial stuff. Central banks are (on paper) meant to be politically independent. That’s what monetary policy is all about: the central bank raises or lowers interest rates depending on the needs of the broad economy.

This is usually defined as keeping inflation at a certain level (usually 2%, a target basically invented by the New Zealand central bank in the late 1980s and then picked up by everyone else – Merryn reckons she found the paper they based it on, as we discussed in this podcast a month or so ago).

Once you start getting into the idea of favouring certain sectors or industries, that’s entering the political arena. That’s fiscal policy – making decisions about what to spend on, rather than simply the general level of money floating around the economy.

Indeed as, Germany’s Bundesbank boss Jens Weidmann – a perpetual thorn in the side of his more utopian-thinking ECB colleagues – argued before acquiescing, this move to make funding cheaper for “green” business is essentially a form of industrial policy, and that’s something the electorate should have a say in.

A giant green fig leaf

Of course, you can argue that a lot of this is pure semantics. The central bank derives all of its power and authority from the government, as well as its mandate, so the idea that they are in any way politically independent is nothing more than a fig leaf. But those things matter too.

On the one hand, in practical terms, it is 100% true to say that the Bank of England is just an arm of the government, and that when it buys gilts using quantitative easing (QE), it’s exactly like the government writing a cheque to itself.

On the other hand, one of the reasons this can happen without everyone freaking out about it is because we mostly accept that there are enough institutional checks and balances to prevent a government from using this money-magicking ability to do anything stupid, and to avoid relying on it in all but the most dire circumstances.

So you can do it after a financial crisis and you can do it after a pandemic, but you probably should try to avoid doing it for the rest of the time.

Of course, the trouble is that emergency measures have a habit of becoming permanent fixtures, particularly when any negative consequences are not immediately obvious. We’ve already seen that with QE (if it hasn’t caused hyperinflation yet, then why worry about doing more?), and we may see it with masks.

So the increasing politicisation of central banks is just another step down a slippery slope we embarked on decades ago.

How is the Bank of Japan justifying this? As always, there’s an emergency reason for it all. “Climate change could exert an extremely large impact on developments in economic activity and prices as well as financial conditions from a medium- to long-term perspective.”

This is all true (and true of many more potential future events that aren’t climate change) but it is also a very good example of a very large fig leaf indeed.

What constitutes a green project? We don’t know, because we now face too much of an emergency to spend time arguing about the framework, apparently. Is it really such great policy to be driving up the cost of our main energy sources when we don’t really know if we have effective replacements yet? Sorry, it’s an emergency; don’t have time to talk about that.

In some ways though, these are in themselves all side issues. It’s clear that the next step is to go from preferential interest rates for green projects to the central banks directly funding them, because it’s an emergency. That step will come if and when it turns out that we still have sclerotic growth even in the wake of all the latest post-pandemic upheaval.

At that point, it’ll be all about using the green infrastructure “emergency” to “stimulate” the economy, by building solar-powered monorails to nowhere rather than roads to nowhere or airfields that will never be used.

Anyway – central bank mission creep is just yet another reason why I expect the ultimate denouement of this cycle to be inflationary rather than deflationary. As for the investment impact – that’s worth keeping an eye on.

On the one hand, more money piling into green projects does suggest a “green” bubble will be very likely at some point. On the other, a side-effect of raising the cost of capital for fossil fuel companies is to also raise the return that investors expect (higher risk means higher returns). So stick with your oil companies for just now. We’ll have more on green bubble candidates in upcoming issues of MoneyWeek magazine. Get your first six issues free here.

You might have missed it, but a central bank actually raised interest rates this month.

Last week, Iceland’s central bank became the first in western Europe to actively tighten monetary policy since the pandemic began.

You’ll now get a whole 1% if you stick your money in an Icelandic savings account (in theory – yes I know some of you still bear the scars from last time).

The thing is, it’s not just Iceland. Quite a few central banks are now muttering about hiking rates.

So what does that mean for markets?

Central banks are starting to tighten

Iceland’s central bank raised interest rates this month. If we put aside the pandemic and the post-2008 general fear of tighter monetary policy, and just look at the economic data, it’s very obvious why it did so.

Inflation in Iceland is sitting at 4.6%; the bank targets 2.5%. Wages and house prices are rising, half of the adult population has had at least one jab, and the economy is set to grow by 3% this year and 5% the next.

Given all that, you can see how even the newly-raised interest rate of 1% might not seem overly restrictive.

Of course, Iceland isn’t the only economy which seems to be running hotter than its key interest rate would suggest. In fact, there are a great many such economies, and lots of them are now starting to think about tightening up.

So far this week, the central banks in New Zealand and South Korea have both called time on emergency monetary policy. The Bank of Canada did the same last month by scaling back its quantitative easing, and earlier this month, Norway confirmed it expects to raise rates later this year.

Our own Bank of England is also forecasting a much stronger economic recovery than it had previously expected, which in turn suggests earlier tightening, although the Bank has also been at pains to emphasise how conditional this all is.

Similarly, the bigger central banks are being much more cagey about how they discuss interest rate changes. The Federal Reserve, America’s central bank, has been very keen to emphasise its patience and the importance of employment data, partly because it is worried about a re-run of the 2013 “taper tantrum”.

The European Central Bank (ECB) meanwhile has been similarly keen to talk down prospects of higher rates or fewer bond purchases. This makes particular sense in the case of the ECB, as it’s always much harder to get the machinery rolling one way or the other when you have such a diverse group of nations jockeying for attention.

However, even in the absence of a clear desire to start increasing interest rates, investors now expect both the Federal Reserve and the Bank of England to raise rates a lot earlier than they did just a few months ago, notes Bloomberg. In fact, markets had expected the Bank of England to be cutting rates in late 2022, whereas now they’re expecting a rate hike. They also don’t see the ECB cutting rates any further.

China’s central bank, meanwhile, is indicating that it doesn’t mind the fact that the yuan is sitting at its strongest level against the dollar for years. There are many factors behind that, but it at least partly suggests that the authorities are more concerned about inflation than they are about growth.

In short, monetary policy – in terms of expectations – is already getting tighter.

Inflation is still the biggest long-term threat to your portfolio

This all helps to explain why the more speculative “growth” assets – the most interest-rate sensitive ones – have had a bit of a wobble this year in particular.

It also helps to explain why the US dollar has been getting weaker over the past couple of months, as the Fed lags behind much of the rest of the world in terms of perceived “hawkishness”.

And it also helps to explain why gold in particular has done well at a time when bitcoin (nicknamed “gold 2.0”) has had a much rougher period.

The question now is: what happens next?

For now, it looks as though markets are a little less worried about inflation than they were earlier this year. That concern probably peaked around about when it became the biggest fear of fund managers in Bank of America’s most recent global fund manager survey.

This easing of concern is partly down to the wave of mild tightening across the globe. If central banks are mostly now not ignoring inflation, then investors will be less concerned that it’s going to take off.

Does that mean we can stop worrying about it? Well, no.

What you have to remember here is this: none of this is about the absolute level of rates, or even the direction of rates. It’s about where central banks are relative to what’s going on in the “real” world.

Remember that prior to 2008, interest rates in most developed markets were a good way above inflation. So “real” interest rates were positive virtually all of the time.

Today, “real” interest rates are negative almost everywhere and have been for a long time. And if inflation keeps rising while rates remain the same, or just go up a bit slower, “real” rates will in fact fall.

It will be a bumpy ride. Obviously, you can never predict the future even at the best of times. Right now, there is an awful lot of extra noise in the data.

However, central banks – and the Fed in particular – are still erring very much on the side of caution. Politicians (and electorates) are in no mood for talk of public spending cuts. So the longer-term bias is towards central banks being “behind” the curve rather than ahead of it.

That in itself is a major shift, and one that doesn’t actually require us to hit rampant or even double-digit inflation to be disruptive to portfolios.

We’ve been writing a lot about this in MoneyWeek magazine and we’ll be writing a lot more on it. If you’re not already a subscriber, get your first six issues free when you sign up here.

Mario Draghi has a “grand plan” to transform Italy, says Hannah Roberts on Politico EU. The Italian prime minister wants to spend €222bn on a raft of projects, including rolling out high-speed internet, extending high-speed rail, “earthquake-proofing millions of homes” and improving the energy efficiency of public buildings. €191.5bn of the money will come from Next Generation EU, the EU’s landmark pandemic recovery fund. Another €30.6bn will come from extra Italian government borrowing.

