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Central Banks Fool The Markets Again, But Only For A Little While

Over the weekend, the following happened: China’s exports and imports fell by 11.2% and 18.8%, respectively, numbers which, for a trading power, are nothing short of apocalyptic. Japan’s Q4 GDP shrank at an annualized rate of 1.4% which, for a country that had spent the previous three years borrowing and printing record amounts of new currency, is an extraordinary admission of failure. And US allies Turkey and Saudi Arabia appeared to be invading Syria, putting them — and by implication the US — in direct confrontation with Russia.

This combination of disturbing trends and events would, you’d think, produce a dark and chaotic opening for Monday’s global financial markets. But you’d be wrong, because while the above was going on, Mario Draghi, head of the European Central Bank announced that he “will not hesitate to act” to keep the past month’s instability from spreading. And traders responded the way they’ve been trained to, with panic buying of pretty much every dicey financial asset and panic selling of safe havens like gold, Treasury bonds and euros.

This came after previous attempts by central banks — including China’s yuan devaluation and Japan’s foray into negative interest rates — failed to get the markets’ juices flowing. So why did Draghi succeed? Three reasons:

1) He has a history of this kind of thing. Recall his 2012 “whatever it takes” promise that ignited the most recent leg of the global asset bubble. So despite the fact that he doesn’t actually do much, traders seem to find the ex-Goldman Sachs banker’s words inordinately comforting.

2) One of the things Draghi seems to be offering this time around is protection against Italy’s imminent banking system implosion. 18% of Italian bank loans are “non-performing,” i.e., not making payments. This is almost without precedent for a whole country and extremely rare for individual banks — usually the latter die before things reach this point. So if the ECB changes the rules to, for instance, allow Italian banks to use non-performing loans as collateral for new financing, that might keep them alive for a little while longer. Though at the cost of vastly increased taxpayer liabilities.

Traders of course don’t care about vague notions of future obligations, assuming that they’ll be inflated away or otherwise forgiven by some future Super Mario. So the prospect of bank bailouts is, to them, an unalloyed good thing.

3) It was time for a counter-trend rally. The first six weeks of 2016 were among the worst starts to a year ever for stocks and junk bonds (and among the best ever for safe havens like Treasuries and gold). Trends don’t go in a straight line; instead they take two steps forward and one step back, repeating those dance steps until the cycle ends. So traders were waiting for an excuse to buy suddenly-cheap bank and tech stocks.

Based on past experience, the pop might endure for another few days or even weeks. But then the abject failure of recent central bank experiments will once again start to color perceptions. To take just a couple of examples: Four years after Draghi’s “whatever it takes” boast, Italy, as previously mentioned, is imploding and Deutsche Bank, Germany’s dominant financial institution, is releasing a drumbeat of bad/ominous news including escalating losses, massive lay-offs and flat-lining divisions. It is now being mentioned in the same breath as Lehman Brothers.

Japan, meanwhile, offers a useful clue about the effectiveness of whatever the ECB and for that matter the Fed might try next. The money it has pumped into the economy, as measured by central bank assets — the bonds and stocks it has bought with newly-created yen — rose from 25% of GDP in 2007 to nearly 80% today. But the Japanese economy has gone exactly nowhere. For a great recap of the wasted effort that is QE, see $12.3 trillion of QE has added up to…this?

Central bank balance sheets Fed 16

In short, the limits of this kind of monetary policy are now visible for all to see. Despite differing levels of ease, all the major economies are performing pretty much the same way, with slow to slightly-negative growth, steadily increasing debt, and spiking asset price volatility. More QE is unlikely to change that.

So…what next? Probably a brief respite from “risk-off” followed by the resumption of turmoil (financial, geopolitical or both). Into this breach will step the US Fed because, as Deutsche Bank noted today, only the Fed can do it:

Only the Fed can save stocks now: Deutsche Bank

(CNBC) – The prolonged sell-off in risk assets across the globe will only abate if the U.S. Federal Reserve changes its path and begins to loosen its monetary policy once again, according to strategists at Deutsche Bank.

Chinese growth fears, stress in the U.S. energy sector and fragile balance sheets in European financial companies have all been credited in the last week for fueling the sell-off. However, there’s only one real cure for this current bout of weakness, according to a team of European equity analysts at the German bank, led by Sebastian Raedler.

“Without policy intervention, there is more downside risk for equities,” the bank said in a note entailed “The smell of default” on Monday.

A major focus for the analysts has been rising bond yields on riskier corporate debt in the U.S.. This has been seen as a sign of an end of the current credit cycle, which in turn could that could pave way for a number of defaults in the country, the bank noted. Raedler said that U.S. high-yield spreads – the difference between investment grade and non-investment grade bonds – have risen above their 2011 peak and warned of the potential for a self-fulfilling “full default cycle.” He highlighted the stress had started with energy firms – that have been hit by the oil price plunge – but added that it wasn’t confined to this sector.

“To avoid a further rise in U.S. defaults, we will likely need to see a Fed relent, leading to a sustainable drop in the dollar, higher oil prices and reduced energy balance sheet stress,” the bank said in the report.

The problem for investors is that there is little sign of the Fed wanting to change course, Raedler added. Data last week from the Bureau of Labor Statistics showed that U.S. firms were continuing to hire with 5.6 million job openings in December 2015, up from 5.43 million job openings in November.
Rather than cutting, these data are likely to leave the U.S. central bank on course for more rate hikes after it decided to tighten policy at its December meeting last year. However, Fed Chair Janet Yellen sounded a more cautious tone in her testimony to Congress on Thursday.

