The Central Bank Bubble: How Will It Burst?

Alberto Gallo of Algebris Investments steps up to take his shot at the $64,000 (more like trillion) question in a report published this week “The Central Bank Bubble: How Will It Burst?”

Gallo manages the Algebris Macro Credit Fund described as “an unconstrained strategy investing across global bond and credit markets, and with lead responsibility for Macro Strategies” on the company’s website.

Gallo sets the scene as follows.

Most investors are still playing the game, and in the same direction. We estimate there are currently around $11tn in negative-yielding bonds and over $2tn in strategies that explicitly or implicitly depend on stable volatility and asset correlations. If low interest rates and QE have been the lever pushing up prices of dividend and coupon-paying assets, central banks are the fulcrum.

This fulcrum is slowly shifting: the ECB has just announced a reduction in its bond purchase programme, the Bank of England is likely to hike this month – even in the face of economic weakness –the Fed will likely hike rates again in December, and the PBoC has recently warned of asset overvaluation.

One of our favourite parts of the report is “The Magic Money Tree” infographic which explains how QE has benefited a plethora of investment strategies and created the current bubble to end all bubbles.

Now Gallo is obviously savvy because he doesn’t nail his colours to the mast on one factor which will prick the central bank bubble. Instead he offers four scenarios. The first threat is a rise in inflation, which he summarises as follows.

1. Inflation: after nine years of low-flation, the probability of a sudden rise in inflation is increasing, as job markets get tighter, globalisation leaves way to protectionist policies and liquidity reaches job-creating small and medium businesses as banks re-start lending.

Wage inflation aside, Gallo believes China could continue to export inflation based on a more resilient than expected Chinese economy. Gallo believes that China may have sufficient policy options to smoothly deflate its credit bubble. While we might disagree, it is a possibility.

The second threat to the central bank bubble is…central bankers.

2. Central bankers themselves: central banks appear to have shifted their tone to worry increasingly about financial stability. There are good reasons to do so. We are many years into a global synchronous expansion, and there will be little monetary policy ammunition to fight a new slowdown, with interest rates near record lows and $20tn in global central bank balance sheets. In some countries, like Japan and Switzerland, central banks have grown their balance sheets to sizes similar to their respective economies. The good news is some central banks are trying to curb stimulus before their mandate ends. The Federal Reserve is poised to raise rates again in December, the Bank of England will likely hike, the ECB has announced a reduction in purchases and the Bank of Canada has hiked too. The bad news is that markets have so far largely ignored this reduction in stimulus.

It makes sense…central banks created the bubble via QE and ZIRP/NIRP, so reversing that strategy might prick their own bubble.

The third threat is another merry band of miscreants.

3. Politicians: central bank QE has not only lowered yields and boosted asset prices. It has also artificially suppressed volatility. Yet volatility may come back as the consequences of rising inequality in the distribution of wealth, opportunity and natural resources across the world. The last decade has been great for billionaires, not so good for Main Street. Inequality of wealth and opportunity in developed economies has fuelled anti-establishment protest votes like the ones for Brexit or President Trump. Other populist parties are on the rise in Continental Europe and Scandinavia. In turn, domestic populism and nationalism in developed countries can increase commercial conflict and protectionism - see for instance the potential withdrawal from NAFTA, or the EU-UK tariff threat - as well as exacerbate militarism and geopolitical conflict. Populism has historically fuelled government spending and fiscal stimulus, higher taxes and aggressive redistribution policies, which could all re-price overvalued assets and/or target assets used as a store of value. 

We have nothing to add.

4. The market: rising growth, low inflation and low interest rates have proven a boon to global markets. There are now $20tn in central bank assets globally, and around 10% of global sovereign debt is yielding negative. Investors have been buying equities for yield and bonds for capital gains, and have been selling volatility explicitly or positioned in strategies that are implicitly short volatility. These assume a stable volatility and correlation among the price of assets. For example, risk-parity strategies assume a negative correlation between risky assets, like stocks, and "risk-free assets", like U.S. treasuries. But what happens if both decline together, and short volatility investors become forced to unwind their portfolios?

Exactly, this is what we’re waiting for, but what is the catalyst? Nobody knows.

If we were forced to guess what will prick the bubble, we would probably place more emphasis on China than the Algebris report does. However, putting aside what causes it, we share Gallo’s view on some of the key mechanics which will be “in play” when a crisis unfolds.

What will the next crisis look like?

