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Free Lunches, Fragile Fed Faith, & Minsky Moments

Tyler Durden's picture




 

via Scotiabank's Guy Haselmann,

“It isn’t that they can’t see the solution.  It is that they can’t see the problem.” – G.K. Chesteron

Down Side Up

It has been quite evident that central banks have been hyper-active in their attempts to mitigate the financial crisis and its aftermath. They have also taken a noticeable role in regulatory efforts to prevent a similar future crisis. For several years, their “whatever-it-takes” efforts have rewarded any investor (willing to get in front of and piggy-back off of their policies) with abnormal and outsized returns. However, the flaws in this unwritten and implicit contract are now being exposed.

Having few alternatives, once interest rates were pushed to zero, (we know) central banks had to resort to asset purchases (QE). It should be remembered that QE works by purposefully distorting market prices and altering investor behavior by flooding the system with money. Based on this evaluation measure alone, QE was wildly successful. However, the initial macro benefits are likely to reverse when central banks attempt to extract themselves from this policy stance - because there is ‘no free lunch’.

There is little doubt that investors were lured into playing along by the allure of easy profits through central bank-induced asset price appreciation. Moreover, there was great conventional pressure to outperform peers and benchmarks. Therefore, since being left behind risked job security, it was important to play along.

Central banks were successful at lowering market volatilities and correlations as investors herded into similar trades. As time passed, investors were lulled into ever-riskier assets at higher and higher prices which in turn pushed volatilities lower and lower. The result is a classic set-up for a ‘Minsky moment’ as the risk/reward of holding assets became ever-more skewed to the downside.

Since these QE policies are unproven, untested, and experimental, there are no good ways to measure their long-term success. There is also no way to determine when these policies have gone too far, or even when they have become counter-productive. Certainly, the negative consequences of debt-driven consumption and long-term financial repression have yet to be felt.

Unfortunately, investors have not adjusted adequately as the Fed’s stance has shifted, and as other warning signs have appeared. Complacent investors still remain fearful of ‘missing the upside’. At this point, investors in the US should be more fearful of participating in a downside correction. After all, the ‘Fed’s put’ that has ‘protected’ portfolios has been pushed further and further out-of-the-money, when:  1) the Fed’s balance sheet stopped growing last autumn; 2) the ‘forward guidance’ promises of low rates was removed; and, 3) the FOMC began threatening a near-term hike.

The clearest and most dramatic example of a major central bank policy mistake (so far) was in January when the Swiss National Bank removed its promise of pegging the Franc; which in turn led to a 40% currency re-pricing in 10 minutes.

The ECB announced an aggressive QE program the following week. Its intent was to lower the Euro and lift stock and bond prices.  Markets originally moved aggressively as expected; that is, until the past two weeks when dramatic reversals materialized. The Financial Times stated today that, “In 12 days, owners of German benchmark bonds have seen the plummeting price wipe out more than 60 years’ worth of income, as the Bund sees the biggest rout in total return terms since 1994”.

Investors are beginning to question the efficacy of these extreme central bank policies. More are joining the chorus of critics that believe policies have become counter-productive in both the short and long run.  If true, it could mean that a Fed hike might come sooner than markets believes; and may occur prior to the arrival of the desired and optimal economic conditions.

There must be a lesson to learn for those investors who blindly follow central bank actions.  The lesson embedded in the dramatic re-pricing in European financial markets during the past 12 days may simply be that there are dangers when chasing assets irrespective of price levels. It seems to me that the ability of central banks to generate a Pavlovian or conditional investor response to their policy actions is now rightly being called into question.

The lesson for central banks is that zero or negative yields can cause highly-unstable capital flows.  The ECB’s mistake may be that they tried to implement an aggressive and well-advertised QE policy after markets had already pushed yields to absurd and non-economic prices. This demonstrates that there is a practical limit to central bank policies (which may have already been reached).  One consequence for markets going forward will be much greater market volatility.

Follow-up, Treasury Market Comment

There were four main causes of low Treasury yields over the past several months: 1) Fed hoarding of securities; 2) regulatory rules requiring bank hoarding; 3) no signs of inflation, and; 4) an attractive yield relative to European debt.  A change in one of these factors was necessary for Treasury yields to rise.  Factors #3 and #4 changed and Treasuries re-priced accordingly.