The spending looks “well-targeted”, says Neil Unmack on Breakingviews. Italy badly needs to digitalise its public services, while €30bn will go towards addressing the country’s weaknesses in education and research. Italy has plenty of “catching up to do”: annual GDP growth has averaged just 0.3% over the past decade. Public debt is heading towards an eye-watering 160% of GDP. Reforming Italian governments often have “a short shelf life”.

A key priority for Draghi is reforming Italy’s sluggish courts, say Miles Johnson and Sam Fleming in the Financial Times. The World Bank reports that it takes more than 1,100 days to enforce a commercial contract in Italy. That’s almost double the average in other big EU economies and a deterrent to foreign investment.

Italy needs a Thatcher

The rise of the highly regarded former European Central Bank chief to the Italian premiership has cheered markets. The country’s FTSE MIB stock benchmark has gained 9.5% so far this year. Trading on a cyclically adjusted price/earnings (p/e) ratio of 21.9, the country’s shares are no longer the clear bargain they once were, although they remain slightly cheaper than the Japanese or French markets.

The eurozone’s third-largest economy has been a source of constant anguish for European policymakers, says Charlemagne in The Economist. The hope is that even if Draghi’s term in office proves short, he will leave behind a “new fiscal blueprint” that future Italian governments will be unable to discard. But the man is “not a miracle-worker”. A central banker can “pull a lever and money comes out”; in Rome, politicians often discover that the levers they pull are “connected to nothing at all”.

Fiscal hawks might question whether Italy needs more spending, but its high public debt is a “symptom” of deeper problems, says Roger Bootle in The Daily Telegraph. The country badly needs fundamental reform of everything from its byzantine tax code to its mediocre education system.

Stark disparities between the wealthy north and poorer south are another challenge. Distant though it now seems, before 1990 Italy was a “raging economic success story”; it was Britain that was the sick man of Europe. Transformation is possible, but Draghi will require the same “fortitude” as the iron lady to get there.

US president Joe Biden’s mammoth $1.9trn relief bill has left Europe’s own stimulus efforts looking scrawny, says Johanna Treeck in Politico. Figures from the Organisation for Economic Co-operation and Development show that US pandemic stimulus measures amount to 13% of GDP, much higher than the 7% spent in the eurozone.

That partly reflects America’s lack of a social safety-net, which forced Washington to step in with extra spending last year, Nicolas Goetzmann of asset manager Financière de la Cité told Aziliz Le Corre in Le Figaro. Nevertheless, there is now a “chasm” between US fiscal largesse and Europe’s more cautious approach.

The recovery gap

The result? The European Central Bank projects that the euro area won’t regain its pre-crisis GDP until the second quarter of 2022, a year behind the US. Europe’s policymakers are reluctant to part with their “old economic totems” of budgetary discipline above everything else.

The stockmarket doesn’t seem to mind, says Anna Hirtenstein in The Wall Street Journal. The Euro Stoxx 50 index is up by 7.5% for the year to date, compared with the S&P 500’s 6.5% gain. Italy’s FTSE MIB has returned more than 8%. The continent’s bourses are profiting from the ongoing “rotation” from growth to value stocks.

European markets are heavily weighted towards value sectors such as financials, industrial and energy companies, which jointly comprise 38% of the pan-European Euro Stoxx 600 index. The recent uptick in yields has also boosted the region’s unloved banks.

Super Mario

Despite a “sometimes sclerotic image”, Europe remains “a world leader” in sectors such as luxury goods (Louis Vuitton, Gucci), cars (Daimler) and “high-end engineering” (Siemens), notes Martin Sandbu in the Financial Times. An early push into green policies has helped renewable-energy businesses steal a march on the global competition.

Europe’s growing technology scene is often overlooked, adds Stefan Wagstyl in the same paper. While lacking household names to rival Facebook or Apple, the continent specialises in the “nuts and bolts” of industrial and business-to-business tech; Dutch firm ASML plays a vital role in global chip production. Europe isn’t perfect, but “it’s a lot better than many investors think”. The news is also brightening on the political front, says The Economist. Recent Dutch election results could make one of the EU’s most frugal members “a tad less parsimonious”. New Italian prime minister Mario Draghi is rallying support for much-needed reforms to Italy’s complicated tax code.

Mebane Faber of Cambria Investment Management notes that Italian shares started 2021 on a cyclically adjusted price/earnings (Cape) ratio of 19.8, a discount to Japan. On 18.7, German stocks are 50% cheaper than their US peers. Spain, on 13.6, is even cheaper than the FTSE 100. The lack of any US-style speculative exuberance in Europe, says The Economist, is a plus for investors seeking less GameStop-style drama and more “deep value”.

The European Central Bank (ECB) has the toughest job in central banking. Most central banks only have one government to keep happy. The ECB has 19 different governments to keep happy. On top of that, the country with the biggest and generally strongest economy (Germany) mostly has a different view on what monetary policy “should” be than everyone else does.

And yet, yesterday’s latest ECB conference shed some light on a common problem that all central banks are facing right now – credibility.

Europe’s economy is lagging and yet its bond yields have been rising too

While the US and the UK appear to be well on the way to reopening, Europe has been struggling somewhat. For various reasons, which we won’t bother getting bogged down in here (otherwise we’ll never drag ourselves away from the slanging match and back to the point in hand), Europe is lagging much of the rest of the developed world when it comes to vaccinations.

That in turn means that the recovery is going to be slower than had been hoped. Indeed, as Reuters reports, “growth is actually weaker than forecast... challenging expectations for a rapid rebound in spring”.

That’s a pretty stark contrast with the US in particular. And there’s also the fact that the US is spending a lot more than the eurozone is. Joe Biden has just pumped nearly $2trn into the US economy (when I’m treating $100bn as a rounding error, you know it’s a lot of money). Europe’s support has been more modest.

Now, we’ve spent a fair bit of the past few weeks writing about bond yields spiking in the US because people are worried that inflation will take off, because growth will be strong, and so interest rates will have to be raised sooner than expected. Clearly, the economic backdrop is different in Europe. So your logical conclusion might be that bond yields would reflect this, and stay relatively calm even as American ones rose. You would think, wouldn’t you? But not a bit of it. This year, eurozone bonds have seen “a steady rise in yields that has mostly mirrored a similar move in US Treasuries rather than reflecting improved economic prospects” for the eurozone.

So that’s left the ECB with a problem; arguably a trickier one than the US. In the US, the Federal Reserve – the US central bank – is basically trying to convince markets that it would rather focus on unemployment than on inflation, and therefore they shouldn’t worry that it’s going to raise interest rates. But in the eurozone, the rise in interest rates is happening despite a weak economy, and the risk is that if yields go much higher, they’ll start to impinge on the recovery. In short, the US doesn’t want tighter monetary policy, but the eurozone really can’t afford it.

So yesterday, the ECB took more aggressive action than anyone expected. To cut a long story short, it plans to buy eurozone bonds at a faster rate “over the next quarter” than previously planned. In other words, it’s going to do more quantitative easing (QE). This all comes about under its Pandemic Emergency Purchase Programme (PEPP).

Why? The ECB will “purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions”. In other words, it’s not going to buy a specific amount; instead it’s going to try to make sure that interest rates don’t go up too much. This is “yield curve control” by any other name (something that Lagarde explicitly denied, which only makes it clearer that it’s definitely yield curve control).

Eventually, central banks will have to ’fess up

This is where it starts to get tricky though. And this is where all central banks are having the same problem. Good central bank management is all about expectations. You don’t necessarily have to print lots of money or do anything terribly complicated. You just have to convince the market of a) your intentions and b) your ability to back them up.

Mario Draghi, as I’ve said many times before, was the master of this. In summer 2012, he talked his way out of the eurozone imploding by saying that the ECB would do “whatever it takes” to prevent the euro from disintegrating. He convinced markets that he would be able to get his way, and the acute part of the crisis was over.

These days, no one doubts the ability of central banks to back up their intentions – they’ve printed enough money to convince markets of that. However, their intentions themselves are more complicated. And this is where the communication problem is arising.

