"... it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.... Despite the euphoria in financial markets, investment remains weak. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions.
As history reminds us, there is little appetite for taking the long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end.
- Bank of International Settlements, 84th Annual Report
It was a year ago when the general manager of the Bank of International Settlements (the central banks' central bank), Jamie Caruana warned that the "Monetary Kool-Aid Party Is Over [25]." Since then central banks have proven their own supervisor wrong in their ability to kick the can, because even as the Fed has commenced tapering its own QE (due to the same bond market liquidity issues we warned about last summer [26]) the ECB has more than offset the Fed's brief attempt at policy normalization by escalating, for the first time in history, from ZIRP to NIRP. In other words, the Kool-Aid keeps flowing.
Which brings us to the BIS' just released annual report. There are many reason to read the full report cover to cover, but perhaps the most prominent one is that, once again, the Bank of International Settlements has merely compiled a book report of all Zero Hedge posts not only over the past year, but since our inception.
A quick summary of the report comes from FT [27]:
The Bank for International Settlements has warned that “euphoric” financial markets have become detached from the reality of a lingering post-crisis malaise, as it called for governments to ditch policies that risk stoking unsustainable asset booms.
While the global economy is struggling to escape the shadow of the crisis of 2007-09, capital markets are “extraordinarily buoyant”, the Basel-based bank said, in part because of the ultra-low monetary policy being pursued around the world. Leading central banks should not fall into the trap of raising rates “too slowly and too late”, the BIS said, calling for policy makers to halt the steady rise in debt burdens around the world and embark on reforms to boost productivity.
In its annual report, the BIS also warned of the risks brewing in emerging markets, setting out early warning indicators of possible banking crises in a number of jurisdictions, including most notably China.
“Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on,” it said.
The BIS, the bank for central banks, has been a longstanding sceptic about the benefits of ultra-stimulative monetary and fiscal policies and its latest intervention reflects mounting concern that the rebound in capital markets and real estate is built on fragile foundations.
Or, as Hyman Minsky and Zero Hedge would call it "common sense."
But why use an establishment paper, one whose very existence has repeatedly been shown to rely on perpetuating the broken and unsustainable status quo, when one can quote from the BIS itself. Of course, to anyone who has read Zero Hedge either extensively or in isolation in the recent and not so recent past, all of this will be very familiar territory.
Below we present some of the key excerpts from the 84th BIS Annual Report. As you read these, please recall all those idiots who said the Fed is not solely focused on boosting stock prices and that anyone claiming that is a conspiracy theorist.
Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.
Yes BIS, we know you read us. Here's why:
The global economy continues to face serious challenges. Despite a pickup in growth, it has not shaken off its dependence on monetary stimulus. Monetary policy is still struggling to normalise after so many years of extraordinary accommodation. Despite the euphoria in financial markets, investment remains weak. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions. And despite lacklustre long-term growth prospects, debt continues to rise. There is even talk of secular stagnation.
And here the BIS explains broken markets so easily, even a Janet Yellen can get it:
Financial markets have been exuberant over the past year, [...] dancing mainly to the tune of central bank decisions. Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks.
* * *
Growth has picked up, but long-term prospects are not that bright. Financial markets are euphoric, but progress in strengthening banks’ balance sheets has been uneven and private debt keeps growing. Macroeconomic policy has little room for manoeuvre to deal with any untoward surprises that might be sprung, including a normal recession.
* * *
There is a common element in all this. In no small measure, the causes of the post-crisis malaise are those of the crisis itself – they lie in a collective failure to get to grips with the financial cycle. Addressing this failure calls for adjustments to policy frameworks – fiscal, monetary and prudential – to ensure a more symmetrical response across booms and busts. And it calls for moving away from debt as the main engine of growth. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy manoeuvre will run out.
* * *
The combined public sector debt of the G7 economies has grown by close to 40 percentage points, to some 120% of GDP in the post-crisis period – a key factor behind the 20 percentage point increase in total (public plus private sector) debt-to-GDP ratios globally.
[28]
... government debt-to-GDP ratios have risen further; in several cases, they appear to be on an unsustainable path.
* * *
Once more, communication from the Federal Reserve and the ECB [...] helped support credit and equity markets, with the major stock exchanges reaching record highs in May and June 2014.
* * *
The S&P 500 Index, for gained almost 20% in the 12 months to May 2014, whereas expected future earnings grew less than 8% over the same period. The cyclically adjusted price/earnings ratio of the S&P 500 stood at 25 in May 2014, six units higher than its average over the previous 50 years.
* * *
On record low default rates:
Low corporate bond yields not only reflect expectations of a low likelihood of default and low levels of risk premia, but also contribute to the suppression of actual default rates, in that the availability of cheap credit makes it easier for troubled borrowers to refinance. The sustainability of this process will ultimately be put to the test when interest rates normalise.
What forward guidance leads to:
If the public fails to fully understand the conditionality of the guidance, the central bank’s reputation and credibility may be at risk if the rate path is revised frequently and substantially, even though the changes adhere to the conditionality originally announced. Forward guidance can also give rise to financial risks in two ways. First, if financial markets become narrowly focused on it, a recalibration of the guidance could lead to disruptive market reactions. Second, and more importantly, forward guidance could lead to a perceived delay in the speed of monetary policy normalisation. This could encourage excessive risk-taking and foster a build-up of financial vulnerabilities.
As Bloomberg summarizes, "Central bank policy makers, who expressed concern low market volatility is masking future risks, are helping suppress price swings with their accommodative monetary policy." Aka, Bill Dudley hypocrisy 101 [29]:
The developments in the year under review thus indicate that monetary policy had a powerful impact on the entire investment spectrum through its effect on perceived value and risk. Accommodative monetary conditions and low benchmark yields – reinforced by subdued volatility – motivated investors to take on more risk and leverage in their search for yield.
But the biggest "heresy": even the BIS is suggesting that, gasp, deflation isn't the end of the world:
It is essential to discuss the risks and costs of falling prices in a dispassionate way. The word “deflation” is extraordinarily charged: it immediately raises the spectre of the Great Depression. In fact, the Great Depression was the exception rather than the rule, in the intensity of both its price declines and the associated output losses. Historically, periods of falling prices have often coincided with sustained output growth. And the experience of more recent decades is no exception. Moreover, conditions have changed substantially since the 1930s, not least with regard to downward wage flexibility. This is no reason to be complacent about the risks and costs of falling prices: they need to be monitored and assessed closely, especially where debt levels are high. But it is a reason to avoid knee-jerk reactions prompted by emotion.
And the punchline:
Never before have central banks tried to push so hard.
Which nobody will care about until it's too late, for one simple reason:
As history reminds us, there is little appetite for taking the long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end.
So when even the BIS says it's game over, it may be time to sell every last VIX contract, because the alternative - admission that the central banks have finally failed - is hardly an enjoyable one.
The alternative message is more pleasant: indeed - why worry. Just because every single previous central-bank inflated bubble has always burst, resulting in tears for most (if not those who precipitated the crash and managed to load up on liquidating hard assets at firesale prices) this time will be different.
As for the BIS authors of its last two annual reports: please stay away from nail guns.
Full BIS report below (pdf link [30])
