Where Does The Biggest Risk(s) Lie?

In reflecting upon the many doomsayers prognostications regarding systemic risk in the system and their attempts to make the case that it is worse now than in 2008, I see their points but struggle to see the timing. Sure, we are likely to see a cyclical decline or recession. The markets no doubt will be hamstrung by that, but I don't get the sense of a systemic risk event predicated upon a Minskian leverage moment. To be true, corporate balance sheets are not as strong as the aggregate numbers may propose. Much of the cash outstanding is concentrated among a small number of mega sized firms, and that is quickly being netted off against debt issuance to fund stock buybacks. A troubling development in my book and one for caution. There are many who point to the "too big to fail" banks having grown even bigger. There are many who point to the economic recovery being anemic. There are many who point to ZIRP and QE as creating an artifice for asset prices. There are many who point to China. Many who point to the potential for hyperinflation. Many who point to the obesity of the Fed's balance sheet. The global financial system is connected and interconnected. It is a tightly coupled complex system prone to collapse. But I think it takes significant time to build imbalances via increasing leverage brought about by growing confidence leading to complacency and hubris. I don't think we are there yet. The greatest accumulation of debt/leverage has taken place on central bank balance sheets and country debt. I think that is where the next crisis will arise from. But until confidence is punctured, central banks and countries can continue to issue bonds and increase their liabilities. The puncture is likely to be an "emperor has no clothes" moment and will forever re-shape the global financial system as central banks become ground zero for fear and contagion.

Monetary Roulette

Another thought to be developed is monetary roulette.

This is the game the central banks of the world are playing with their credibility and the global monetary system on the line as they continue to roll the chambers adding new QE to the system.

By now, they may have bought their own line that it may not actually have an effect.

The key question for policy makers are, when will the market call their bluff, and how big is the problem when they do."

Paraphrasing Herb Stein, "if something can't go on forever, then it won't."

Playing with fire

From January 1941 through September 1981, per Bernstein's figures, U.S. Treasuries shed 67.3% of their real value.

At a 3% nominal yield and 2.5% long term average inflation…locking in 0.50% real return….if inflation really gets going then all bets are off...and that return doesn't even take account of taxes.

Here is the real risk. Catastrophic risk. I don't think it is deflation. That is because the central banks are already all in on that one. They have already told us in no uncertain terms that they will do everything they can to forestall deflation. Fine. I believe them. If deflation takes place then the CBs are going to combat it. I think the real risk is that they are skating on thin ice. They not only lack credibility (they have used much of it up) but they lack the capacity to expand the monetary base (it is already overextended/on borrowed time). The likely result is things flipping from deflation to hyperinflation as total trust and confidence in the system evaporates. They are skating a fine line right now. If they do manage to get us out of the fire, then they will have been incredibly lucky.

If we don't go into deflation again, then we risk rising inflation and potentially hyperinflation (although that would require a real shock to the system).

We have plastered over the cracks. The system is fragile. Our psyches are fragile. Confidence is fragile (although I think it is very much seeping into the system at the moment and could very easily take us to the next level). But the whole thing is a facade, an emperor with no clothes. No one knows when the music will stop again, but stop it will.

Cat Among The Pigeons

Rising interest rates have thrown the cat among the pigeons.

Global markets are in flux as they weigh the likelihood and the implications of an end to the interest rate cycle.

I think this is classic market "crisis" following the pattern from the last few summers. Equity markets had been on a tear and needed a timeout and it was only a matter of time before the market latched onto something to justify it.

Abe gave them reason to worry and Bernanke caught them by surprise.

I don't think CBs have abandoned the QE formula and will provide confirmation of that if the markets continue a more sizeable pullback, ie. 12%.

Now at some point in the future rising rates are going to be a real issue, but I think current palpatations are a little premature. With the 10 yr pulling back from 2.3% we might have seen the high in interest rates for at least the next 6-12 months.

Playing With Fire

Central banks of the world really are playing with fire. Their margin for error is much reduced. Their capacity to expand their balance sheets is now more limited. All of which means their options are diminished.

What they really risk is the markets confidence in their ability to manage the process evaporating. If that were to happen, then all bets are off.

Japan looks to be the poster child for so much. First for the demographic shift the developing world will be experiencing over the next 20-40 years, but more presciently for how the market and economy respond to unlimited QE.

Short term, the effects of QE, whether in the US, Europe or Japan, have been impressive - at least from a market perspective. Each successive policy implementation followed by a surging market response only reinforces the belief that you "don't fight the Fed." And it doesn't hurt that there appears to be some causative correlation with economic improvement. In this environment it is easy to be lulled into a simplistic notion of cause & effect which misreads the visible immediate causes against the less visible long term effects. Beware. The longer term effects are still to be tallied.