The problem is that central banks have mostly targeted inflation for the past two decades or more. But now that inflation looks as if it might actually be achievable, they’re going to have to shift the goalposts. Because the truth is that – with varying degrees of transparency – the job of central banks has changed. Forget inflation. The job now is to make sure governments can finance the public spending that they’ve decided is necessary to drive the post-pandemic recovery.

That involves keeping interest rates low, pretty much regardless of what happens to inflation. Indeed, significantly higher inflation would be a good thing as long as it doesn’t go too wild.

The thing is, it’s very hard for central banks to just say: “Actually in an ideal world, inflation would hit about 4% and be there for a long time, and we’d keep interest rates pretty much where they are, because that’s going to get rid of the debt in a politically acceptable timeframe”. Instead they must fudge it. Because if the central bank comes out and says that it’s going to ignore inflation, then what’s it for? Other than to buy government debt that no one else will buy at a given price? That’s not a question anyone wants to raise while there are still private holders to sell bonds.

But that then leaves the question: “How much is too much? How high is too high?” As Helen Thomas of Blonde Money puts it, “central banks must make credible commitments to one target. It can be a quantity, a price, or a time period”. At the moment, they aren’t giving the game away because it’s getting harder to maintain the necessary fiction that there’s a difference between “independent monetary policy” and “financing fiscal policy”. But that’s unsustainable, notes Thomas. “If central banks don’t improve their signalling and communication, they will be forced into it by the market.”

It’s one thing to say that you think inflation will be temporary, so you’ll “look through” it. But if the market disagrees with you and thinks inflation won’t be as temporary as you imply, that doesn’t help. And the reality is that it will test you until you push back. Which implies volatility and also confusion as central banks adjust their stances.

In the end, central banks may have to consider doing something radical like finding a completely different number for markets to fixate on. Employment seems an obvious one for the Fed. And where the Fed goes, others might follow.

Once markets understand that there’s a new regime in town, they’ll adapt (and to be clear, it’ll be a pro-inflation regime – it can’t be anything else). But while the mixed messages are continuing, it’s going to be a bumpy ride.

You can read more about all this in the next issue of MoneyWeek, out next Friday. If you’re not already a subscriber, get your first six issues (plus a beginner’s guide to bitcoin) absolutely free when you sign up here.

As we’ve said many times before in Money Morning, the US dollar is one of the most important – if not the most important – prices in the world.

Right now, the US dollar is on the slide. That’s good news, for reasons we’ll reiterate in a moment. A falling US dollar keeps the “reflation” trade intact and means asset prices are likely to keep rising.

So what – if anything – could derail this?

Here’s why the US dollar matters so much

Why is the US dollar so important? It’s because everyone needs US dollars. Close to 90% of all currency trading in the world involves the US dollar. Any widely traded good or commodity you care to mention is primarily priced in US dollars.

You can think of the US dollar as the oil that lubricates the machinery of global trade, or as the operating system on which global finance runs. In short, it’s the global reserve currency. One day, that might change. It has in the past. But that’s not today’s topic. Today we’re looking at far shorter-term issues.

So we’ve established that everyone needs US dollars. A logical extension of this point is that a weaker US dollar is in fact a good thing for markets and for the global economy. If the dollar is weak, then the dollar is cheap. If the dollar is cheap, that means there’s more of it around, it’s easy to get hold of when needed, and there clearly aren’t lots of people running around panicking trying to get hold of US currency.

Put even more simply, w

hen the US dollar is cheap, global monetary conditions are nice and loose. That’s good for risk assets (like equities, for example) and in particular emerging markets, whose need for US dollars makes them more vulnerable to spikes in the exchange rate. Right now, the US dollar is not especially cheap or expensive relative to history. But the good news is that it is getting cheaper.

The easiest way to look at the US dollar is via the DXY – a measure of the value of the US currency against a basket of the currencies of its biggest trading partners. Below, courtesy of Stockcharts.com, is a chart of the US dollar index going back for 20 years.

You can see that during the easy credit era running up to the global financial crisis, the dollar grew persistently weaker (note the little rebound in 2005 which was a brief period when it looked as though the party might end early, before everyone got back to the punchbowl again). As credit dried up, you can see that the US dollar spiked higher in 2008. Then during the post-2008 recovery process, the dollar fluctuated but on a broader view was flat, before taking off higher towards the end of 2014, as the European Central Bank (ECB) finally embarked on quantitative easing.

Why was this so significant? Because the euro is the world’s second-most widely-used currency. It’s a long way behind the dollar, but it represents the biggest weighting in the DXY basket. So when the euro goes up or down against the dollar, it has a big impact on the chart above. We’ll return to this in a moment.

But in any case – for most of Donald Trump’s time as president, the dollar has mostly been really pretty strong (above 100 in 2017 and at the start of this year, as Covid-19 produced a spike in demand for US dollars) but not quite strong enough to cause major problems. Ironically for Trump, it now looks as though Joe Biden will be getting what he, Trump, always wanted – a structurally weaker dollar. In all, that’s good news for risk assets and the whole “reflation” post-Covid trade. So what’s going on and what could throw a spanner in the works?

Why the European Central Bank will struggle to stop the euro from rising against the dollar

As hinted at in the chart above, one big factor in the dollar weakening has been the euro strengthening. Most of this is driven by differences in interest rates and rate expectations. But there are other factors too. One issue that has hung over the euro and kept it weak in recent years is the concern that it simply won’t survive. However, that fear is all but gone from the market now. That has helped the euro to rally in recent months.

However, the ECB won’t necessarily be happy about that. The persistent problem in the eurozone is that it has to make monetary policy for a set of diverse economies. Some (small, tourist-dependent economies like Greece and Portugal) need a weaker currency, while others (leading global economies like Germany) really should have stronger currencies.

When the US was recovering fast post-2014 and thinking of raising interest rates, while Europe was only just getting around to QE, it was easy to keep the euro weak. Conditions just aren’t the same today. And what makes things even trickier is that the eurozone is returning to its old habits – the need for political consensus means it is struggling to do things like push recovery budgets through, and take the sorts of aggressive monetary action that would be needed to keep a lid on the currency.

In turn, that means you’ve got a situation where markets can see a world in which the US does a lot of public spending, while the eurozone struggles to get much done. That’s not ideal for eurozone economies, but arguably if it helps us to stay on the path to a weaker dollar, it’s certainly good news for emerging markets.

The question is: will the ECB attempt to do something about it? The ECB has voiced concern about the euro rising above $1.20 in the past. But it’s now above $1.21, so there’s only so much that “jawboning” can achieve. There is another meeting of the ECB later this year – next Thursday in fact. They’d have to do something quite drastic to ignite the currency wars again and it’s unclear whether they’d have sufficient backing to do so.

So it looks for now, certainly, that the dollar weakness will continue unabated. That’s good news for the rally. Of course, in the longer run, it is possible for the dollar to get too weak – lots of countries export goods to America and they don’t want their currencies to rise against the dollar as a result. But for now, we’re a while away from that point.

In short, stick with the reflation trade. If you want to know how to play it, pick up the next issue of MoneyWeek, out tomorrow. (And get your first six issues free here if you don’t already subscribe).

There’s been a lot of talk from the Bank of England recently about introducing “negative interest rates”. So what on earth are they, and what would they mean for your money?

Usually, if you lend money to someone, you expect them to pay you the money back, plus interest. This is why your bank pays you interest on your savings – technically, you are lending your money to the bank. Interest rates are usually positive with good reason. After all, why would you pay someone else for the privilege of lending them money?

Nevertheless, several countries now have negative interest rates. For example, the European Central Bank’s main interest rate is currently minus 0.5%. Negative rates turn the financial world on its head. If a borrower borrows at a negative interest rate, they end up paying back less than they originally borrowed. In other words, savers are charged to save, and borrowers are paid to borrow.

So why would a central bank impose negative rates? The theory is that if savers are charged to save money, they will spend rather than save. In turn, that will encourage more economic activity and growth. In practice, it’s not at all clear that this is what happens. Indeed, some argue that negative rates have the opposite effect.

For example, rather than spend money, savers might just save even harder to compensate. And rather than invest in new capacity, companies might view negative rates as a sign that the economy is in dire trouble, and focus on using cheap borrowed money to buy back their own shares instead. On top of that, any companies with pension liabilities will find that those liabilities balloon as interest rates fall ever lower, which also discourages investment. Of course, none of this will necessarily prevent central banks in the UK and perhaps even the US from following their European counterparts into negative territory.