Last Thursday morning, I wrote in a “quick Treasury market comment” that Treasury risk/reward remained to the downside in the near term. I wrote the following:

“It wasn't so long ago that Yellen and crew were talking about needing to see wage growth.  Well, the ECI wages and salaries increased from 2.3% to 2.6% in Q1 from year ago and 2.8% y/y in terms of private sector wages and compensation. Also, claims are at the lowest level since 4/14/2000 when Funds were 6%. This is happening when Bunds are under strong pressure. Most importantly, all this is occurring one week before a payroll report where the market will be afraid of a strong number....so Treasuries will have a difficult time gaining any traction”.

Tactically however, the risk/reward for re-establishing a long in Treasuries is now much improved.

If today's payrolls data is seen as a strong number...should be good support for 10’s in the mid 2.30’s (i.e., sub 2.40%).  By several measures, back-end technicals are already quite over-sold;  a move lower would increase that oversold condition. In addition, a strong number should make the curve flatten and cause some ‘risk off’ flight, as the odds of a ‘sooner’ rate hike rises. The dollar should also strengthen, benefiting Treasury bonds over stocks and foreign assets. Therefore, buying that dip may pay off.

 

If today's payrolls data is seen as a weak number...  should also help Treasuries, while the May Treasury refunding (next week) and large corporate issue calendar might allow a reasonable entry level. A weak number may cause a drop in expectations for growth and inflation - supporting Treasuries. A weak number might lead to a further questioning of the effectiveness of central bank policy in general. It could also cause more European troubles, particularly if the Euro is pushed higher.

In addition, the 10-year Treasury bond still yields 160 bps over the comparable Bund.  It remains the world’s only safe haven asset, despite the chatter that Treasuries are in bubble territory. The world, no doubt, is in the midst of some great challenges and geo-political tensions.

Greece

The most immediate obstacle (next week) is the negotiation in Brussels between Greece and its creditors. I am not in the camp that there will be limited contagion risk from a default or Grexit as policy makers’ state.  I also believe it will be exceptionally difficult this time to find a way to ‘muddle along’.

This past Tuesday the Syriza-led government passed a law that allows them to re-hire 15,000 public sector workers. Those workers were let go as part of the reform enacted by the previous government as a condition of receiving the bailout money. In addition, the Greek government was supposed to have a primary surplus in 2015 of 3.0%, but instead has a deficit of 1.5%.  Earlier this week, the European Commission downgraded its forecast for Greek economic growth.

Greece is headed in the wrong direction. I find it difficult to see how Brussels can reach a compromise this time with a government that seems rebellious towards its creditors and unwilling to implement the necessary reforms. After intense negotiations in Latvia two weeks ago, Greek Finance Minister Varoufakis was called “a gambler, a time-waster, and an amateur”. He responded by saying that he “welcomes their hatred of him”.

At a minimum, the ECB may demand (as soon as next week) increases on haircuts for the ELA-posted collateral, and refuse to increase Greek T-bill issuance limits that were requested by Athens. Such ECB actions would mark the beginning of the end of Greece’s membership in the Eurozone.

“The sooner you fall behind, the more time you have to catch-up.” - Steven Wright

 

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Fri, 05/08/2015 - 12:46 | 6073251 SoilMyselfRotten
SoilMyselfRotten's picture

They don't need investors, they are the market

Fri, 05/08/2015 - 12:51 | 6073273 Ham-bone
Ham-bone's picture

The veneer of US growth and normalcy has worn paper thin...all dependent on an outrageous, obvious off-shore treasury buying scheme through a handful of locations...

http://econimica.blogspot.com/2015/05/veneer-of-us-growth-normalcy-has-worn.html

Fri, 05/08/2015 - 12:54 | 6073278 KnuckleDragger-X
KnuckleDragger-X's picture

When all you have is a hammer... The FED has been relying on Keynesian monetary brute force to solve all problems for a long time. Unfortunately if you hammer on anything long enough, it'll break and the cracks are becoming noticeable to everybody but them.....

