Mapping The Crisis Contagion Process: The Flowchart
When one looks across markets and reflects on the actions of the world’s central banks since 2008, it’s easy to get confused.
That is, how could it possibly have come to this?
In polite circles and certainly in the mainstream media echo chamber, Ben Bernanke’s deployment of unconventional monetary policy in the wake of the crisis is credited with pulling the world back from the edge of a veritable financial apocalypse and if that’s true, then the proliferation of these world-saving monetary measures should by all rights have brought about a dramatic global economic recovery.
Only that didn’t happen.
Instead, we stand once again at the precipice of crisis and central banks are out of ammunition and, perhaps more importantly, completely out of credibility. Indeed, the fact that we are facing a new Asian Financial Crisis, emerging market mayhem, harrowing bouts of volatility accompanied by ever more frequent flash crashes across asset classes seems to prove that far from "smoothing out" the business cycle, Keynesianism gone wild in fact does the exact opposite: it creates the conditions for still greater booms and busts and thereby serves to destabilize markets.
In light of the above, we present the following flowchart from BNP which should serve as a helpful roadmap for those wondering how we just went from one major crisis to another in the space of seven years and all we have to show for it is more debt and trillions in printing press money that did next to nothing to boost aggregate demand.
The global financial repression pushed investors to invest cash in risky assets, such as property and equity. The scale of global policy interventions is trumping all fundamental factors for now. Investors should keep in mind that the road is never straight and next month should be full of potentially disruptive events impacting sharply overcrowded assets and trades. History shows that such misallocation of resources creates bubbles that can last before fully blowing; the question is not if, but when."
Make no mistake, the writing has been on the wall for quite some time and we haven't been shy about pointing it out.
Central banks are losing control.
Trillions upon trillions in post-crisis asset purchases haven’t given the global economy the defibrillator shock the world’s central planners were depending on to bring about a sustained and robust recovery.
Indeed, the opposite appears to have materialized.
Subdued demand and trade looks to have become structural and endemic rather than cyclical and rather than create "healthy inflation", seven years of accommodative monetary policy has only served to bury the world in a global deflationary supply glut. And that’s just the big picture. The more granular we get, the more apparent it is that central banks are no longer in the driver's seat.
Inflation expectations across the eurozone have collapsed despite Mario Draghi’s best efforts to assure the public that PSPP has been an overwhelming success and similarly, inflation expectations have tumbled in the US ahead of a expected rate hike which looks less likely by the day. Meanwhile, in Sweden, the Riksbank has sucked so much high quality collateral from the system that QE has actually reversed itself, giving the world its first look at what happens when QE demonstrably fails. And let’s not forget Japan, where the world’s most hilariously absurd example of central bankers gone stark raving mad has done exactly nothing to pull the country out of the deflationary doldrums.
And so here we stand, on the precipice of crisis with central banks having run out of both ammunition and credibility. In short, it’s time to ask if central banks have officially lost control. For the answer, and for the "QE end-game decision tree", we go to BNP.
Note that if CB's do lose it, the likely scenario is: "deflation, vicious cycle... economic depression".
* * *
Not "IF" but "WHEN central banks lose control?"
The global financial repression pushed investors to invest cash in risky assets, such as property and equity. The scale of global policy interventions is trumping all fundamental factors for now. Investors should keep in mind that the road is never straight and next month should be full of potentially disruptive events impacting sharply overcrowded assets and trades. History shows that such misallocation of resources creates bubbles that can last before fully blowing; the question is not if, but when.
Risk assets and risk parameters would be massively affected in the event central banks lose control;in the meantime, EDS Asia believes that central bank maturities that use forward guidance matter more than the QE process itself. The Fed and the ECB have been providing guidance which partly explains the low short-term volatility. The BoJ is moving toward this behaviour, managing the news flow: therefore there is a case for the NKY index going up slowly with a lower upfront volatility and a term structure closer to the US one: in that sense, we have started to observe an "SPX-isation of the NKY Index" in the past few months before this summer’s risk-off, as short dated volatility was trading lower. In China, the PBoC intervention learning curve is steep; this is the reason we believe the next equity leg up will be accompanied by an elevated volatility regime.
The quantitative easing started in the US more than six years ago and the SPX index, as well as selective risky assets, are now hovering at the high end of their valuation histories. Recent price actions are testimony of the fragility of imbalances built over the years. Investors may recall the Japan easing experience in 2005 and 2006; an early exit, together with a global financial crisis, caused a Japanese equities meltdown (between mid-2007 and late-2008).