So far at least, negative rates only affect big institutional savers. Banks are not yet passing negative rates onto small depositors like you or I – although more might start charging for current accounts, which amounts to the same thing. Sadly though, you’re unlikely to get a negative interest rate mortgage.

For more on how all of this might affect your investments, subscribe to MoneyWeek magazine.

Digital currencies are catching on fast with central banks. The idea is simple. We know from the success of bitcoin and its rivals that electronic forms of money have carved out a place in the global financial system. In a world where trade and commerce increasingly takes place on the internet, it makes sense to have a safe and secure internet-based monetary unit as well. Bitcoin offers that in a purely private form. Now central banks are looking at issuing their own version.

A bitcoin for realists

Purists attracted to bitcoin for its outlaw, anarchic qualities may not like that, but many of us will have a little more faith in a monetary unit backed by a major central bank than in an obscure algorithm no one really understands. How many people remains to be seen. But it is likely to be quite a few – and probably a lot more than were ever willing to trade in bitcoins.

The European Central Bank is furthest down the track. Launching a discussion paper last week, its president, Christine Lagarde, said a decision on whether to go ahead would be made by the middle of next year. The Bank for International Settlements, which coordinates all the major central banks, last week put out a paper outlining the core principles for national digital currencies.

So far, the UK is simply keeping up with its rivals. The Bank of England has made its own plans for a new currency, as well as signing up for international initiatives. But it should be getting out in front and trying to win this race. At first glance, a “bitpound” may not seem a natural contender for global dominance, especially when compared with a digital dollar or euro. The British economy is relatively small in comparison. Sterling is no longer a reserve or trading currency of any significance, and the UK’s percentage of global output is only likely to get smaller over the next couple of decades as emerging countries keep growing. Yet the UK has three big advantages on its side.

First, it can take “first-mover advantage”. Apple with its easy-to-use smartphones, Microsoft with its operating systems, Tesla with its electric cars – there are countless examples of companies and products that have managed to secure lasting dominance of an industry simply by being there first. The same could easily be true of a digital pound. If there is genuinely a market for a digital currency backed by a central bank then potential customers will start using whichever one gets there first. Once they have started using it, inertia will mean they carry on. If the Bank of England got its skates on and launched its electronic unit before any of its rivals then it would create a permanent advantage for itself.

Second, credibility. The Swiss National Bank is also looking at a digital currency of its own. So why not team up with the Swiss, merge the two plans, and create a unit backed by the two oldest central banks in the world? In many ways, Zurich and Geneva are the two most complementary financial centres to London. They are flexible, deregulated and outside the EU. A currency backed by both central banks would have instant credibility in the markets.

Play to our strengths

Finally, we should use the strength of the City. A new digital currency will only be relevant insofar as you can actually use it. London has the huge advantage of being one of the biggest centres in the world for trading currencies (London has 43% of the global market for money trading, compared with 16% for New York, its closest rival), and it has the infrastructure of legal systems, traders, and consultants to support the industry. If trading in bitpounds was legally established from day one in the UK, and if, even better, we threw in a minor tax break or two, then it would help launch the currency, and steal a march on its rivals.

There is a big prize at stake and the

UK should be trying to win it. If a bitpound established itself as the world’s pre-eminent electronic currency then it would be a huge boost both for our technology and financial services industries, two key sectors for the British economy over the next decade. We’ll have to move fast.

The Bank of England’s governor, Andrew Bailey, has spoken of negative interest rates as being “in the tool bag”. Monetary Policy Committee (MPC) member Silvana Tenreyro says that the evidence for negative interest rates is “encouraging”. Yet Dave Ramsden, another MPC member, this week cast doubt on the idea that rates could fall below 0.1% without the policy backfiring.

Negative rates are supposed to stimulate bank lending by charging banks fees for any cash they leave stashed in their accounts at the Bank of England, says Ruth Sunderland in the Daily Mail. It remains an open question whether the banks would dare pass along negative rates to their own customers. Sweden’s central bank was the first country to experiment with a negative interest rate in 2009 when it began to charge banks interest on overnight deposits. Its headline interest rate went negative in 2015. The European Central Bank cut its deposit rate to -0.1% in 2014, followed by Switzerland the following year. The Bank of Japan cut its key rate to -0.1% in 2016. Negative rates have an underwhelming record as a stimulus measure. They have done little to remedy chronically weak inflation in the eurozone and Japan, says Brian Blackstone in The Wall Street Journal. They seem to have little effect on the amount that people choose to save and spend. Negative rates have also meant a miserable decade for European bank profitability.

There is evidence that negative rates reduce lending costs, but diminishing returns set in quickly. The debatable rewards of the policy should be set against the significant downside risks: inflated asset bubbles and damage to banks and pension funds, says James Mackintosh in The Wall Street Journal. Note that Sweden last year ended its negative interest-rate policy.

The new era of global central banking is well and truly underway, says Howard Davies on Project Syndicate. Last month Jerome Powell, the chair of the US Federal Reserve, announced that the central bank would become more tolerant of inflation passing temporarily above the 2% target. Last week, the Fed held interest rates close to zero and signalled that they will stay there until the end of 2023.

The new dovishness has been prompted by persistently low US inflation, which has undershot the target 63% of the time over the past decade. Where the Fed leads others will follow. The European Central Bank is currently conducting its own policy review. Some are keen for the Bank of England to follow, but matters are more complicated for the UK: thanks to the persistently weak pound, “average inflation has been more or less on target” in recent years.

Heading towards zero

The Bank of England’s monetary policy committee (MPC) held interest rates at 0.1% and continued the current quantitative easing programme at its most recent meeting. Minutes revealed that policymakers were briefed on plans to roll out negative interest rates in the future. Governor Andrew Bailey this week reiterated that the policy is “in the tool bag” but pushed back against suggestions that they will be brought in soon.

“Reading between the lines” it looks like the BoE will not be operationally ready to roll out negative rates until next spring, and then only if it wishes to do so, says Samuel Tombs of Pantheon Macroeconomics. In the meantime, policymakers will lean on more rounds of quantitative easing, which we expect to come around the new year. In the case of a no-deal Brexit, there will be even more quantitative easing and perhaps an interest rate cut to – “but not below” – zero.

MPC members will be studying the experience elsewhere in Europe, where negative interest rates are credited with arresting a deflationary spiral and boosting bank lending, says Tom Stevenson in The Daily Telegraph. Yet there is “scant evidence” that the policy increases economic activity and the effects on bank profits are dire. Beneath a certain level – known as the “reversal rate” – negative rates actually harm economic activity.

Investors adhere to the maxim that you “don’t fight the Fed”, says Jon Sindreu in The Wall Street Journal. The idea is that easy money means stocks are bound to rise. Yet this year’s tide of easy money has not lifted all boats: tech stocks have soared, but some other sectors have slumped. Perhaps there’s a simpler investment prescription for the new monetary era, David Rosenberg of Rosenberg Research tells Barron’s. The Federal Reserve’s “promise to nail rates to the floor” amounts to a giant “‘buy gold’ advertisement”.

If your dream is a United States of Europe you may not much mind a crisis: it is usually one of these that prompts a new step towards EU integration. So it is with Covid.

The strict lockdowns most EU governments adopted as their main pandemic policy have created economic carnage across the continent. The European Central Bank (ECB) has done its bit – but it also asked and asked for a dose of fiscal intervention as well. The Commission has delivered: its latest seven-year budget is to be bumped up with the €750bn Next Generation EU Fund (NGEU) to help the worst affected countries.

This comes with three interesting bits. The first is that the €390bn of the cash is to be distributed as grants, not loans – usually, the EU likes to pretend that it is not in the business of fiscally transferring between rich and poor EU members by dressing transfers up as loans (conditions can always be changed later).

The second is that the cash is to be directly borrowed by the Commission itself with the issue of new bonds with various maturities from three years up, extending to 2058, and guaranteed by its own revenues. Previously, Eurobonds have been jointly guaranteed by the EU countries, something the German public (the most likely to end up on the hook) have not always been mad for.

The third relates to the second – if the Commission is to guarantee payback from its own revenues (known as “own resources” in EU-speak) it’s going to have to bump them up. Right now, the Commission gets a smallish flow of cash from the EU countries in the form of customs revenues and a percentage of each country's VAT revenues. That’s not enough – so the new deal comes with a new ability for the Commission to raise its own resources via new taxes (on digital activities and carbon, for example).

