Quicknote: As central banks raise rates, markets are starting to break

As central banks continue raising rates, their attention will start to shift from inflation to financial stability. We saw this last week when the Bank of England stepped in to stop a financial disaster taking place in the UK economy.

I suspect there’s more to come with strong rumours in markets this weekend about a large European financial institution facing liquidity problems. I have no evidence other than what is being speculated, just enough experience to teach me that where there’s smoke, there is also usually fire.

It’s not about the rumours being true or not, its about the sentiment and we probably crossed an important threshold last week with the Bank of England’s intervention. Its hard to think that there won’t be more financial stability problems in the short term.

If we do see another Leeman style of collapse, or something close to it, central banks will quickly shift their focus from fighting inflation to fighting to ensure financial stability. That will be a turning point. The fear of a financial meltdown is much larger than the fear of high inflation.

Bottom line: The worst possible situation is liquidity drying up in markets, because of a bank failure. Central banks are carefully monitoring. So the next two weeks are extremely important for the interest rate outlook of most major developed economies. There’s no question that inflation data, historically, is problematic.

But the game at the moment is looking forward and hoping that we don’t see something big, break fast. If we do, its game over for interest rate hikes.

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