Does this Black Swan look like a Grey Goose?

Does this Black Swan look like a Grey Goose?

Historical Backdrop:

In the previous 125 years of the Global economy, no two events overshadow the system fragility of the financial system as the economic woes of the 1920’s and 1930’s and the crisis of 2008.

The historical and economic memory of the post WWI and pre-WWII European economies certainly presents itself in an ominous way when dealing with the current situation in the EU.  Although, tangible and theoretical economic thought existed during the inflation/deflation of the said period, the role of the central banker was remarkably different. The Federal Reserve was created a few years after the turn of the last century.  Though theoretical economic theory existed, one could make an argument for the lack of functional experience in dealing with massive economic calamities.  

Unless you have been living in the far distant villages of Nepal (no offense) for the last 9 years, not one business day passes without a journalist discussing the implication of the crisis of 2008.  Considering society has a remarkable ability to enact our short term memories rather keenly, we rely on this piece of history quite well and effectively.

Recalling the notion of the Black Swan, as economists and traders we begin to search for the next potential Black Swan event.  

In this article we evoke history as an antidote for the nay-Sayers and as a scare-tactic for the optimists.

We show the intensity of true inflation and the debilitating power of deflation.  Below are graphs showing how high CPI was through the two crises’. Anecdotal evidence: 1) The inflation of the 1920’s was so severe that restaurant waiters in Germany during the 1920 had to announce menu prices every half hour to stay up to date on inflation indicators.  During the 2008 crisis, the need to divest from all asset classes, gold withstanding, hedge funds were buying the commodity to store in bank vaults as a just-in-case the world ends tomorrow move.

Looking at the historical CPI data, we see that the range in CPI during the 1930’s was in a range of positive 20 to negative 20 (US Data). In the 1980 through 2008 timeframe, the range of CPI was 15 to -5 (US Data).  If you compare the inflation indicator in recent years, CPI seems rather tame. Most recent CPI indicated 1.7 on an annual basis.

So clearly, we are not anywhere near crisis levels either on the inflationary or deflationary front.  Could this change rather quickly? Absolutely.

He are three scenario’s that could decouple optimism from the investor:

One: Central bankers overstate their presence and promote the inevitable inflationary environment.  One could argue that the goal of stimulus is to perhaps overshoot the 2% target.  The objective of central bankers is to also promote growth.  We know from historical evidence that public money has a much lower multiple than private funds (capex, corporations, small business, etc.).  The disastrous situation that could develop from stimulus alone is that there is an overabundance of cheap capital. In turn, causing inflationary pressure in a number of economies. As inflation gets out of control, rates climb to unsustainable levels, borrowers can no longer afford the higher cost of loans, and we will begin to witness recessionary and deflationary pressures.

Two: Selling the $4 Trillion fed balance sheet.  How does the fed orchestrate the sale of such a massive position? Laws of Demand and Supply teach us that an influx of supply will decrease the price of a unit.   Keeping in mind the inverse relationship of bonds prices and rates, we can infer that as prices drop the yield will climb rather quickly.  The caveat: A coordinated effort between the fed, global central banks, pension funds, insurers, and foreign entities to simultaneously purchase Treasures as the Fed is selling the positions.  We see that central bank coordination is quite likely judging by the recent Japan QE monetary easing a day and a half after the FOMC stopped QE3.  

Three: Deflation.  Granted we are not in the 1920’s and 1930’s.  But, the recent “decrease in inflation” does give credence to the deflation concern.  Can we slide deep into negative GDP, CPI, and PCE territory? Yes.  We do not want deflation.  There are a lot of indicators that need to coincide for this to happen.  Remember, our economies our more mature that 70 years ago.  At the moment, we do not have serious systemic risk on balance sheets that would cause severe panic in the markets.  

Having said this, concern exists.  If many investors believe in and find the proverbial Black Swan and take the necessary position against such an event, will it happen? Does this make the notion of the Black Swan obsolete? By definition a Black Swan is an unpredictable (dove tail) risk.  Think the effect of the Japanese earthquake. 

I argue that we have calculated the potential risks in the global economy and possible implication is not pretty.  This is under the assumption that the global central bankers completely mucks this up.  

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