This is all important. it means the Commission will no longer be just a middle-man between national tax revenues and EU spending: it can leverage its own budget with common debt. It also means that it can directly subsidise countries for the first time. Neither of these things could have happened (indeed, been imagined outside the minds of fanatics) this time last year.

You can argue that this is a one off, that the amount is not that big (€750bn is small beer in a money-printing world) and note there is an “emergency brake” in there (allowing countries to object to the way others spend grant money). But the history of EU emergency brakes is not a useful one.

We also know there is little so permanent as a temporary EU scheme that advances the federal cause: note the way in which the European Financial Stability Facility (created as a bailout vehicle in 2010) is still with us. Future crises are bound to be met with similar schemes. And the definition of a crisis will be fast watered down – particularly given the low rates at and ease with which the EU will be able to borrow.

The NGEU fund does, then, represent a real moment for the EU. But a Hamiltonian moment? No. This deal looks as if it brings EU countries closer together; as if it is the kind of muddle-through that makes the EU’s survival more likely than less. But there is a chance that its explicitness does the opposite. Several one-time red lines have already been crossed here – and the “own resources” one is yet to come.

Many EU populations already find their financial obligations to the EU irritating, but at least the cash they send it is non-direct. New taxes levied directly on their activities to pay for things they didn’t vote for might make them wonder again about the democratic legitimacy of the EU. Charles Michel, the European Council president, referred to the magic of the European Project when this latest deal was announced. Like all magic, it might work best in the dark.

In September 2011, gold hit an all-time high in US dollars of $1,923.70 an ounce. That was an intraday high (ie, it happened during the session). The closing high was a bit lower, set in August 2011 at $1,891.90.

Both of those highs have now been beaten. Gold ended the day on Friday at $1,897.50, a new closing high, while this morning it rose to a new intraday high of $1,944.39.

It’s only taken nine years. Good things come to those who wait, it seems.

Of course, you could argue that these numbers are not as significant as they might seem. As John Authors points out in his Bloomberg newsletter this morning, once you take inflation into account, gold is still below the 2011 US dollar high. That in itself was also below the 1980 high, which saw gold spike to $850-odds.

Also, gold has been setting new all-time highs in pretty much every other global currency for a while now. For example, gold’s 2011 high in pounds was around £1,180. Today, it’s around £1,500.

Lest you think this is purely Brexit-related, it’s the same story for the euro. A record high in 2012 (just after European Central Bank boss Mario Draghi drew a line under the eurozone crisis with his “whatever it takes” speech) of around €1,380 has given way to fresh highs above €1,600.

So, yes, gold still has a way to go to hit an inflation-adjusted dollar high. And yes, it’s a very dollar-centric way to look at things, given that gold has been hitting new records in every other currency for ages.

But the US dollar is the most important currency in the world. And the fact that gold has now hit a genuinely new high in said currency, means that it’ll draw a lot more attention than all the other new highs did.

What’s next for gold?

So, what now? In the short term, as with any asset, it’s anyone’s guess. You shouldn’t be worrying about the short term, because you’re not a day trader.

(But in case you are, be aware that the Federal Reserve is holding its latest meeting on monetary policy this week, with the outcome announced on Wednesday evening our time – so there’s the potential for volatility, setbacks, etc around that.)

In the longer term, we like gold for two reasons.

One, we see it as portfolio insurance. It’s something you should always have in your portfolio – along with bonds, equities (and property), plus cash – simply because it does something that no other asset class does.

Gold doesn’t rely on any other counterparty for its value. If you own equity, the underlying company can go bust. If you own a bond, the underlying company or government can go bust. And if own cash, the underlying government can go bust.

Gold is just an inert, relatively rare metal that human beings happen to place a value on. So it has “intrinsic" value.

That value goes up and down depending on what’s happening in the world. But it’s highly unlikely to go to zero until we can produce it out of thin air, in which case we’ll have solved the scarcity problem and we won’t need money anymore in any case.

That’s what makes gold unique. That’s what gives it its diversifying properties. And that’s why we reckon you should pretty much always own at least a bit of gold, regardless of the backdrop, or whether the outlook is bullish or bearish for the yellow metal. This is the reason why we’ve always told you to own it.

Conditions are ripe for further gains

However, currently we also like gold for a second reason – because the conditions are ripe for gold to continue to go higher. And while it’s now hit a record high (and so might take a breather, or might not), we still think there’s room for it to go higher.

I explained the key reason why in the most recent issue of MoneyWeek magazine (you can get your first six issues free here if you don’t already subscribe). But to cut a long story short, if inflation goes up and interest rates stay where they are, that’s good news for gold.

Obviously gold has come a long way. But the levels of exuberance (magazine covers, mainstream news appearances) that we saw in 2011 aren’t apparent yet.

That’s partly because gold’s got plenty of competition from the likes of tech stocks and Tesla to keep investors occupied. But it’s also because this has been a particularly stealthy and quick bull market.

I mean, it was only a few months ago that market pundits were pointing at gold’s slide during the early days of the coronavirus crash and joking about its “safe haven” qualities, having failed to understand that in a crash, the quality stuff (blue chips, Treasuries, precious metal) gets sold off to fund margin calls on all the dodgy stuff.

So, while I expect gold to get a few headlines now, and while we’ve seen the occasional big number target ($3,000 from Bank of America a few months ago), I don’t think we’re at the peak yet.

So, if you don’t own gold, it’s worth holding some. You can invest via bullion dealers (either get the gold and stick it in a safe, or pay them to store it for you). Or you can use an exchange-traded fund (ETF) – go for the physical-backed ones.

If you own gold, but you are interested in placing a bet on prices rising further, then there are other options to consider.

Silver has rocketed even faster than gold. It’s a brutally volatile, contrary, vicious metal (Dominic has written of his painful history with silver here), but if you have the stomach for it, then you could look into the silver ETF. Just bear in mind that silver really does swing about a lot – the last time it hit its peak of nearly $50 an ounce in April 2011, it practically halved in value the following month.

Another potential catch-up play is the precious metals miners. These have come a long way since their coronavirus March lows (the junior miners ETF has more than doubled, for example). However, if gold stays at these levels or goes higher, then they should be able to rise a good deal further.

Last time gold was at these levels, the miners were spraying cash around the room like they had their own personal central bank printing presses. These days there’s less exuberance, as Dominic recently pointed out.

Which miners? We’ve discussed some individual ideas in MoneyWeek magazine (another good reason to subscribe), but if you’re not a stock picker – and bear in mind that even a mining index is risky let alone buying individual miners – then sticking with a tracker or a gold mining fund is your best bet.

The implications of a soaring gold price are not necessarily happy news for most other assets. But we’ll discuss that another day. This is why we diversify, after all.

People often joke that the past is a foreign country. When it comes to financial markets, it seems more like another universe. So many extraordinary things have happened since we launched the magazine in November 2000 that, if I went back in time and tried to explain it all to my younger self, he would suggest I go and lie down in a dark room. First and foremost, we actually had interest rates in 2000. The Bank of England’s base rate was 6%. The European Central bank’s (ECB) was 4.75%. We analysed the euro’s enduring slump against the US dollar in a section called Euroviews. Along with Dotcom Disaster of the Week, it was my favourite part of the magazine.

In stockmarkets, air was hissing gently out of the dotcom bubble. Analysts spoiled by the longest bull market on record – valuations in the US, which sets the tone for world markets, rose steadily between 1982 and the March 2000 peak – were more bullishly bullish than ever, refusing to believe that stocks would suffer anything other than a mild correction. Buy on the dips, they said. It will be fine.

We didn’t think it would be fine, because we read beyond the City and Wall Street’s hype machine. History shows that market cycles, just like economic ones, go in ups and downs, with long periods (typically well over a decade) of valuations rising from very low to very high and back again as investors alternate between exuberance and despair. In 2000, we were due a long-term, or secular, bear market.

The economist Joseph Schumpeter talked of “creative destruction”: recessions were necessary correctives to booms, a cleansing and resetting process that paved the way for a healthy upswing. They clear out dead wood and prevent economies from developing longer-term structural problems – by becoming too skewed towards certain sectors, for instance. Secular bull and bear markets showed that markets had Schumpeterian cycles too.