In the decision tree, EDS Asia addresses the potential "QE end-game scenarios" [attempting to] answer the question "Are central banks losing control?" and providing a time horizon and probabilities affecting each path, which should allow investors to get a clearer overview.
The "Great Accumulation" Is Over: The Biggest Risk Facing The World's Central Banks Has Arrived
To be sure, there’s been no shortage of media coverage regarding the collapse in crude prices that’s unfolded over the course of the past year. Similarly, it’s no secret that commodity prices in general are sitting near their lowest levels of the 21st century.
When Saudi Arabia, in an effort to bankrupt the US shale space and tighten the screws on a recalcitrant Moscow, endeavored late last year to keep oil prices suppressed, the kingdom killed the petrodollar, a move we argued would put pressure on USD assets and suck hundreds of billions in liquidity from global markets.
Thanks to the fanfare surrounding China’s stepped up UST liquidation in support of the yuan, the world is beginning to understand what we meant. The accumulation of USD assets held as FX reserves across the emerging world served as a source of liquidity and kept a bid under things like US Treasurys. Now that commodity prices have fallen off a cliff thanks to lackluster global demand and trade, the accumulation of those assets slowed, and as a looming Fed hike along with fears about the stability of commodity currencies conspired to put pressure on EM FX, the great EM reserve accumulation reversed itself. This is the environment into which China is now dumping its own reserves and indeed, the PBoC’s rapid liquidation of USTs over the past two weeks has added fuel to the fire and effectively boxed the Fed in.
On Tuesday, Deutsche Bank is out extending their "quantitative tightening" (QT) analysis with a look at what’s ahead now that the so-called "Great Accumulation" is over.
"Following two decades of unremitting growth, we expect global central bank reserves to at best stabilize but more likely to continue to decline in coming years," DB begins, before noting what we outlined above, namely that the "three cyclical drivers point[ing] to further reserve draw-downs in the short term [are] China’s economic slowdown, impending US monetary tightening, and the collapse in the oil price."
In an attempt to quantify the effect of China’s reserve liquidation, we’ve quoted Citi, who, after reviewing the extant literature noted that for every $500 billion in EM FX reserve draw downs, the effect is to put around 108 bps of upward pressure on 10Y UST yields. Applying that to the possibility that China will have to sell up to $1.1 trillion in assets to offset the unwind of the great RMB carry and you end up, theoretically, with over 200 bps of upward pressure on yields, which would of course pressure the US economy and force the Fed, to whatever degree they might have tightened by the time China’s 365-day liquidation sale ends, to reverse course quickly.
Deutsche Bank comes to similar conclusions. To wit:
The implications of our conclusions are profound. Central banks have accumulated 10 trillion USD of assets since the start of the century, heavily concentrated in global fixed income. Less reserve accumulation should put secular upward pressure on both global fixed income yields and the USD. Many studies have found that reserve buying has reduced both bund and US treasury yields by more than 100bps. For every $100bn (exogenous) reduction in global reserves, we estimate EUR/USD will weaken by ~3 big figures.
Declining FX reserves should place upward pressure on developed market yields given that the bulk of reserves are allocated to fixed income. A recent working paper by ECB staff shows that the increase in foreign holdings of euro area bonds from 2000 to mid-2006... is associated with a reduction of euro area long-term interest rates by about 1.55 percentage points, in line with the estimated impact on US Treasury yields by other studies. On the short-term impact, one recent paper estimates that “if foreign official inflows into U.S. Treasuries were to decrease in a given month by $100 billion, 5- year Treasury rates would rise by about 40–60 basis points in the short run”, consistent with our estimates above. China and oil exporting countries played an important role in these flows.
Which of course means the Fed is stuck:
The current secular shift in reserve manager behavior represents the equivalent to Quantitative Tightening, or QT. This force is likely to be a persistent headwind towards developed market central banks’ exit from unconventional policy in coming years, representing an additional source of uncertainty in the global economy. The path to “normalization” will likely remain slow and fraught with difficulty.
Put simply, raising rates now would be to tighten into a tightening.