Fri, 05/08/2015 - 13:44 | 6073437 prefan4200
prefan4200's picture

Oh, they see the cracks, too, but if they acknowledge them, then they have to talk about a plan to fix the cracks.  And, of course, there isn't one - it's going to painful no matter what they do at this point.  So the Fed tells everyone that everthing is awesome, as they sit around the campfire and sing this song:

https://www.youtube.com/watch?feature=player_detailpage&v=w5Fgp-KihIA

Fri, 05/08/2015 - 13:16 | 6073358 Model T
Model T's picture

Shorted ES again this morning, at 2110.25.  Expecting buyers remorse next Tuesday. Everytime I do this, I make money; they've got me trained.

Fri, 05/08/2015 - 12:45 | 6073255 mc225
mc225's picture

unregulate banking. let anyone be a banker. allow all manner of competing currencies. this whole thing of, 'the central bank's policy is mistaken' is a flawed premise, in that it allows for the monopolization of money in the first place.

Fri, 05/08/2015 - 12:57 | 6073286 KnuckleDragger-X
KnuckleDragger-X's picture

Your talking about what used to be called "the good old days" but the smartest people ever has taken over and we'll have Nirvana any day now.....

Fri, 05/08/2015 - 12:52 | 6073256 Mrs. Cog
Mrs. Cog's picture

There must be a lesson to learn for those investors who blindly follow central bank actions.

the lesson... listen to the thunder.

 

Fri, 05/08/2015 - 12:59 | 6073290 Thisisbullishright
Thisisbullishright's picture

The lesson learned is "investors" saw gains EXPLODE by well over 200%!

 

Fri, 05/08/2015 - 13:02 | 6073301 lawyer4anarchists
lawyer4anarchists's picture

It is all a con from the fake money to the fake right to keep secrets. Excerpt:   "I am going to pull back the curtain on one of the very HEARTS of this utterly bogus supposed “constitutional claim” of executive privilege which is the BULWARK for how they keep the vast majority of secrets. I want to show you how utterly HOLLOW it is. And when I do this I will hopefully get a “bonus play” and you can see yet another example of how the branches work TOGETHER to screw WE the people."  http://www.thetruthaboutthelaw.com/the-supreme-court-just-made-up-the-co...

 

Fri, 05/08/2015 - 13:02 | 6073302 Thisisbullishright
Thisisbullishright's picture

Weak jobs report = stawks explode higher

Strong jobs report = stawks explode higher

 

Fri, 05/08/2015 - 13:04 | 6073313 polo007
polo007's picture

http://www.thedailyobserver.ca/2015/04/27/usury-once-in-control-will-wreck-any-nation

In 1935 William Lyon Mackenzie King warned Canadians that "Once a nation parts with the control of its currency and credit, it matters not who makes the nation's laws. Usury, once in control, will wreck any nation." According to the lawsuit, the Trudeau government's 1974 decision has resulted in the payment of $1 trillion dollars in interest to private domestic and international financial institutions. These interest payments have given banks enormous risk-free profits for over 40 years.

It is important to realize that fiat currencies such as the Canadian dollar are not backed by anything tangible like gold. Rather, they are created out of thin air whenever a loan is made. As admitted by the Bank of England in March of 2014, "Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created."

Give yourself a moment to let this sink in. Banks do not need to attract deposits first in order to make loans. When you are borrowing money from the bank, you are not borrowing money deposited by someone else. Instead, it is your own borrowing that is creating the money that is being lent and which you will be expected to pay back (with interest).

When the Bank of Canada was obliged to lend money to Canadian governments, money was similarly created but at least the loans were held as assets by the Bank of Canada. Under the current arrangement, however, every loan made to individuals, businesses and governments serves to increase the wealth and power of the commercial banking system. So long as the world uses fiat currencies, and so long as the power to create fiat currency is held by private banks, these banks have every incentive to, as William Lyon Mackenzie King put it, 'wreck any nation' in order to preserve their power.

Fri, 05/08/2015 - 13:07 | 6073318 polo007
polo007's picture

http://rabble.ca/columnists/2015/04/can-courts-liberate-bank-canad

The Bank of Canada was established as a private bank in 1935 under private ownership but in 1938, recognizing that money should be created in the public interest, the government amended the Bank Act and turned the Bank into a public institution. The Bank was almost immediately harnessed to finance not only Canada's war effort (we ranked fourth in production of allied war materiel) but a long list of infrastructure projects including the Trans-Canada highway, the St. Lawrence Seaway, and over the decades, hospitals and universities across the country. It was mandated to lend not only to the federal government but to provinces and municipalities as well, with a limit of one-third of the federal budget and one-quarter of a province's.