The dead hand of the state

But what happens if they aren’t allowed to complete them? That is the recurring theme of the past two decades. Central banks have waded into markets to such an extent that downturns have been artificially tempered or repeatedly postponed. This has caused all sorts of new problems in markets and economies that could ultimately land us in far bigger trouble in future than if we had let markets correct naturally.

Returning to the early-2000s bear market, remember what happened after stocks lurched down again in 2002, terrifying the life out of the bullish establishment. In 2003, US Federal Reserve chairman Alan Greenspan slashed rates to just 1%, cementing a pattern he had started to establish in the late 1980s: whenever markets wobbled, he would come to the rescue with cheap money. Stocks duly bounced and the economy ticked up, although we were among those pointing out that the upswing was unusually sluggish. The US labour market, for instance, took far longer to recover its losses than after previous recessions. But central bank action put a floor under stocks, propelling them upwards despite a lacklustre economic backdrop. All the cheap money encouraged rampant speculation across all asset classes, especially in property derivatives. Enter subprime.

Bubble, bubble, toil and trouble

When that bubble burst, central banks slashed rates to nearly zero and resorted to emergency measures. Until then, quantitative easing (QE), injecting cash into the system by buying bonds with printed money, was a policy that only existed in economic-theory textbooks in the Western world (Japan had dabbled in it a few years before). But suddenly, in the years after the financial crisis, it become part of the standard central-bank toolkit. Britain, America, Japan and the ECB all resorted to it.

It did little for economic growth. If you have just gorged on an eight-course dinner, suddenly getting a free or very cheap meal won’t restore your appetite. Similarly, economies soaked in public or private debt didn’t borrow more just because money was practically free. The Anglo-Saxon economies and the eurozone all recovered from their debt crises extremely slowly and hesitantly. Post-2009, Western economies have essentially been trying to walk up a down escalator with a heavy suitcase.

Freshly created money has to go somewhere, however, and it tends to find its way into asset markets. All the liquidity lifted bonds and equity prices. Government debt, which had been in a bull market since former Fed chairman Paul Volcker squeezed inflation out of the system in 1981, just got more and more expensive, with yields sliding lower and lower and eventually falling below zero. Developed-world equities embarked on another multi-year upswing without having reached the valuation lows associated with long-term bear market bottoms.

The extreme becomes mainstream

By the time global growth appeared to be faltering in 2019, slashing rates and printing money to buy assets weren’t emergency measures anymore; they were standard policies. The Fed, having raised rates in baby steps and soaked up some of the money injected into the system by QE, reversed course. It cut rates three times in 2019, even though the relatively solid data showed no sign of an imminent collapse in growth. The ECB made clear it was frustrated by persistently low inflation and hinted that it might add equities to its QE programme. Japan had been hoovering up anything that wasn’t nailed down with printed money since 2012. It owns 75% of the exchange-traded fund (ETF) market. So nobody there batted an eyelid at the ECB’s extraordinary suggestion.

The trouble with resorting to emergency measures as a matter of routine, however, is that when a real emergency hits, you really need to produce something special. So when Covid-19 arrived, central banks threw the kitchen sink at it. The Bank of England’s latest QE programme is literally QE on speed: in the past few weeks it has been buying bonds at twice the rate seen during the financial crisis, says Capital Economics. The Fed is wading into the corporate debt market with its latest blast of QE. It is buying junk bonds. Junk bonds. It is this sort of thing, along with the ECB potentially buying stocks, that would make my younger self’s jaw drop. It would drop further if I told him that several major emerging markets are doing QE now too.

Markets don’t work anymore

Where has all this liquidity got us? The Fed’s balance sheet has soared to over $5.3trn. That’s well over a quarter of the country’s national income. And if you think that’s a lot of printed money, consider that Japan has now bought assets worth more than its GDP. It owns half the government bond market. All this and it has yet to lift inflation significantly. But on it charges: it wants to quadruple its holdings of commercial paper and corporate bonds. Credit-ratings agency Fitch calculates that the central banks of America, Japan, Britain and the eurozone will buy $6trn of assets this year. That’s three times their 2013 haul, which was the previous peak. The Fed, the ECB and the Bank of Japan collectively have balance sheets worth about $18trn. For perspective, global GDP is $86trn.

It’s clear that simply hosing economies with liquidity doesn’t galvanise them into growing faster. But it also has several negative side-effects that boil down to one key problem: it stops markets working properly. This is clearest in the bond market, where QE has seen off the so-called bond vigilantes. Back in the old days, governments would be discouraged from borrowing and spending too heavily because bond markets would sell off their paper, raising yields (implied long-term interest rates) and thus punishing spendthrifts.

But now central banks are underwriting bond markets with QE, profligate governments are off the leash. It doesn’t matter how reckless they are: rates will stay low because bonds are always being hoovered up. Stocks, meanwhile, will always find a floor, even though valuations have never fallen to levels that in the past implied the start of a long-term bull market.

Then there are negative interest rates. Just over $11.4trn of debt worldwide has a negative yield, almost a fifth of the world’s total. Some central banks, notably in Europe, have pushed short-term rates below zero. As far as bonds are concerned, this is encouraging speculation. If you hold a negative-yielding bond to maturity you make a loss, so the only way to profit is to sell it on to someone else and make a capital gain.

More fundamentally, being paid to borrow, and not earning interest on savings, is a distortion of basic economics. Based on the price of money, we choose to borrow and spend because we think we can make a higher return than the cost of money. If money is essentially free, we will be more reckless than usual, storing up future trouble – or perhaps so fearful given this absurd backdrop that we will sit on our hands. Either way, it bodes ill.

Time to panic?

Central banks, then, have landed us with two fundamental problems. Firstly, “markets have lost the capacity to self-adjust and correct”, as Doug Noland of the Credit Bubble Bulletin puts it. And the price of money has lost its meaning. At the macroeconomic level, distortions caused by years of interference have included the rise of zombie companies – unviable businesses that only still exist because interest rates are so low – and economies unhealthily skewed towards the financial sector, as we witnessed in the run-up to the 2008 crisis. “The saving grace of capitalism, its often cruel efficiency, is steadily being lost”, says John Authers on Bloomberg.

World markets are going further and further through the looking glass. Quite how all this monetary dysfunction finally comes to an end is unclear; we suspect it will be through a nasty bout of inflation, and we will explore the issue in depth in future MoneyWeeks. But for now, we find ourselves in the same position as throughout most of the surreal past two decades: cyclically bullish owing to the sheer amount of liquidity sloshing around; structurally bearish because the entire global market edifice is so hideously flawed; and holding on more tightly to our gold than ever before.

Central banks, alongside governments, are going all-out to tackle the disruption being caused by the coronavirus outbreak. We’ve had “Save our Small Businesses” from the Bank of England. We’ve had “QE Infinity-plus” from the Federal Reserve. We’ve had “Let’s Become the Biggest Shareholder in Japan Inc” from the Bank of Japan.

And now we’ve got the most controversial of them all – “Operation Bailout Italy” from the European Central Bank.

What’s the difference between fiscal policy and monetary policy?

Last week, the European Central Bank announced plans to buy another €750bn of bonds (via quantitative easing – ie, printing money) in order to underwrite the region’s economy.

Now, QE was always controversial in the eurozone. Ultimately, it’s a form of monetary policy that very much crosses the line into fiscal policy territory.

Let’s take a step back and explain that for a moment. Put simply, monetary policy is stuff the central bank does. The elected government gives the central bank a job. That job is to keep inflation at a certain level, or employment at a certain level, or both, depending which central bank you’re talking about. The central bank then does that job by moving interest rates up and down.

That’s it. It’s a deceptively simple job and it doesn’t involve doing anything other than trying to stick to the rules the elected government has laid down for you.

Fiscal policy is stuff that governments do. That’s because it typically involves the redistribution of money. So this is things like tax policy and welfare and infrastructure spending. The key is that fiscal policy is really all things that voters, via democratically elected governments, should be giving the nod to.

In practice, the line is blurred anyway. If you cut interest rates, you take from one group (savers) and give to another (debtors). But having an explicit target means you can say: “just doing my job, guv”.

So why does QE blur the line so much? Because it takes us much further into the realm of picking winners and losers. It’s still hotly contested (mostly by the people behind the policy) but QE tends to boost asset prices and thus deliver gains for people who own assets. That means it arguably increases wealth inequality, for example.

