In previous posts I had laid out what I believe has been happening across the financial markets this past week on the heels of the FOMC statement and Chairman Bernanke's comments.
In summary - the Fed, the ECB and the BOJ, have created an environment in which the word "RISK" had no meaning. Once upon a time, in a galaxy far, far away, investors looking to put rare, scarce and hard-earned capital to work weighed the costs of so doing against the potential yield or earnings that they could expect. All things considered, if the reward was sufficient, they would choose to allocate that capital.
That all died with the advent of Central Bank intervention into the marketplace. Hailed by many, who are too short-sighted in their thinking in my view, as necessary saviors and as a sort of cosmic fire hose used to extinguish various financially-related infernos, they gave the green light to hedge funds, institutional buyers and sovereign wealth funds to throw any caution or reservations they might have to the wind and jump into a host of markets with little regard as to what might happen when the spiked punch bowl would be withdrawn.
In a near zero interest rate environment, yield hungry investors were focused on only one thing - how much they could make. Ne'er a thought flit through their minds about how much they might lose. After all, who was going to lose a dime if the almighty Central Banks were there continuously pumping liquidity into the financial systems? When this sort of environment is created, history has already taught us what to expect - a proliferation of highly leveraged, one-way bets. As long as the general consensus of the market players is that the status quo will continue, the game proceeds according to expectations and the seas are smooth.
Let a few rogue pebbles be introduced into the serene pond; a few stray gusts of wind arise, and suddenly, the sleeping mariners are startled from their complacency. That is what occurred this week.
I find it particularly insightful to observe what has happened in the interest rate markets. I have said many times, that those markets are the most significant on the planet, far more so than the equity markets and even more so than the currency markets.
Look at this chart of the US long bond. Notice the continued plunge even in the face of a sell off across the equity markets. Typically we see the exact opposite occurring when equities sell off, namely, bonds rise as money flows into safe havens. In other words, if "RISK OFF" is the play, bonds rise when equities sink.
What we had this week was BONDS FALLING right alongside EQUITIES. This is something far more than "risk off". It is a shift in perceptions aggravated by an enormous unwinding of one way bets in the interest rate and equity markets. Remember, the drive higher in stocks has been the continued expectation of unlimited amounts of liquidity. Same goes for bonds in the sense that $45 billion of Treasuries were going to be bought each and every month by the Fed as part of QE4's $85 billion per month.
Large speculators had positioned themselves accordingly in these markets to take advantage of that continued liquidity. The slightest fear that it would slow or cease altogether has set off a chain of uninterrupted selling as those massive positions built up since the start of the new year are being violently unwound en masse. Selling fuels more selling as margin calls proliferate and losses compound due to that same leverage now working against its owners. One has to wonder if we are seeing the beginning of the Central Bank encouraged bubble bursting?
Selling of the nature that we are witnessing in these markets can continue longer than many expect because it is all about money flows, reducing risk, rethinking exposure, cutting losses, etc. It will continue until all of that repositioning has been accomplished. Then the dust will settle out and we can re-evaluate.
In watching these things for as long as I have been trading, I keep coming back to the same thesis - the SOLE CAUSE OF THE WILD, INCESSANT AND UNPREDICTABLE VOLATILITY IN TODAY'S FINANCIAL MARKETS IS EVERY BIT THE CONSTANT INTERFERENCE BY THE CENTRAL BANKS. They refuse to leave the markets alone and are thus distorting the signals that would otherwise be generated. Their actions move markets from one extreme to the other by herding speculative forces and directing them in whatever direction those policies are designed to drive them. In the process of so doing, they create the perfect environment for reckless leveraging which always ends in creating more havoc and chaos. You would have thought they might have learned something from all the crises faced since the year 2000. Apparently not. Humility is certainly not a virtue found roaming the halls of the buildings that house these Central Bankers.
"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat
Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput
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