It also created a subsidiary, the Industrial Development Bank, helping create the industrial base that recent Liberal and Conservative governments have all but destroyed through trade and investment agreements. The list goes on and on -- and includes social programs like the Old Age Security Act and programs to assist WW2 veterans with vocational training and subsidized farm land. The interest on its loans, of course, simply went back into government coffers.

But after nearly 40 years of this incredibly productive use of publicly created credit, unprecedented economic growth and increasing income equality, international finance got its chance to launch the free market counter-revolution against democratic governance. Stagflation -- simultaneous stagnation, unemployment and inflation -- was one of the first launching pads for Milton Friedman's radical free-market ideas: putting the creation of credit into private hands and creating debt burdens which would restrict the potential for democratic governance.

Freidman argued that stagflation was the direct result of irresponsible governments issuing too much money or borrowing recklessly from their central banks and sparking inflation. His radical free-market ideology was shared by the Bank for International Settlements (the bank of central bankers) and in 1974 it established a new committee, the Basel Committee, to establish global monetary and financial stability. Canada -- that is the Pierre Trudeau Liberals -- joined in the deliberations. The committee's solution was to encourage governments to borrow from private lenders and end the practice of borrowing interest-free from their own central banks. The rationale was thin from the start: central bank borrowing was and is no more inflationary than borrowing through the private banks. The only difference was that private banks were given the legal right to fleece Canadians. The effect of the change was to effectively take a powerful economic tool out of the hands of democratic governments.

Fri, 05/08/2015 - 13:15 | 6073354 Hongcha
Hongcha's picture

Bad news bears - market up big again today.

Base

New high

Rinse & repeat

 

Fri, 05/08/2015 - 13:19 | 6073363 madbraz
madbraz's picture

can't stand fools that start their pompous economic commentary with some cute quote, let alone one who also ends his with one.

 

 

 

 

Fri, 05/08/2015 - 13:24 | 6073379 polo007
polo007's picture

http://www.theaureport.com/pub/na/chris-mancinis-high-quality-gold-miner...

The Gold Report: The U.S. Federal Reserve has downgraded its forecasts for both economic growth and inflation. That being the case, why would it raise interest rates?

Chris Mancini: There's a certain contingent in the Fed that believes that its zero interest monetary policy might result in adverse consequences going forward. This contingent is dead set on raising rates and trying to get back to some level of normalcy in interest-rate policy.

TGR: There's a school of thought that holds that the U.S. economy has become addicted to cheap money. What's your view?

CM: There's no question that much of U.S. economic growth in recent years is due to very low interest rates. The average interest rate on auto loans is the lowest ever. That obviously spurs auto sales. The rates charged for federally subsidized student loans are close to historic lows. That spurs demand for college and university courses. And even though the housing industry is still struggling with an inventory glut, the 30-year mortgage rate of 3.75% spurs demand for housing.

So, I think that if interest rates do rise, there's a good chance that the economy will slow, and there will be a panicked reaction from the stock market.

TGR: Despite this soft recovery, the equity markets have never been stronger. Why has this happened?

CM: It's another function of low interest rates. If you keep your money in the bank, you're getting zero percent and thus losing money on a real basis. This has forced savers into other asset classes. And money is flooding into America from all over the world because, compared to, say, the Eurozone and Japan, which are struggling with deflation, the U.S. economy looks pretty good.

TGR: Is an economy that punishes savers sustainable?

CM: It's sustainable until it's not. Asset prices continue to increase greatly, and at some point people will start to realize that the value of money is not what it seems. That will lead to a crisis of confidence and, eventually, to the deterioration of the monetary system. The question is when. And I don't know the answer to that.

TGR: Should an interest rate hike backfire, could we see the return of quantitative easing (QE)?

CM: If the economy slows after a rate hike, I think the first thing the Fed will do is to lower rates to zero again. And if that doesn't kick start the economy, which it probably won't, there's a good chance we will get QE4.

Fri, 05/08/2015 - 14:01 | 6073503 taketheredpill
taketheredpill's picture

 

Chesterton

 

Fri, 05/08/2015 - 14:13 | 6073538 taketheredpill
taketheredpill's picture

"Therefore, since being left behind risked job security, it was important to play along".