That is, the liquidation of EM FX reserves is QE in reverse. The end of the great EM FX reserve accumulation means QT is set to proliferate in the face of stubbornly low commodity prices and decelerating Chinese growth. And indeed, if the slowdown in global demand and trade turns out to be structural and endemic rather than cyclical, the pressure on EM could continue unabated for years to come. The bottom line is this: if the Fed hikes into QT, it will exacerbate capital outflows from EM, which will intensify reserve draw downs, necessitating a quick (and likely embarrassing) reversal of Fed policy and perhaps even QE4.
The Market's "Other" Panic Indicator Just Went Off The Charts
With indicators from macro-fundamentals (e.g. retail sales, core capex, inventory-to-sales) to market-oriented measures (VIX levels and backwardation, HY credit spreads, commodity prices) all flashing various colors of dead canary in the coal-mine red, we thought today's colossal spike in the Arms (TRIN) Index was a notable addition.
An Arms Index value above one is bearish, a value below one is bullish and a value of one indicates a balanced market. Traders look not only at the value of the index, but also at how it changes throughout the day. Traders look for extremes in the index value for signs that the market may soon change directions. The Arm's Index was invented by Richard W. Arms, Jr. in 1967. In essence, a sudden surge in the TRIN indicates a jump in trader lack of confidence, as everyone scrambles to either go long the 2-3 rising stocks, or to sell or short the biggest decliners, ignoring the bulk of the market..
Today's move was far greater than "Black Monday's market-halting crash:
Having done lots of fishing this summer at Camp Kotok in northern Maine, Danielle DiMartino Booth is here interviewed by FRA's Gordon T Long. Danielle is a former Dallas Federal Reserve Bank Advisor and now the Chief Market Strategist of The Liscio Report. She takes an Austrian School of Economics viewpoint on economic and financial matters.
Danielle emphasizes how she understands financial repression "in her bones" because she worked in "The Financial Repression Factory", referring to the Federal Reserve. She understands the level of malinvestment, mispricing and lack of price discovery as the unintended consequences of repressive and obfuscating monetary policies of central banks. She thinks the Federal Reserve "does not have a deep enough appreciation of malinvestment .. as if Ludwig von Mises never walked the planet."
She is angered by the considerable level of savings which has been foregone thanks to the quantitative easing (QE) policies of the Federal Reserve. Gone are the days of retiring on a Certificate of Deposit paying a decent level of interest income, due to the virtually 0% interest rates.
Danielle says there must be a renewed emphasis on education and innovation in America for it create jobs and jobs that are higher-paying generally than is currently the case.
Check out her recent speech - subscribe to our Mailing and Alert System and we will email you the PDF or view the Scribd below:
Low-income workers and their families do not earn enough to live in even the least expensive metropolitan American communities, according to a new analysis of families’ living costs published Wednesday.
The analysis, released by the left-leaning Economic Policy Institute, is an annual update of the think tank’s Family Budget Calculator that reflects new 2014 data. The Family Budget Calculator is a formula designed to determine the income “required for families to attain a secure yet modest standard of living” in 618 different communities across the country that the U.S. Census Bureau defines as metropolitan areas. The formula uses data collected by the government and some nonprofit groups to measure costs of housing, food, child care, transportation, health care, “other necessities” like clothing, and taxes for families of 10 different compositions in these specific locales.
The updated Family Budget Calculator shows that even the most affordable metropolitan areas in the country are beyond the reach of millions of American families with incomes above the official federal poverty level. The official federal poverty level for a family of two parents and two children in 2014 was $24,008, according to the EPI. But the least expensive metropolitan area in the country for this family type is Morristown, Tennessee, where a family needs an income of $49,114, according to the Economic Policy Institute’s budget calculator.
The Economic Policy Institute also estimates that minimum-wage workers — who almost universally earn less than the federal poverty level — lack the income needed to make an adequate living in any of the communities surveyed, even if they are single and childless. The think tank notes that this includes minimum-wage workers living in cities or states with a higher minimum wage than the federal minimum of $7.25 an hour, or $15,080 a year for a full-time worker.
Even families with incomes closer to the middle of the earnings spectrum lack the means to maintain an adequate standard of living. The nation’s median household income was $51,939 in 2013 — the most recent year in which data were available — not much higher than the cost of living in the relatively inexpensive Morristown.
