The Poison of Central Planning
As is well known, central banks around the world have deployed a range of “unconventional policies” in recent years, ranging from imposing zero to negative interest rates, to outright money printing (QE).
We have seen a number of people argue that “QE” does not really involve “money printing”, but as we have explained at length, these arguments are misguided (see e.g. our in-depth discussion of the modus operandi of the Fed here: “Can the Fed Print Money?”).
Additional money created in the US economy since January of 2008 (inside the blue rectangle). The Fed created most of it – click to enlarge.
As far as we understand it, the first error is the belief that only bank reserves are created, when in reality, both bank reserves and deposit money are created in QE operations (the latter is clearly “money”, as it can be used for the final payment of goods and services in the economy). The second error is to argue that because new money isn’t just dropped from helicopters (not yet, anyway), but involves asset purchases, it somehow doesn’t qualify as “printing”. However, it is important to keep in mind that the money used for these purchases is still created ex nihilo, at the push of a button.
As an aside, it has by now become clear that the ECB also creates both reserves and deposit money to the extent of its securities purchases, whereas Japan’s case still requires some digging on our part which we haven’t gotten around to yet (Japan e.g. excludes deposits held by securities companies from its money supply data; in some ways this is sensible, as it allows for a more fine-grained analysis of money and its potential uses, but it may also disguise how much money the BoJ is really creating).
The distortion of relative prices in the economy has become visible in a number of ways: obviously, there has been a bubble in titles to capital, a.k.a. “risk assets”, and previously there was also quite a bit of upward distortion in the prices of commodities (which was egged on additionally by credit expansion in China). One after the other of these bubbles has begun to fall apart (commodities and junk bonds being exhibits 1 and 2 so far), with only the stock market and certain government bonds left standing (especially on the short end of the curve, with many European sovereign bonds trading at negative yields to maturity, which is utterly perverse).
As far as the stock market is concerned, what is actually still “left standing” at this point is only the small handful of stocks responsible for the bulk of its gains over the past 18 months; the majority of stocks can be considered to be in downtrends already (market breadth as measured by a Goldman Sachs proprietary indicator has collapsed to a multi-year low, on a par with what has been seen near a number of major market peaks).
Recently, yet another earthquake has hit the junk bond market, especially the lower quality end of same (we have mentioned the sharp increase in trading in bonds of distressed issuers only yesterday).
Things are going haywire in the lowest rated segments of the high yield market – click to enlarge.
In the course of researching this point, we have come across a list of other distortions in the financial markets that are hinting at both actual as well as potential market dislocations that may soon become more obvious by hitting market segments that have hitherto escaped. In these cases it is not only extreme central bank policies, but also the plethora of new financial regulations that have created distortions.
Dislocations in Various Financial Market Segments
The capital goods industries are the sector of the economy that is as a rule most sensitive to the suppression of interest rates in a major expansion of money and credit engendered by loose central bank policy. This is so because these goods are temporally the most distant from the consumption stage. The lower the time discount applied to calculating the net present value of long-lived, durable capital goods, the higher their prices will be. This incidentally explains also why the prices of titles to capital (such as stocks) rise disproportionally relative to other prices in the economy during a major credit expansion/ boom period.
By comparing relative prices in the economy, one can easily see these distortion effects, which ultimately weaken the economy structurally, in spite of the “feel good” period of the boom. It stands to reason that certain segments of the financial markets will also reflect extreme monetary policy, as well as regulations that force funds to flow into certain assets (the fact that many government bonds in the euro area trade at negative yields to maturity is partly due to new bank capital regulations). Bloomberg lists the following recent examples:
1.) US swap spreads have turned negative. This particular signal of a budding (or actual) market dislocation has recently been mentioned by an increasingly worried BIS as well (see BIS quarterly report, pdf). A detailed discussion of the phenomenon can be seen at Zerohedge, from where we have taken this fairly recent chart:
US swap spreads have turned deeply negative – click to enlarge.
Bloomberg explains why this isn’t supposed to happen:
“[S]wap spreads have become the talk of financial markets in recent weeks as they plumb historic lows and seemingly defy market logic. At issue is the fact that swap rates—or rates charged for interest rate swaps—have dipped below yields on equivalent U.S. Treasuries, indicating that investors are charging less to deal with banks and corporations than with the U.S. government. Such a thing should never happen, as U.S. Treasuries theoretically represent the “risk-free” rate while swap rates are imbued with significant counterparty risk that should demand a premium.
That may have changed, however, as new financial market rules require interest rate swaps to be run through central clearing houses, effectively stripping them of counterparty risk and leaving just a minimal funding component. At the same time, funding costs for U.S. Treasuries are said to have gone up due to a host of post-financial crisis rules that crimp bank balance sheets, causing costs to go up.
In this case, regulatory effects may be playing an outsized role, but it seems likely to us that the recent divergence in the policies of major central banks is also affecting the situation. We conclude this mainly from the timing – the big downturn in swap rates has only happened this year.
2.) Next, Bloomberg mentions “fractured repo rates” – meaning that the difference between repo rates has widened noticeably:
The repo market is the lubricant for the global financial system, allowing banks and investors to pawn their assets—typically U.S. Treasuries and other high-quality paper—in exchange for short-term financing.
While there used to be little distinction between the rates at which counterparties raised money against their U.S. Treasury collateral, there is now an increasing divergence. “You no longer have a single repo rate,” Joseph Abate, Barclays analyst, said in an interview last week. “The market itself is fracturing.”
