These Fake Rallies Will End in Tears
By Detlev
S Schlichter
Investors and
speculators face some profound challenges today: How to deal with politicized
markets, continuously “guided” by central bankers and regulators? To what
extent do prices reflect support from policy, in particular super-easy monetary
policy, and to what extent other, ‘fundamental’ factors? And how is all this
market manipulation going to play out in the long run?
It is obvious that
most markets would not be trading where they are trading today were it not for
the longstanding combination of ultra-low policy rates and various programs of
‘quantitative easing’ around the world, some presently diminishing (US), others
potentially increasing (Japan, eurozone). As major U.S. equity indices closed
last week at another record high and overall market volatility remains low,
some observers may say that the central banks have won. Their interventions
have now established a nirvana in which asset markets seem to rise almost
continuously but calmly, with carefully contained volatility and with their
downside apparently fully insured by central bankers who are ready to ease
again at any moment. Those who believe in Schumpeter’s model of “bureaucratic
socialism”, a system that he expected ultimately to replace capitalism
altogether, may rejoice: Increasingly the capitalist “jungle” gets replaced
with a well-ordered, centrally managed system guided by the enlightened bureaucracy.
Reading the minds of Yellen, Kuroda, Draghi and Carney is now the number one
game in town. Investors, traders and economists seem to care about little else.
“The problem is
that we’re not there [in a low volatility environment] because markets have decided
this, but because central banks have told us…” Sir Michael Hintze, founder of
hedge fund CQS, observed in conversation with the Financial Times (FT,
June 14/15 2014) [1]. “The beauty of capital markets is that they are voting systems,
people vote every day with their wallets. Now voting is finished. We’re being
told what to do by central bankers – and you lose money if you don’t follow
their lead.”
That has certainly
been the winning strategy in recent years. Just go with whatever the
manipulators ordain and enjoy rising asset values and growing investment
profits. Draghi wants lower yields on Spanish and Italian bonds? — He surely
gets them. The U.S. Fed wants higher equity prices and lower yields on
corporate debt? — Just a moment, ladies and gentlemen, if you say so, I am sure
we can arrange it. Who would ever dare to bet against the folks who are
entrusted with the legal monopoly of unlimited money creation? “Never fight the
Fed” has, of course, been an old adage in the investment community. But it gets
a whole new meaning when central banks busy themselves with managing all sorts
of financial variables directly, from the shape of the yield curve, the spreads
on mortgages, to the proceedings in the reverse repo market.
Is this the “new
normal”/”new neutral”? The End of History and the arrival of the Last Man, all
over again?
The same FT
article quoted Salman Ahmed, global bond strategist at Lombard Odier Investment
Managers as follows: “Low volatility is the most important topic in markets
right now. On the one side you have those who think this is the ‘new normal’,
on the other are people like me who think it cannot last. This is a very
divisive subject.”
PIMCO’s Bill Gross
seems to be in the “new normal” camp. At the Barron’s mid-year roundtable 2014
(Barron’s, June 16, 2014) he said: “We don’t expect the party to end with a
bang — the popping of a bubble. […] We have been talking about what we call the
New Neutral — sluggish but stable global growth and continued low rates.”
In this debate I
come down on the side of Mr. Ahmed (and I assume Sir Michael). This cannot
last, in my view. It will end and end badly. Policy has greatly distorted
markets, and financial risk seems to be mis-priced in many places. Market
interventions by central banks, governments and various regulators will not
lead to a stable economy but to renewed crises. Prepare for volatility!
Bill Gross’
expectation of a new neutral seems to be partly based on the notion that
persistently high indebtedness contains both growth and inflation and makes a
return to historic levels of policy rates near impossible. Gross: “…a highly
levered economy can’t withstand historic rates of interest. […] We see rates
rising to 2% in 2017, but the market expects 3% or 4%. […] If it is close to
2%, the markets will be supported, which means today’s prices and
price/earnings are OK.”
Of course I can
see the logic in this argument but I also believe that high debt levels and
slow growth are tantamount to high degrees of risk and should be accompanied
with considerable risk premiums. Additionally, slow growth and substantial
leverage mean political pressure for ongoing central bank activism. This is
incompatible with low volatility and tight risk premiums. Accidents are not
only bound to happen, they are inevitable in a system of monetary central
planning and artificial asset pricing.
Low inflation, low
rates, and contained market volatility are what we should expect in a system of
hard and apolitical money, such as a gold standard. But they are not to be
expected – at least not systematically and consistently but only intermittently
– in elastic money systems. I explain this in detail in my book Paper Money Collapse – The Folly of
Elastic Money [3]. Elastic money systems like our present global fiat money system
with central banks that strive for constant (if purportedly moderate) inflation
must lead to persistent distortions in market prices (in particular interest
rates) and therefore capital misallocations. This leads to chronic instability
and recurring crises. The notion that we might now have backed into a
gold-standard-like system of monetary tranquility by chance and without really
trying seems unrealistic to me, and the idea is even more of a stretch for the
assumption that it should be excessive debt – one of elastic money’s most
damaging consequences – that could, inadvertently and perversely, help ensure
such stability. I suspect that this view is laden with wishful thinking. In the
same Barron’s interview, Mr. Gross makes the statement that “stocks and bonds
are artificially priced,” (of course they are, hardly anyone could deny it) but
also that “today’s prices and price/earnings are OK.” This seems a
contradiction to me. Here is why I believe the expectation of the new neutral
is probably wrong, and why so many “mainstream” observers still sympathize with
it.
