The stock market reached all-time highs last week based upon the machinations of central bankers and the perceptions of speculators that these bankers will always have their back. Yellen, Kuroda, and Draghi are growing increasingly desperate as everything they have done in the last five years has failed to revive their moribund economies. The average person in the U.S., Japan and Europe is far worse off today than they were in 2009 at the height of the worldwide recession. The .1% have vastly increased their riches through the ZIRP and QE policies of central bankers. The rise in stock markets is nothing but a confidence game built upon the false belief that there will always be a greater fool to buy overvalued assets acquired by borrowing from the central bankers at 0%. John Hussman understands the nature of markets:
We’re mindful that the financial markets move not based on what is true, but by what is perceived.
At present, the entire global financial system has been turned into a massive speculative carry trade. A carry trade involves buying some risky asset – regardless of price or valuation – so long as the current yield on that asset exceeds the short-term risk-free interest rate. Valuations don’t matter to carry-trade speculators, because the central feature of those trades is the expectation that the securities can be sold to some greater fool when the “spread” (the difference between the yield on the speculative asset and the risk-free interest rate) narrows.
He is also understands the move by the BOJ on Friday was made out of panic. It will set in motion tragic consequences for the Japanese people and world financial systems:
With regard to the recent move by the Bank of Japan, seeking to offset deflation by expanding the creation of base money, the move has the earmarks of a panic, which is counterproductive. The likely response of investors to panic is to seek safe, zero-interest money rather than being revolted by it. The result will be a plunge in monetary velocity and a tendency to strengthen rather than reduce deflationary pressures in Japan. In our view, the yen has already experienced a dramatic Dornbusch-type overshoot, and on the basis of joint purchasing power and interest parity relationships (see Valuing Foreign Currencies), we estimate that rather than the widely-discussed target of 120 yen/dollar, value is wholly in the other direction, and closer to 85 yen/dollar (the current exchange rate is just over 112). The Japanese people have demonstrated decades of tolerance for near-zero interest rates and the accumulation of domestic securities without any material inclination to spend them based on the form in which those securities are held. Rather than provoking strength in the Japanese economy, the move by the BOJ threatens to destroy confidence in the ability of monetary authorities to offset economic weakness – in some sense revealing a truth that should be largely self-evident already.
The carry trade is like picking up nickles in front of a steam roller. We’ve seen it all before. The result will be the same.
The narrative of overvalued carry trades ending in collapse is one that winds through all of financial history in countries around the globe. Yet the pattern repeats because the allure of “reaching for yield” is so strong. Again, to reach for yield, regardless of price or value, is a form of myopia that not only equates yield with total return, but eventually demands the sudden and magical appearance of a crowd of greater fools in order to exit successfully. The mortgage bubble was fundamentally one enormous carry trade focused on mortgage backed securities. Currency crises around the world generally have a similar origin. At present, the high-yield debt markets and equity markets around the world are no different.
Hussman can prove that QE and suppressed interest rates below the rate of inflation have completely failed to benefit the real economy and the real people. It has only benefited Wall Street profits, insiders, and rich speculators. They have set the stage for a financial collapse that will make 2008 seem like child’s play.
High real interest rates generally reflect strong demand for borrowing, driven by investment opportunities that are seen as productive enough to justify borrowing at those rates. They also encourage savings that can be directed to those productive investments. As a result, higher real rates are generally associated with more efficient investment and faster economic growth.
In contrast, depressed real interest rates are symptomatic of a dearth of productive investment opportunities. When central banks respond by attempting to drive those real interest rates even lower to “stimulate” interest-sensitive spending such as housing or debt-financed real investment, they really only lower the bar to invite unproductive investment and speculative carry trades.
We wouldn’t suggest that the Fed target above-equilibrium interest rates, but we are also entirely convinced that below-equilibrium interest rates are harmful to long-term economic and financial stability. Despite the ability of these policies to create short-term bursts of demand – enough to hold the global economy at growth rates that remain just at the border that has historically delineated expansions from recessions – the ultimate and rather predictable result of these policies will be another round of financial chaos.
Bernanke and Yellen created $3.5 trillion out of thin air since 2008 and have done absolutely nothing for Main Street USA. None of that $3.5 trillion has ever reached average people in the real world. It has been funneled to the .1% and used to speculate in the markets, creating simultaneous stock, bond and real estate bubbles. Now central bankers around the world desperately attempt to keep the bubbles from bursting simultaneously. They will fail once again.
As the central bank creates more money and interest rates move lower, people don’t suddenly go out and consume goods and services, they simply reach for yield in more and more speculative assets such as mortgage debt, and junk debt, and equities. Consumers don’t consume just because their assets have taken a different form. Businesses don’t invest just because their assets have taken a different form. The only activities that are stimulated by zero interest rates are those where interest rates are the primary cost of doing business: financial transactions.
What central banks around the world seem to overlook is that by changing the mix of government liabilities that the public is forced to hold, away from bonds and toward currency and bank reserves, the only material outcome of QE is the distortion of financial markets, turning the global economy into one massive speculative carry trade. The monetary base, interest rates, and velocity are jointly determined, and absent some exogenous shock to velocity or interest rates, creating more base money simply results in that base money being turned over at a slower rate.
Those expecting hyperinflation from these money printing measures will have to wait awhile. It will happen after deflation engulfs the world and those in power panic. But, confidence in fiat currency and those controlling its issuance is waning rapidly.
Hyperinflation results when there is a complete loss in the confidence of currency to hold its value, leading to frantic attempts to spend it before that value is wiped out. I expect we’ll observe significant inflationary pressures late in this decade, but present conditions aren’t conducive to rapid inflation without some shock to global supply.
The fact is that all financial markets are extremely overvalued and will crash. The speculators have already forgotten the tremors of the coming earthquake which occurred two weeks ago. Treasury rates plunged, along with stock markets, as there were no buyers to be found. Confidence dissipated in an instant. Fear was palpable. Everyone has a choice. You can look like an idiot before the crash or after it.
Overvalued bull market peaks may still be drawn-out and frustrating. They can seem endless (see The Journeys of Sisyphus) and then suddenly unravel far more rapidly than it seems they should (see Chumps, Champs, and Bamboo) at which point the “lagging” features of a defensive stance are often reversed with striking speed. As the late MIT economist Rudiger Dornbusch once observed, “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.” Recall that the 2000-2002 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to May 1996. The 2007-2009 decline wiped out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to June 1995.
As we’ve noted before, the problem with what we call the Exit Rule for Bubbles – “you only get out if you panic before everyone else does” – is that you also have to decide whether to look like an idiot before the crash or an idiot after it.