And to the extent to which it is inflationary (also hotly disputed), it favours certain groups (debtors) over others (savers). So if you’re going to take steps that are as radical as this, then arguably there needs to be some democratic oversight.

The reality is that this doesn’t matter in most countries, because the idea of central bank independence is a convenient figleaf. When push comes to shove, the central bank is an arm of the government and it does what the government wants. This is not a conspiracy theory, this is just very clearly the nature of things.

Unfortunately for the eurozone, it matters a lot more there, because the European Central Bank (ECB) is the central bank (the one that really matters) for several countries. And not all of them agree on the course of action that it should take.

Moreover, if you are picking winners and losers then it means that (whether in reality or merely in popular perception), some countries are going to be bigger winners and others are going to be bigger losers.

Even when the ECB was merely shifting interest rates up and down in the days before the financial crisis, there was a level of tension involved. Rate policy tended to be set with the dominant German economy in mind. This was struggling at the time, which meant that much of the time rate policy was far too loose for the likes of Spain and Ireland, who saw property booms as a result.

Now that money printing and other radical measures are on the cards, it’s far more controversial.

The European Central Bank rips up the rulebook

So what’s happened now? Well, when QE was first introduced to the eurozone, the ECB had limits on what it could do. The central bank said that it would not buy more than a third of any country’s eligible bonds.

That, as the FT points out, “was put in place to ensure that the ECB does not buy so many bonds that it is accused of directly funding national governments, which is against EU law.”

Problem is, markets are vicious things when they spot a loophole. The coronavirus crisis has raised fresh concerns about the solvency of certain eurozone countries – Italy most prominently.

Italy has to spend a lot of money to get over this and it’s also going to be whacked with a massive recession. It was never a healthy economy in the first place and it has vast levels of government debt (that said, in many ways France is in a far worse state, but that’s a story for another time).

Anyway – so a key indicator of distress in the eurozone has been that Italian government debt has started to yield a lot more than German government debt (the “spread” has widened). And you can see the problem here. The closer that the ECB got to its one-third limit, the harder the market would have pushed the matter.

The ECB couldn’t let that happen – particularly after new boss Christine Lagarde messed up badly by arguing that the spreads were of no concern of the ECB at a recent press conference.

And so it has tossed the one-third rule aside. I suppose you could say that it will now buy “whatever it takes”.

As Frederik Ducrozet at Pictet put it: “In a nutshell, the decision removes virtually all constraints on asset purchases, in a further boost to the credibility of the ECB’s commitment.”

Italian government debt and Greek bonds surged in price (ie, yields fell). This is unsurprising, as essentially the eurozone now has one single lender of last resort, with ultimately unlimited buying power, standing behind all debt issuance in the eurozone. Suddenly the “convergence trade” (where all countries are basically Germany) makes sense again.

What does this mean? For me, it kicks out another pillar of the “deflationist” argument. The potential collapse of the eurozone has been the biggest deflationary risk in the years following the global financial crisis. But if the ECB is effectively underwriting the financial system in the same way as the Fed and the Bank of Japan and the Bank of England, then this won’t happen.

That’s not to say that the eurozone might not disintegrate for political reasons as these crisis-led steps to ever-closer integration are pushed through without voters really quite grasping what’s going on. But that’s an issue further down the line.

Right now, everyone is too worried about the impact of coronavirus to raise huge objections and even Germany is turning on the spending taps.

The helicopters are taking off all over the world. Will inflation follow? I suspect it's only a matter of time. And what does it all mean for markets? I’ve given our view in the latest issue of MoneyWeek magazine, which comes out tomorrow. Subscribe now to get your first six issues free.

Quick, immensely simplified history lesson this morning. Very quick. The world used to be on the gold standard. Every country’s currency was tied to gold. If you wanted to do business with other countries, you needed to hold enough gold to do it.

Trouble was, when a crisis hit, everyone wanted to get their hands on gold, and there wasn’t enough to go around. That tightened monetary conditions drastically. In other words, you couldn’t get your hands on money for doing anything else. That in turn made cratering economic conditions much much worse. That is pretty much a potted history of why countries dumped the gold standard.

Why do I bring it up this morning? Because the exact same thing is happening with the “dollar” standard right now...

Here’s why the dollar is soaring

Markets were so ugly yesterday that it was pretty easy to ignore what would otherwise have been the biggest story of the day – the fact that sterling plunged to its lowest level against the US dollar since the days of the miners' strike.

It’s partly because the Bank of England and the chancellor have been more aggressive than most countries so far in terms of financial support pledged to the wider economy.

The chancellor is promising a package worth at least 15% of GDP, while the new governor of the Bank of England – Andrew Bailey – has basically promised open-ended quantitative easing to provide working capital for big businesses. He also said he remains open to printing money to fund government infrastructure projects, which is pure MMT (Modern Monetary Theory).

Given those moves, you’d expect sterling to struggle a bit. (The European Central Bank has caught up a bit since but it’s still moving at its usual sluggish pace in terms of getting ahead of events).

However, this isn’t really about the pound. It’s about the dollar. The US dollar is the global reserve currency. When things go properly pear-shaped, there’s only one asset that everyone really wants, and that’s cash. And the specific form of cash they want is US dollars.

If you have US dollars in a crisis like this, you can ride out the ups and downs. US dollars represent the ultimate form of liquidity (and yes that includes gold – liquid but still volatile – and even US government debt).

But demand for dollars is so high that it is strangling the money available for anything else. It’s similar to the problems of being on the gold standard all over again.

The advantage of the dollar standard (and you can argue that this is a disadvantage too – I’ll park the economic and hard money debates for the moment) is that you can print dollars and parcel them out. You can’t print extra gold (which is one reason why we like it so much). But if there’s a dollar shortage, the US central bank should be able to address that.

Here’s where we get a tiny bit technical but I’m going to try to keep it very simple.

Basically, the Federal Reserve has things called FX swap lines with other major developed-world central banks. These enable banking systems in those countries to get hold of dollars easily, via their own central banks.

One big problem right now is that not every country in the world has access to those facilities. And nor does the “shadow banking” system – non-bank entities which have effectively been playing the role of banks since the 2008 financial crisis made it harder for banks to do so.

What does this mean? As Zoltan Poszar of Credit Suisse – who is currently the analyst du jour because he’s been on top of all of this mind-numbingly technical financial plumbing stuff for a couple of years or more now – puts it: “The Fed’s liquidity response may not trickle down to every corner of the financial system… it feels like the Fed needs to do more still.”

Now I’m not going to go into potential solutions as there are too many moving parts and I can’t wrap my head around them all as yet. But long story short, until the Fed figures out a way to splatter dollars across the entire global financial system, we’re going to see a rush into dollars, and a corresponding tightening in financial conditions. Which is not what we need right now.

Everyone has been leaning to one side of the boat – and now the wave is here

This is being exacerbated by another core problem here: and this is that going into this crisis, the world has been epically short volatility.

What does that mean? In English, it means that everyone has been betting on markets remaining very calm regardless of what happens. You can call it “faith in the central bank put”.

This takes many forms. You can be very clever about being short volatility – you can put together lots of derivative structures that quite literally bet on low volatility. Or you can be unwittingly short volatility – being heavily long expensive stocks, for example, in the faith that they’ll only ever go up.

Or you can be somewhere in the middle. Taking on loads more leverage than you can really afford because you don’t realise just how exposed you’ll be if markets fall by even a little bit more than your hopelessly inadequate worst-case scenario outlines.

So what it adds up to is that everyone has been leaning over to one side of the boat. Now a big wave has come and tipped it over.

The people who are now all thrashing around desperately in the water are hoping that the central bank is going to come out with lifeboats and pick them all up. But this is a much bigger job than anything anyone’s tried to do before.

What’s the upshot? The Fed will be firefighting. There may well be big institutions who are currently on their knees dumping stuff desperately into markets. You’ve doubtless seen lots of names circulating, I’m not going to repeat them here because I don’t have the facts to hand.

But none of this is something for you to worry about overly. We’ll see chaos. We’ll see havoc. We’ll see scary moments. But if you currently have ready access to cash, and you have a portfolio which is made up of components that you fully understand (by which I mean no exotic weird structured products that are about to explode in your face), then I guess my best advice is still to sit it out.

Look at your watchlist. Assume (and it is an assumption, let me make that clear) that we will get through this, and that therefore the financial markets will still be standing, and that most major brands that you are familiar with today will still be here in six months’ time, simply because they are too big to fail. And think about if, given all that, markets are probably fairly cheap or not.

