The implausibility of a crash

Everyone agrees. The biggest risk to the markets is obvious. Central bankers are swapping quantitative easing (QE) for quantitative tightening (QT).

And QT could make the world blow up in all sorts of ways.

Citibank credit strategist Matt King told CNBC about how QT is creating the current market turmoil:

“what we are seeing is relatively modest withdrawals from the central banks suddenly have broader consequences than the central banks have been anticipating, and that therefore does constitute a greater tightening as if we had two extra Fed hikes more than they were anticipating.

“So far it is not systemic, yes we are not worried about banks falling over in the same way as 2008 or even 2012. At the same time, we would expect a broadening out of the stresses, or the tensions, beyond where they are at the moment. So far it’s just Libor-OIS it’s not cross-currency bases, and yet there are reasons to think that as the Fed drains excess reserves from the system, we will see that tension broaden out.”

It’s not just the amount of money that’s the key.

Higher interest rates from central banks and in government bond markets are causing turbulence too.

Bond fund manager and market celebrity Jeff Gundlach explained to CNBC too:

“the thing is that the stock market can’t take higher bond yields. And the line in the sand that we talked about in the past was 2.63 on the ten-year. And I said if that we break above 2.63, it’s gonna be trouble for stocks. And boy is that right. The second we went above 2.63 is when stocks started to get wobbly…”

Fund manager Russell Napier and UK columnist Ambrose Evans-Pritchard focused back on the money supply:

What everyone needs to know is that the USD remains the world’s reserve currency, and they have stopped making more of it.

And:

Key monetary indicators in the US, Europe, Japan, and China are flashing signals of an economic slowdown later this year, raising fears of a global recession in 2019 and a stock market slump without a shift in policy.

Monetarist experts warn that the global money supply is slowing much faster than widely appreciated, suggesting that the shift away from quantitative easing by the major central banks is already starting to have profound consequences.

Throw in the proliferation of zombie companies around the world who rely on low interest rates to survive, and those who borrowed in US dollars instead of their home currency because rates were low, and you have the potential for things to go dramatically wrong.

Despite all these risks, central banks are unwinding their support for government and corporate bonds in Europe, stocks in Japan and all sorts of mortgage-related securities in the US.

But I don’t understand something about all this.

Tightening monetary policy, in all its facets, is a reaction to economic growth and a bull market.

Remember, markets drive QE, not the other way around. Central bankers are watching inflation, GDP, stockmarkets, corporate bond markets, government bond markets and more. Based on the information there, they decide policy. They call it “data dependent”.

How can a crisis be triggered by data-dependent policy? If market moves determined QE, how can there be a sustained lack of QE that causes markets to fall? Policy will reverse immediately to reflate markets at the slightest sign of trouble.

Don’t get me wrong. There may be something else that triggers a crash.

Trump’s trade war is escalating by the minute. Although I agree that the war was really fought decades ago and lost by the Americans for the most part. One of their few victories was to force Japanese and German car manufacturers to move production to the US. The man who negotiated all that for Ronald Reagan is back working for Donald Trump now.

Back to today’s topic though. If the crash potential of the market is tied up in policy risk, but that policy risk is based on market performance, then how do you get a crash?

Yes, central bankers could make a mistake. They could raise rates too fast too late and uncover a bubble they financed. That’s what happened many times previously. But the world has changed. QE and directly buying financial assets is now the norm, not just interest rate fiddling. The interference in markets is now far more direct.

Central bank willingness to save the world from financial chaos is just a symptom of the deeper problem. These days, very few people are immune from financial market action. A central bank or politician who does not rescue us from the evils of a recession or financial crisis is toast.

In Australia, over 9% of your income goes straight to your so-called superannuation fund. And Australia’s super funds are overinvested in stocks. Where do you think this leaves a nation during a stockmarket crash? It’s a total nightmare. Politically and financially too.

The link is less obvious in Britain and around the world. But it’s still hugely important. No politician or central banker will withstand the media barrage of a flailing financial system.

Signs that QE is far from over

Above I mentioned that central banks are ending their QE programmes. The problem is, they aren’t.

Each time there’s strain in the markets, QE programmes bounce back. They’re already proving my point.

In March it was the European Central Bank (ECB) with its corporate bond purchases. Goldman Sachs reported they were suddenly 55% higher than average in the month when corporate bond rates had blown out.

In the same month, Japan’s central bank made its biggest purchases of stockmarket exchange-traded funds (ETFs) going back to 2010. This in the aftermath of the February correction in stocks.

The Japanese example is particularly interesting. The Bank of Japan (BoJ) now owns 77% of local stock ETFs. And foreigners own a huge chunk of the Japanese stockmarket. Theoretically, printing yen to buy stocks pushes up the stockmarket at the expense of the yen’s value in foreign exchange. Any escape attempt by foreign investors would send both the Japanese market and the yen crashing.

The point here is that the downside in markets would appear to be capped. And not just theoretically as I argued above, but actively as shown by the ECB and BoJ last month.

Yes, I’m certainly hedging my statement. I don’t know how true it is that there’s a limit to any crash before policy responds.

My real worry is that I can’t seem to find how all this snaps. Where does the crisis trigger which central banks can’t deal with come from? I don’t know.

Where does this leave investors? Well, despite arguing against every potential crash trigger I can find, buying fragile stocks seems like a bad idea. Just because central banks can prevent a crash, doesn’t mean there won’t be some sort of bear market. So stay out of financials and heavily indebted companies.

My suggestion is to invest in real stuff. Commodity and energy producers. Their products cannot be printed. And some, like precious metals, are the antidote to monetary madness.

You have a few days left to register for our upcoming Exponential Energy Summit. It’s all about investing in the various opportunities of energy markets. Especially technologies that have the potential to completely shift how those markets function. These could boom independent of any chaos in the rest of the financial market.

Until next time,

Nick Hubble
Capital & Conflict

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Category: Central Banks

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