Central bank smackdown

July 09, 2014 14:15
Federal Reserve chief Janet Yellen is basically saying she won't have anything to do with risk and productivity and will continue fostering a low-rate environment. Photo: Bloomberg

The term “smackdown” was first used by professional wrestler Dwayne Johnson (a.k.a. The Rock) in 1997. Ten years later its use had become so ubiquitous that Merriam-Webster felt compelled to add it to their lexicon. It may be Dwayne Johnson’s enduring contribution to Western Civilization, notwithstanding and apart from his roles in The Fast and The Furious movie series. All that said, it is quite the useful word for talking about confrontations that are more for show than actual physical altercations.

And so it is that on a beautiful July 4 weekend we will amuse ourselves by contemplating the serious smackdown that central bankers are visiting upon each other. If the ramifications of their antics were not so serious, they would actually be quite amusing. This week’s letter will explore the implications of the contretemps among the world’s central bankers.

The opening riposte came from the Bank for International Settlements, the “bank for central banks”. In their annual report, released this week, they talked about “euphoric” financial markets that have become detached from reality. They clearly fingered the culprit as the ultra-low monetary policies being pursued around the world. These are creating capital markets that are “extraordinarily buoyant”.

BIS pointed out that despite the easy monetary policies around the world, investment has remained weak and productivity growth has stagnated. There is even talk of secular stagnation. They talk about the need for further capitalization of many banks (read: European banks). They decry the rise of public and private debt.

On July 2, two days after the release of the BIS report, Federal Reserve chief Janet Yellen took the stage at the International Monetary Fund conference and basically said she was having nothing to do with risk and productivity and spent her time defending the low-rate environment she has been fostering in the United States.

Mario Draghi of the European Central Bank piled on the next day, as if to reemphasize that the leading central bankers of the world are simply not going to pay any attention to increasing financial instability risk.

Immediately following an ECB meeting, Draghi gave us the following statement: The key interest rates will remain at present levels for an extended period ... [and] the combination of monetary policy measures decided last month has led to a further easing of the monetary policy stance. The monetary operations to take place over the coming months will add to this accommodation and will support bank lending."

My own interpretation is that Mario said, “I’ll see the Fed’s tapering and raise it by €1 trillion.”

The next crisis is shaping up to look a lot like the last one, just with a different cause. It is going to be a liquidity crisis.

What was the cause of the last crisis? Everybody points to subprime debt, but that was really just a trigger. What happened was that everybody in the financial world became distrustful of everybody else’s balance sheet and so decided to go to cash, but there was so much debt and so much invested in illiquid assets that everybody couldn’t get out of the theater at the same time.

It is happening again today. The intense drive for yield is driving down interest rates and volatility, pushing up assets of all kinds, and setting us up for the same song, second verse of the 2008 crisis.

French 10 bonds (OATS) are paying 1.7 percent. Spanish (2.68 percent) and Italian (2.83 percent) debt are paying roughly the equivalent of US debt. German debt, at 1.27 percent, pays less than half of US debt at 2.64 percent. Somewhere in that equation, sovereign debt is spectacularly mispriced. Rated 10-year corporate bonds are paying between 3 percent and 3.4 percent. That is less than a 1 percent premium for bonds that are only single-A. Seriously?

Meanwhile, Kenya recently broke the African record for a sovereign debut. After raising US$2 billion for “general budgetary purposes” – infrastructure was mentioned somewhere in the prospectus – and at a rate lower than expected (6.875 percent for 10-year maturities), as Dylan Grice wrote in his latest “Popular Delusions”.

There is a bull market in complacency. As Grice goes on to say, the illusion of central bank control is in full force. And one of the chief ironies is that a bull market can last longer than any of us can reasonably expect – and then end more abruptly than even the most cautious bulls suspect.

The St. Louis Fed Financial Stress Index is at its lowest ebb since they began calculating the index. How much lower can it realistically go? The answer is that no one really knows.

I don’t know what the trigger for the next debt crisis will be, but whatever it is, it will result in an even deeper liquidity crisis than we saw in 2008. That is just the nature of the beast.

You need to look into your portfolios, deep into your portfolios, and see what your various investments did back in 2008-09. Then take a deep, long, serious look in the mirror. Ask yourself, “Can I withstand another shock like that?”

Do you think you are smart enough to pull the trigger to get out in time? Do you have automatic triggers that will cause you to exit without having to be emotionally involved? Are there illiquid assets in your portfolio that you want to own right on through the next crisis? Would you rather be biased to cash today, when cash is in a true bear market and at its lowest value in years, if that cash will give you the buying power to purchase assets at prices that will once again look like 2009’s? Think about how you will feel in the wake of the next crisis, when cash will be king!

You should be thinking of cash not as cash per se, but as an option on future deep-value trades. There are few truisms in the investment world that are really valid, but one of them is that you make your money when you buy. That you sold at a profit is just another way of saying that you were smart to buy when you did. There is going to come a time when buying opportunities are once again going to be all around you.

The writer is an author, a commentator and publisher of the Thoughts from the Frontline newsletter.

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A noted financial expert, a New York Times best-selling author, an online commentator, and the publisher of investment newsletter Thoughts from the Frontline