Over the weekend, we posted Matt King's latest must read report, which showed "seven signs of a deeply dysfunctional market", and in which the Citi head credit strategist joined Paul Singer's warning, cautioning about "surprising, sudden, intense" tail risks, driven by failed central bank policies:
Most doctors – and even patients – know that when a course of drugs seems not to be working, you don’t simply keep on doubling the dosage. This applies particularly when the patient, if no longer as sprightly as they used to be, is nevertheless doing more or less fine. The side effects of such a course are more likely to kill than to cure. Yet this is what central banks now seem intent on doing. They have too much invested in their models to consider changing them in our view.
And yet the more stretched all these relationships become, and the more extreme the central banks’ policies, the greater is the tail risk, and the more nervous we become about investing in line with these forecasts. It’s not just the risk of Bill Gross’ “sputtering engine”; it’s the risk that Paul Singer is right, and that the end of the current environment proves “surprising, sudden, intense, and large.
So how did central banks manage to not only break the markets, but in the process fail to propel the economy, and inflation, higher?
Matt King gave the answer this morning in a follow up, terrific in its simplicity, presentation titled "Saturation point - or sweet spot", which explains so well how virtually everything went wrong during the period of financial repression, that even the central bankers - those responsible for the current state of the world - will get it. More importantly, it also gives a glimpse of what comes next.
He starts by noting that even as central banks continue to offer free money, policymakers have a problem: nominal growth has remained painfully weak.
King then pivots, showing that declining growth should not be a surprise as a result of declining employment and productivity growth.
What is surprising, King asserts, is that nobody noticed the troubling trends earlier. The reason for this, perhaps, is that the obvious decline was masked by rising credit growth.
And while previously expansionary credit strategy would have been inflationary, something the central banks desperately need, this time subdued inflation allowed central banks to pursue the same policies for longer.
The reason why the underlying demographic, employment and economic trends are now becoming apparent is that credit growth is finally starting to fade: as King puts it "rock bottom yields have done little to stimulate loan demand."
King then shifts to what is the biggest flaw in central bank thinking over the cycle: namely that rate cuts never actually stimulated borrowing, as can be seen by the record drop in debt yields.
Lack of debt demand is not to be found in its cost as interest coverage metrics have "seldom looked better."
The Citi strategist looks at corporates for the answer why there has been no pick up productive borrowing and believes it can be found in the already substantial excess capacity.
Aging households, on the other hand, are not borrowing because they have to save even more for retirement: saving in the form of equity, not debt.
Which is not to say there is no borrowing: there is, and at the corporate level, it has rarely been higher, however, the issue - as we have said for years - is the use of proceeds: most of these have not gone into the real economy.
Instead, the new debt has been stuck in capital markets, propping up asset prices.
But even this process may have hit its limits, as the effect are "becoming uneven"
This brings us back to square one: why is growth starting to stagnate? The answer, as we have shown before in the case of China, is that the credit impulse from new credit creation - which until recently pushed global GDP ever higher, is now fading.
It's not just GDP that is set to suffer, however: so are asset prices, as "a weaker impulse means lower asset prices returns."
Which takes us to the key question: what happens at turning points. As King says, reducing borrowing exerts a negative impulse; debt/GDP may initially continue to rise; then once borrowing stops falling, deleveraging becomes much easier. That said, "Going on a diet is much harder than sticking to it." In other words, it's not the deleveraging that is difficult, it is the reduced borrowing which results in a negative credit impulse.
Now in a normal world, this would be the end of the leverage cycle - since debt is at near record highs across the globe: "we don't need more credit" as the world has already turned the corner.
This brings us to the punchline, because while the market is ready for a debt purge, "that's not how central banks see things." Instead, they remain dangerously obsessed with “potential.” To which King has a question: what do readers prefer: Growth = potential + debt crisis; or Growth < potential + deleveraging.
The conclusion follows: as central banks refuse to let the system delever, and instead as they "double up", expect the distortions to get bigger still.
Meanwhile, the S&P may and likely will continue to hit all time highs, propelled higher by even more misallocated debt (and outright central bank buying as the BOJ and SNB admit) giving the impression that all is well, when in reality the system continues to edge ever closer to the perilous edge, until one day it careens over with central banks powerless to offset the crash.
Which is why the head of credit strategy at Citi beckons central banks: "think not of potential, but of sustainability"
We doubt any central banker will listen.