Abate argues that much of this has to do with new regulation that requires banks to hold more capital against all their assets, regardless of their riskiness. The so-called supplementary leverage ratio makes it more expensive for banks to facilitate repo trades, placing more emphasis on quality of the counterparty and leading to ructions in rates.”
Again, regulations evidently have a great deal of influence on the situation in this particular case.
Fracturing repo rates: “The first chart shows the rate for General Collateral Financing trades (GCF) vs. the Bank of New York Mellon triparty repo rate. The second shows the GCF repo rate minus the rate that money market funds earn on their own U.S. Treasury repos. All are slightly different repo constructs against the same collateral, yet the difference between the rates paid on each has been widening.” – click to enlarge.
3.) Another regulatory intervention that may actually be partly responsible for the increasing dislocation in high yield bonds is the fact that banks have been forced to vastly reduce their proprietary trading books in corporate bonds. As a result, they no longer fulfill their previous function as market makers.
As we have mentioned several times already, this could eventually lead to a bond market panic, as sellers will find that the market has become extremely illiquid. Of course in this case, central banks have created a major bubble, by pushing investors to take ever higher risks in the search for returns, exacerbating the risks. The corporate bond inventories of banks have recently actually turned negative.
The corporate bond inventories of formerly market-making banks have collapsed – click to enlarge.
This strikes us as a potentially especially dangerous development, not least because there are so many ETFs loaded with illiquid bonds theses days. Many investors are employing a lot of leverage in this sector to boot.
4.) A more esoteric segment of the market that is behaving unnaturally of late is synthetic credit, which has begun to trade tighter than cash credit – in the investment grade segment of the corporate debt market:
Synthetic credit tightens relative to cash credit
As Bloomberg explains, this is one of the symptoms of the increasing lack of liquidity in the bond markets:
“Investors struggling to trade bonds amid an apparent dearth of liquidity have turned to a bevy of alternative products to gain or reduce exposure to corporate debt.
Such instruments include derivatives like credit default swap (CDS) indexes, total return swaps (TRS) and credit index swaptions. The rush for derivatives that are supposed to be more liquid than the cash market they track has produced another odd dislocation in markets.
Above is the so-called basis between the CDX IG, an index that includes CDS tied to U.S. investment-grade companies, and the underlying cash bonds. The basis has been persistently wide and negative in recent years, as spreads on the CDX index trade at tighter levels than cash.
5.) “Impossible” market moves keep happening with increasing frequency. Inter alia this has been egged on by the SNB this year, as it dropped its exchange rate peg and instead instituted deeply negative deposit rates. Not even US treasury bonds are immune. As Bloomberg notes:
“Much of Wall Street runs on mathematical models that abhor statistical anomalies. Unfortunately for the Street, such statistical anomalies have been happening more frequently, with short-term moves in many assets exceeding historical norms.
Barnaby Martin, a credit strategist at Bank of America Merrill Lynch, made this point earlier this year. The number of assets registering large moves—four or more standard deviations away from their normal trading range—has been increasing. Such moves would normally be expected to happen once every 62 years. […] Perhaps the best-known example is Oct. 15, 2014, when the yield on the 10-year U.S. Treasury briefly plunged 33 basis points — a seven standard-deviation move that should happen once every 1.6 billion years, based on a normal distribution of probabilities.
Extreme moves in various asset classes are happening ever more frequently
Stock market moves like the one observed in the late August should be expected to be seen again – and their severity will likely increase. This is also suggested by the next datum.
6.) The volatility of volatility itself is increasing. That’s right, the VIX itself is becoming more volatile – a trend that seems set to continue in 2016:
The volatility of the VIX itself is rising – click to enlarge.
Again, this suggests to us that even bigger dislocations are likely on the way. In this context, readers should also check out this recent article at Zerohedge that discusses the dangers emanating from “short volatility” ETFs.
Finally, we learn from Marketwatch that a rarely observed phenomenon has occurred in the stock market over the past month. Apparently, it is very rare for the SPX not to post any back-to-back gains in an entire month. As Marketwatch informs us:
“The fact that the market is pulling back after Friday’s surge shouldn’t come as a surprise. In fact, the S&P 500 hasn’t posted back-to-back gains in a month. This rare pattern has happened only a handful of times in the past 20 years and, as shown in this chart, it historically rears its head during “severe bear markets or large corrections,” according to a post on Monday from Michael Harris of the Price Action Lab blog.
Obviously, we are not in a “severe bear market” right now, although as noted above, many stocks are indeed immersed in short to medium term downtrends. We therefore take this statistically rare behavior as yet another warning sign for risk assets.
S&P 500: no back-to-back gains in a month – click to enlarge.
Government interference by both central banks and regulators (the latter are desperately fighting the “last crisis”, bolting the barn door long after the horse has escaped, thereby putting into place the preconditions for the next crisis) has created an ever more fragile situation in both the global economy and the financial markets.
As the above charts and data show, price distortions and dislocations have been moving from one market segment to the next and they keep growing, which indicates to us that there is considerable danger that a really big dislocation will eventually happen. With that we mean an event in which normally disparate market segments suddenly become highly correlated, as a scramble for liquidity starts in one sector. The non-scientific name for such an event is “crash” (if you want a more scientific sounding term, Bob Bronson refers to it as a “mass-correlated, hyper-volatile illiquidity event” or “MCHVIE”).
Extreme caution seems to be warranted, in spite of the fact that money supply growth in the euro area and the US ranges from “extremely brisk” in the former to “sagging, but still brisk” in the latter. We simply don’t know how much money supply growth is really needed to keep the wolf from the door in this brave new world of ZIRP, NIRP and QE. Risk remains extremely high, that much is certain.