The over $2tn in explicit and implicit short-volatility strategies could be the spark, similar to sub-prime for credit markets in 2008, which was $1.4tn. However, a future crisis would be very different from 2008. Growth in passive investing vehicles and in the mismatch between assets they buy and liabilities they issue, lack of risk-free assets and growing collateral chains, diminishing trading liquidity due to higher capital requirements for dealers point to more fragility in financial markets.

It's perfectly set up, if we only knew when.

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Full report below...


2banana Mon, 11/06/2017 - 04:24 Permalink

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I have come up with a partial solution to what is coming.1. Take care of your health.  Exercise. 2. Stay out of debt. Live beneath your means. 3. Keep learning. Learn new skills. Learn how to fix and build things yourself. Invest in yourself. 4. Realize that government (at all levels) will lie to you. Government will not take care of you. Government will take everything you have if it means they stay in power one day longer.5. Save.  Buy a little gold and silver. But realize that this is just a little insurance and not much else. 6. Stay far away from bubbles. Hard to do when friends and relatives are getting "rich" and think you the fool 7. Relationships are worth far more than "stuff." Families are worth way more than "stuff."  Good friends are worth more than stuff. 8. Enjoy life. It doesn't take lots of money. 9. Learn how to shoot safely and have at least one gun. Even if you never touch it again. 10. Be part of "something" bigger than yourself such as a Church or a volunteer organization. All the issues we see today are the same issues seen 2000 years ago.

Hillarys Server Mon, 11/06/2017 - 04:36 Permalink

When? Easy.

The central bank bubble will burst right after I'm dead and buried.

With my cold fingers clenching my roll of silver dimes which will have never gone up one basis point during my lifetime.

That's my fear after standing on the sidelines with mostly cash for the past ten year while everyone around me has raked in a mountain of equity and real estate gains like freshly fallen autumn leaves putting down their rake only long enough to laugh at me.

Debugas Mon, 11/06/2017 - 04:43 Permalink

bubble is in the stocksthe price of stocks will continue to grow until shareholders realize it is cheaper to build the similar company from scratch rather than keep buying stocks of the existing company

Yen Cross Mon, 11/06/2017 - 04:46 Permalink

 I understand economies of scale, and realize the ramifications of too much float. For the life of me, I don't understand Chf and JPY strength, when those two currencies are being so abused. If cryptos really become "mainstrem" I'd be long CRY/JPY and CRY/CHF. Being export economies doesn't make curriencies "havens". I think Kyle Bass is going to be right with usd/jpy in 2018.

Youri Carma Mon, 11/06/2017 - 08:23 Permalink

They can only pretend to wind down QE they can't actually do it.The Federal Reserve balance sheet reduction that didn’t happen…- QE keeps rates low- QE keeps the stockmarket upSo you can stripe away all these arguments on reducing QE and have to look at what's left.- QE doesn't prevent the real economy going down- QE can't prevent the dollar going downThe dollar is the main reason for the FED to pretend and extend and when the realisation of FED's dog an pony show realy sinks in will be the coming to Jesus moment. So you ain't seen nothing yet with Bitcoin. So lock and load!

Econogeek Mon, 11/06/2017 - 10:30 Permalink

Seems to me like there will be no single trigger, it'll be a series of things that shake faith in the system enough to start the first wobbles that keep going.On China, I don't think China will allow anything to pop until they can be assured themselves, by their definition,  that the ROW will pay for it.  A mercantilist solution in other words. So they have to ensure that the petroyuan and the gold-back yuan first reach at least minor reserve-currency status, in my view.If the US messes (up) in North Korea, and China does an 11th-hour ride to the rescue, that could go a long way to advancing the hard yuan’s reserve currency ambitions.  Meaning then, the Chinese Powers that Be could let the air out of some domestic bubbles.I think an uncontrolled pop is what all the world’s CBs and almost all TPTB don’t want and still have the power to prevent. So I think a global pop is coming later rather than sooner.  I’m invested for sooner, so I’m feeling the pain of everyone on here who is also invested for sooner.

MagicMoney Econogeek Mon, 11/06/2017 - 11:45 Permalink

Actually, rising interest rates will trigger it which low rates created this artificial boom on assets in the first place. I don't think central banks will raise interest rates at all but markets will demand higher interest rates. As long as there is stimulus the bull run in assets will continue. Most money will chase higher prices. Bitcoin is basically the poster boy of this economy even though it does not present a systemic risk at all at this moment but it shows what the rage is. Of course, BTC is not a company that produces value in the sense like Apple. It is a fad nonetheless which is run by central banks. More likely central banks are more concerned about the economy crashing than rising prices. A central bank allowing a bonds bust, stock market bubble bust, and a huge credit crunch that basically effects everything in a debtor economy. Politically taboo.

In reply to by Econogeek