1.
Imbalances have accumulated over time. Not all were eradicated in the
recent crisis. We are not starting from a clean base. Central banks
are now all powerful and their massive interventions are tolerated and even
welcome by many because they get “credited” with having averted an even worse
crisis. But to the extent that that this is indeed the case and that their rate
cuts, liquidity injections and ‘quantitative easing’ did indeed come just in
time to arrest the market’s liquidation process, chances are these
interventions have sustained many imbalances that should also have been
unwound. These imbalances are probably as unsustainable in the long run as the
ones that did get unwound, and even those were often unwound only partially. We
simply do not know what these dislocations are or how big they might be.
However, I suspect that a dangerous pattern has been established: Since the
1980s, money and credit expansion have mainly fed asset rallies, and central
banks have increasingly adopted the role of an essential backstop for financial
markets. Recently observers have called this phenomenon cynically the
“Greenspan put” or the “Bernanke put” after whoever happens to lead the U.S. central
bank at the time but the pattern has a long tradition by now: the 1987 stock
market crash, the 1994 peso crisis, the 1998 LTCM-crisis, the 2002 Worldcom and
Enron crisis, and the 2007/2008 subprime and subsequent banking crisis. I think
it is not unfair to suggest that almost each of these crises was bigger and
seemed more dangerous than the preceding one, and each required more forceful
and extended policy intervention. One of the reasons for this is that while
some dislocations get liquidated in each crisis (otherwise we would not speak
of a crisis), policy interventions – not least those of the monetary kind –
always saved some of the then accumulated imbalances from a similar fate. Thus,
imbalances accumulate over time, the system gets more leveraged, more debt is
accumulated, and bad habits are being further entrenched. I have no reason to
believe that this has changed after 2008.
2.
Six years of super-low rates and ‘quantitative easing’ have planted new
imbalances and the seeds of another crisis. Where are these
imbalances? How big are they? – I don’t know. But I do know one thing: You do
not manipulate capital markets for years on end with impunity. It is simply a
fact that capital allocation has been distorted for political reasons for
years. Many assets look mispriced to me, from European peripheral bond markets
to U.S. corporate and “high yield” debt, to many stocks. There is tremendous
scope for a painful shake-out, and my prime candidate would again be credit
markets, although it may still be too early.
3.
“Macro-prudential” policies create an illusion of safety but will
destabilize the system further. – Macro-prudential policies are the new
craze, and the fact that nobody laughs out loud at the suggestion of such
nonsense is a further indication of the rise in statist convictions. These
policies are meant to work like this: One arm of the state (the central bank)
pumps lots of new money into the system to “stimulate” the economy, and another
arm of the state (although often the same arm, namely the central bank in its
role as regulator and overseer) makes sure that the public does not do anything
stupid with it. The money will thus be “directed” to where it can do no harm.
Simple. Example: The Swiss National Bank floods the market with money but stops
the banks from giving too many mortgage loans, and this avoids a real estate
bubble. “Macro-prudential” is of course a euphemism for state-controlled
capital markets, and you have to be a thorough statist with an iron belief in
central planning and the boundless wisdom of officers of the state to think
that this will make for a safer economy. (But then again, a general belief in
all-round state-planning is certainly on the rise.) The whole concept is, of
course, quite ridiculous. We just had a crisis courtesy of state-directed
capital flows. For decades almost every arm of the U.S. state was involved in
directing capital into the U.S. housing market, whether via preferential tax
treatment, government-sponsored mortgage insurers, or endless easy money from
the Fed. We know how that turned out. And now we are to believe that the state
will direct capital more sensibly? — New macro-“prudential” policies will not
mean the end of bubbles but only different bubbles. For example, eurozone banks
shy away from giving loans to businesses, partly because those are costly under
new bank capital requirements. But under those same regulations sovereign bonds
are deemed risk-free and thus impose no cost on capital. Zero-cost liquidity
from the ECB and Draghi’s promise to “do whatever it takes” to keep the
eurozone together, do the rest. The resulting rally in Spanish and Italian
bonds to new record low yields may be seen by some as an indication of a
healing Europe and a decline in systemic risk but it may equally be another
bubble, another policy-induced distortion and another ticking time bomb on the
balance sheets of Europe’s banks.
Read more at : http://www.financialsense.com/print/contributors/detlev-schlichter/these-fake-rallies-will-end-in-tears
No comments:
Post a Comment