The characteristic feeling of the post-2008 world has been one of anxiety.Occasionally, that anxiety breaks out into fear as it did in the last two weeks when stock markets around the world swooned and middle class and wealthy investors had a sudden visitation from Pan, the god from whose name we get the word "panic." Pan's appearance is yet another reminder that the relative stability of the globe from the end of World War II right up until 2008 is over. We are in uncharted waters. The relentless, if zigzag, rise in financial markets for the past 150 years has been sustained by cheap fossil fuels and a benign climate. We cannot count on either from here on out...
Early last month, we noted the irony inherent in the fact that Saudi Arabia, whose effort to bankrupt the US shale space has been complicated by the Fed's ZIRP, was set to opportunistically tap the debt market in an effort to offset a painful petrodollar reserve burn. As Bloomberg reports, Qatar is now doing the same, "raising money from local banks as the slump in oil prices buffets the finances of the Middle East’s largest oil and gas exporters."
Over the past month or so, we’ve spent quite a bit of time detailing the effect the death of the petrodollar has had on Saudi Arabia’s financial position. Recapping briefly, Riyadh’s move to Plaxico itself in an effort to bankrupt the US shale space late last year has forced the kingdom to draw down its petrodollar reserves to ensure that ordinary Saudis aren’t affected by plunging crude. Add in a proxy war (or two) and you get a budget deficit of 20% to go along with the first current account deficit in ages. The cost of maintaining the riyal’s peg to the dollar doesn’t help either.
The situation described above has caused the Saudis to tap the debt market to help fill the gap and indeed, some estimates show the country’s currently negligible debt-to-GDP ratio climbing by a factor of 10 by the end of next year.
But make no mistake, all of the above should not be mistaken as a suggestion that the Saudis aren’t rich - very rich, and if you had any doubts about that, consider the following description from Politico of King Salman's arrival in Washington for his first meeting with President Obama:
In anticipation of King Salman bin Abdulaziz of Saudi Arabia’s stay, the Four Seasons hotel in Georgetown has done some redecorating — literally rolling out red carpets in order to accommodate the royal’s luxurious taste.
Eyewitnesses at the property have seen crates of gilded furniture and accessories being wheeled into the posh hotel over the past several days, culminating in a home-away-from-home fit for the billionaire Saudi monarch, who is in Washington for his first White House meeting with President Barack Obama tomorrow.
“Everything is gold,” says one Four Seasons regular, who spied the deliveries arriving at the hotel. “Gold mirrors, gold end tables, gold lamps, even gold hat racks.” Red carpets have been laid down in hallways and even in the lower parking garage, so the king and his family never have to touch asphalt when departing their custom Mercedes caravan.
The guests staying at the 222-room hotel for the next couple of days are all part of the 79-year-old king’s entourage of Saudi diplomats, family members and assistants, one source said; a full buyout of the entire property was reserved for the visit. Guests who had booked to stay at the Four Seasons during the royal visit have apparently been moved to other luxury hotels in town. A call to the Four Seasons confirmed the hotel is sold out Thursday, Friday and Saturday nights.
King Salman, who ascended the throne in January, has a habit of displacing commoners for his own comforts; this summer, during a sojourn to the French Riviera, his eight-day stay forced the closure of a popular beach, enraging locals. Salman rolls deep, with a reported 1,000-person delegation joining him for his seaside August vacation.
Wall St. Journal reporter Carol Lee snapped this photograph of Salman's entourage arriving at Andrews Air Force Base on Thursday:
The king will reportedly discuss a number of rather pressing issues with the Obama administration including:
Of course the Iran nuclear deal will also come up, especially in light of the fact that, as The New York Times noted earlier this week, "Republicans are considering legislative options to counter the deal, including the possible reimposition of sanctions the agreement is supposed to lift," now that the President has secured the support he needs to sustain a veto of a GOP challenge.
Perhaps more importantly, the two leaders will also discuss Syria and oil prices, with the latter issue now having a rather outsized impact on America's shale producers as well as on US majors' capex plans. Needless to say, the real question from a geopolitical perspective is whether Obama and King Salman come to any closed-door agreements on Syria where, as Al Jazeera delicately puts it, the US and Saudi Arabia are set to orchestrate a "managed political transition."
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
THE CONTENT OF ALL MATERIALS: SLIDE PRESENTATION AND THEIR ACCOMPANYING RECORDED AUDIO DISCUSSIONS, VIDEO PRESENTATIONS, NARRATED SLIDE PRESENTATIONS AND WEBZINES (hereinafter "The Media") ARE INTENDED FOR EDUCATIONAL PURPOSES ONLY.
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