And own some gold just in case that assumption is wrong.

Oh and subscribe to MoneyWeek if you haven’t already, because so far we’re managing to put it our remotely and I think you’ll enjoy tomorrow’s issue.

My former boss, US asset manager John Angelo, used to say that the best explanation for short-term movements in the stockmarket was that there were "more buyers than sellers", or the reverse. Media analyses were nearly always nonsense: "fake views" as opposed to fake news.

The popular narrative for the past 15 months has been to attribute market and currency turbulence to a rotating litany of Trump, tariff wars, Brexit and China, as if markets were slaves to geopolitical events. James Ferguson of MacroStrategy offers a more profound analysis.

The liquidity squeeze

Yields on US government bonds, then rising steadily, would drop as the economy slowed, while equity markets would switch from "risk-on" to "risk-off" investors would become risk-averse and markets struggle. In the US, economic activity would be bolstered by growth in bank credit, but the eurozone, where banks have not recovered from the financial crisis, would bein trouble.

A year on, those predictions have been vindicated.The US economy is slowing, the eurozone is heading for recession, bond yields have retreated and equity markets have struggled.

David Bowers of Absolute Strategy Research, whose views have also been prescient, warns that trouble may not be over yet. Growth in the global money supply has slippedto levels last seen in 2008."The monetary squeeze is not yet reflected in the global economy or markets," he says. The Federal Reserve is changing course on monetary policy: no further increases in interest rates are expected.

The European Central Bank will no doubt inject liquidity, but Bowers fears it is too slow. "The longer it takes for the plunge in monetary growth to change, the greater the risk it spills over into corporate credit. The window for action by policymakers is narrowing."

A crisis without a name

Charles Gave of Gavekal, who warned last July that "a worldwide recession is becoming more and more probable", is very cautious about equities.While he sees "almost no risk of the US cratering into recession" and points to an upward turn in Asian data, he is very concerned about the eurozone, where leading indicators of economic activity indicate recession.

"This will cause the budget deficits and debt-to-GDPratios of France and Italy to shoot up," while "what the European Central Bank would do under that scenario is anyone's guess".

Bowers also forecasts trouble in the eurozone, noting that the near-halving in the share prices of European banks is not going to encourage them to lend, while Gave continues to advocate avoiding financial stocks "everywhere".

Bowers also warns against being complacent about the US market. "The probability of a recession in the next two years is rising" and earnings forecasts are being cut, though not as aggressively as in Europe.

China will bounce back

He forecasts earnings growth of 4.9% in 2019, compared with a consensus estimate of 8.6%, followed by 5.3% in 2020 against 10.4%. This means that the US market is on less than 16 times forward earnings: reasonable value given that the yield on ten-year government bonds has dropped to well below 3% as inflation pressures have eased. Other markets are much cheaper, which should limit the downside, but tight money, slowing growth, and falling earnings estimates are not a recipe for a bull market.

While the official data showed that Chinese growth had slowed to 6.6% last year, most independent economists think the true number is less than half that figure. Bowers sees Chinese monetary growth picking up, leading to better growth in the second half, while Gavekal thinks it is in both Trump and Xi Jinping's interests to seek a resolution to their trade dispute. This would enable Trump to turn his attention to the EU, in particular the food and automotive sectors. Gavekal thinks the imposition of a 25% tariff on US imports of cars from the EU is likely.

The good news is that an upturn in global real monetary growth in the second half of 2019 should be positive for equity markets and boost the world economy.The bad news is that it may take a financial shock to force the hand of central bankers, whether it is, as Bowers suggests, a significant deterioration in corporate credit, or, as Gavekal thinks, another eurozone crisis.

There is a good chance of some sort of crisis, just notthe Trump/China/Brexit one that many are expecting. If it comes, investors should bear in mind Nathan Rothschild's dictum: "buy on the sound of cannons". Don't let a good crisis go to waste.

I wanted to take a quick look at gold this morning.

Gold has had a pretty dull year. In dollar terms, it's currently near its low for 2018. It's doing a little better in terms of pounds sterling and euros, but overall, the story is of an asset becalmed.

Given that this year has been reasonably eventful so far trade wars and ongoing European political spats are just a couple of highlights gold's lack of reaction seems odd.

Are things likely to turn around? Or has the shine come off the precious metal?

What really drives gold prices

One major reason for gold's drift lower this year has been the steady march higher of the US dollar. That in turn has been driven by the divergence between US monetary policy and that of the rest of the world.

The US central bank, the Federal Reserve, seems pretty set on continuing to raise interest rates. If anything, the Fed under Jerome Powell has grown increasingly hawkish. All the other central banks are either going the other way, or catching up only very slowly.

The Bank of England appears to be paralysed by Brexit. Over at the European Central Bank, Mario Draghi is trying to make sure that monetary policy stays as loose as humanly possible, before he hands over the reins next year. And in Japan, there's little signs of progress towards 2% inflation, despite there being more jobs than there are people to fill them. So the Bank of Japan plans to keep printing for as long as it takes.

So the US dollar has got stronger, and that means all else being equal the value of anything measured in US dollars will fall.

MoneyWeek has always suggested that you should have at least 5% of your portfolio in physical gold (whether you choose to do that with an exchange-traded fund or not really depends on how concerned you are about the full-on financial catastrophe side of things).

The point is to diversify your portfolio. When things get really bad, and other assets struggle, gold tends to outperform. So in some ways you can think of it as a form of portfolio insurance. From that point of view, the day to day movements don't really matter all you really need to focus on is keeping your asset allocation roughly in line with your plan.

Equally though, it's interesting to keep an eye on gold as a barometer of what's going on in the financial system. Right now it's becalmed. So what could change that?

We can't predict the future (which is the main reason that we diversify in the first place). But if there's any "macro" factor that seems to drive gold prices, it's "real" interest rates. That is, interest rates adjusted for inflation.

Put very simply, if the Fed allows inflation to rise more rapidly than interest rates, you'd expect gold to go up, because monetary policy if effectively getting looser. If rates rise faster than inflation, you'd expect gold to fall, as "real" rates rise.

This is why I pricked up my ears the other day when I heard a key member of the Donald Trump administration, gently hinting that the Fed should be wary of raising rates too fast.

Donald Trump is not keen on higher interest rates

Central banks around most of the developed world are independent these days. The point of independence is to stop politicians from messing around with monetary policy in the hope of artificially boosting the economy when election time rolls around.

You can certainly have a debate as to whether or not this has in practice made any difference to monetary policy over the last few decades. But that's the theory anyway.

Politicians have by and large, tried to respect that independence. Again, there's been little reason for them not to. Central banks spent most of the last 20 years cutting interest rates or printing money, after all.

But the other day, Larry Kudlow Trump's main economic advisor, and someone who also advised the Ronald Reagan administration was being interviewed on Fox Business. He was asked about the risks to the economy of tighter monetary policy.

"My hope is that the Fed under its new management understands that more people working and faster economic growth do not cause inflation... My hope is that they understand that and that they will move very slowly."

Now that's an interesting line in itself. This may or may not be true (clearly, in Japan, having more people working and faster growth has struggled to cause inflation). But the idea that higher growth and more competition for labour leads to higher wages is certainly the orthodox economic view, and one that you'd expect the Fed to broadly follow.

However, it's more the heavy hints from Kudlow that the Fed should be taking things easy, that's of interest.

We're coming up to US mid-term elections later this year. If Trump wants to do well, then there are a few things he'll be keeping an eye on. The oil price is one hence the desperate attempts to prove that Saudi Arabia is going to pump more oil. And another is the path of monetary policy, and the impact this has on the stock market.

If the Fed comes under political pressure to go easy on rates, that would be no surprise. Trump is hardly backward at coming forward. At the same time however, this would be happening just as inflation is finally showing signs of taking off (it hit a six-year high in the US in May).

Assuming that Kudlow is wrong and the impressive pay rises being awarded in certain under-pressure industries, such as truck driving, suggest he might be then it's quite possible that inflation could surprise on the upside. In turn, that suggests that real interest rates could start to tick lower. Which would be good for gold.

I'm not saying you should pile in to grab it with both hands. But it might be worth checking your asset allocation. If you're a little short on gold, it might be a good idea to rectify that.