 

Agreed.  A choice between Market Risk and Career Risk and many picked the first one, which always seems safest.

 

Re: low Treasury yields....Fed hoarding

Worth keeping in mind the consistent QE pattern of Treasury Sell-off / Equity Rally at the start or just before QE began and Treasury Rally / Equity Sell-off at the end or just after QE ended.

 

People will ask who will buy the Tresuries when the Fed decides to sell, but I expect a lot of investors will be begging for yield, any yield, so long as it's positive.

 


Fri, 05/08/2015 - 14:16 | 6073544 taketheredpill
taketheredpill's picture

 

 

Feels like Fed wants to try Normalizing rates, one hike and see what happens.  But this isn't anything like any previous rate hike cycle where the first hike was the start of a series.  Given artificial state of the markets the Fed's first hike should feel like the last hike in previous cycles.

 

Fri, 05/08/2015 - 21:16 | 6074766 monad
monad's picture

Syme struck his hands together.

"How true that is," he cried. "I have felt it from my boyhood, but never could state the verbal antithesis. The common criminal is a bad man, but at least he is, as it were, a conditional good man. He says that if only a certain obstacle be removed—say a wealthy uncle—he is then prepared to accept the universe and to praise God. He is a reformer, but not an anarchist. He wishes to cleanse the edifice, but not to destroy it. But the evil philosopher is not trying to alter things, but to annihilate them. Yes, the modern world has retained all those parts of police work which are really oppressive and ignominious, the harrying of the poor, the spying upon the unfortunate. It has given up its more dignified work, the punishment of powerful traitors in the State and powerful heresiarchs in the Church. The moderns say we must not punish heretics. My only doubt is whether we have a right to punish anybody else."

"But this is absurd!" cried the policeman, clasping his hands with an excitement uncommon in persons of his figure and costume, "but it is intolerable! I don't know what you're doing, but you're wasting your life. You must, you shall, join our special army against anarchy. Their armies are on our frontiers. Their bolt is ready to fall. A moment more, and you may lose the glory of working with us, perhaps the glory of dying with the last heroes of the world."

"It is a chance not to be missed, certainly," assented Syme, "but still I do not quite understand. I know as well as anybody that the modern world is full of lawless little men and mad little movements. But, beastly as they are, they generally have the one merit of disagreeing with each other. How can you talk of their leading one army or hurling one bolt. What is this anarchy?"

"Do not confuse it," replied the constable, "with those chance dynamite outbreaks from Russia or from Ireland, which are really the outbreaks of oppressed, if mistaken, men. This is a vast philosophic movement, consisting of an outer and an inner ring. You might even call the outer ring the laity and the inner ring the priesthood. I prefer to call the outer ring the innocent section, the inner ring the supremely guilty section. The outer ring - the main mass of their supporters - are merely anarchists; that is, men who believe that rules and formulas have destroyed human happiness. They believe that all the evil results of human crime are the results of the system that has called it crime. They do not believe that the crime creates the punishment. They believe that the punishment has created the crime. They believe that if a man seduced seven women he would naturally walk away as blameless as the flowers of spring. They believe that if a man picked a pocket he would naturally feel exquisitely good. These I call the innocent section."

"Oh!" said Syme.

"Naturally, therefore, these people talk about 'a happy time coming'; 'the paradise of the future'; 'mankind freed from the bondage of vice and the bondage of virtue,' and so on. And so also the men of the inner circle speak - the sacred priesthood. They also speak to applauding crowds of the happiness of the future, and of mankind freed at last. But in their mouths" - and the policeman lowered his voice - "in their mouths these happy phrases have a horrible meaning. They are under no illusions; they are too intellectual to think that man upon this earth can ever be quite free of original sin and the struggle. And they mean death. When they say that mankind shall be free at last, they mean that mankind shall commit suicide. When they talk of a paradise without right or wrong, they mean the grave.

"They have but two objects, to destroy first humanity and then themselves. That is why they throw bombs instead of firing pistols. The innocent rank and file are disappointed because the bomb has not killed the king; but the high-priesthood are happy because it has killed somebody."

"How can I join you?" asked Syme, with a sort of passion.

- G.K Chesterton, very popular with our grands.

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