Equities have been roiled this year with the pan-European Euro Stoxx 600 index down 12 percent and the S&P 500 already losing nearly 9 percent, both on course for their worst year since the 2008 financial crisis. Deutsche Bank shares have been at the forefront of the selling in Europe with questions raised over the quality of its balance sheet.

A “full default cycle” in the U.S. would trigger a further 20 percent downside European equities, Raedler said, but would also increase the risk of a U.S. recession. He believes that this rising cost of debt for corporates would reduce their spend on investment and hiring. Falling equity prices would also urge people to save and thereby dent consumption growth, he added.

22 thoughts on "Central Banks Fool The Markets Again, But Only For A Little While"

  1. Impeach Obama and elect a real President who actually knows how to run a business. The Federal Government INC would have been out of business years ago, had it not been for their ability to print more money out of thin air. You would think that they would at least downsize.

  2. I think we will look like eastern Europe in ten years, Just a shell of a country. We’ll still be fighting wars somewhere and be 100 trillion in debt.

  3. The Western oligarchs will sink Europe first, then America, in order to reset both Continents in their vision…serfs and kings…all safety nets gone…the kings rule and decide who lives, how they live, and who dies, and how they die. Long live the oligarchs…there is no number of serfs too large to sacrifice to keep the oligarchs supreme!

    1. I, for one, welcome our benevolent, new overlords and hope that my children may one day be of useful service.

          1. So you’re not a free market kind of guy? The Constitution never said a word about slavery or child labor.

  4. There is always the secret sauce QE left in the system, CB’s backstopping everyone again like they did in 2009 until the crisis blows over. Except the crisis never really blew over the first time.

    Well, anyway, they have all the digital digit money in the world to ‘lend’ on the sly to the likes of foreign governments and US corps. Don’t think they won’t do it again.

    After all, we need to destroy the system to save the system.

  5. The global stock market was oversold, only in the short-term, and it was a holiday for U.S. traders which means low volume can mover prices higher for the day. Some shorts may be covering overseas also. However, for Deutsche Bank to be crying for Janet to come to their aid, seeing how these banksters have dug their own grave again without the graveyard caretaker present to assist, Tough Nuggies. The well is dry, the cookie jar is empty, and the Fed has shot its last wad and has really an empty bag of tricks.

    Mario has done such a good job for Europe as at least a dozen countries are sinking under the sea of debt, let’s let him run for U.S. President. No history of management successes necessary.

  6. Well, it will be interesting to see what the Fed does. CBs generally have the reputation of making poor decisions so the question becomes, which is worse, further easing that will extend and exacerbate the depth and scope of the ultimate adjustment, or continuing to allow things to deflate gradually like they are now to avoid catastrophe later on? Unless this time is different, it will be A.

    1. I have to cordially question your option B, that things will continue to deflate gradually if they don’t resort to more easing. Feels to me like the options are to kick the can or suffer quick, catastrophic implosion (albeit we don’t know exactly when– it’s a time bomb with an unknown number of minutes left).

      If I were benevolent dictator of the West I would behave like a survivalist, only on a societal scale. Line up natural gas and petrol reserves, rice and wheat stockpiles, request temporary overproduction of all medicines, have the bureaucrats make plans for running public transportation gratis (this applies more to Europe), Identify crucial imports (medicine, lightbulbs, shoes, batteries) and get prepared to backstop these with government-issued letters of credit. Arrange backstops of the commercial paper market should it freeze up. Defer funding from intel and military to FEMA-style emergency services, while still insuring we have enough funds & petrol to get our troops home. Find ways to make sure the schools and schoolbuses still run (all holy hell breaks loose if the schools close). And then… just pull the plug. Blow up the derivatives, devalue vs. gold, wipe away debts, eliminate subsidies, recall virtually all troops, massively curb campaign donations and lobbying to force a political re-boot… and just start over. Get the citizenry through a total financial collapse without (much) loss of life or public health disaster and then move on.

      That the elites will have done *none* of the above before the collapse comes goes without saying, of course.

      1. Interesting ideas. Of course the multi-trillion dollar question is whether or not things will continue to deflate gradually if CBs step aside and stop intervening, or if they will collapse uncontrollably at some point unless more is done. If so, then “kicking the can” for as long as possible may be the most rational approach since catastrophe is considered unavoidable at this point. But maybe that’s not true. Considering the fact that CB interventions haven’t worked as well as expected (or at least as advertised) suggests that no one really understands the financial markets and global economy and so any other predictions based on that misunderstanding are questionable.

        It would be interesting to see how markets would respond if they were told that no more interventions will be forthcoming instead of continually getting the message that CBs will continue to intervene as necessary. Preparing for interventions effectively creates a need for them and so it’s self-perpetuating. Some may think just a little more “help” is all that’s needed for the global economy to “kick start” and resume it’s upward march, but without a better understanding of why their policies haven’t worked better thus far that’s hard to justify and believe. The “conviction” that no more easing will lead to catastrophe may be wrong. When have CBs ever done that? What history is there that justifies that fear?

        1. excellent thoughts. MAYBE Yellen is thinking this with her comments. Maybe the FED will go ahead and raise rates again and stop kicking the can down the road to see what happens. since what they have done so far does not work maybe they will try a new approach as you suggest. To answer your question I know of no previous history on this issue

        2. I would imagine the CBs and their puppet masters are analyzing the cessation of QE and interest rate tightening and then testing what comes next in various locales, like Japan, Europe, etc. to see what they can predict going forwards.

          There is of course a bit of a remote possibility that things will suddenly stabilize and all of the voodoo economics employed in the last 30 years suddenly starts performing per expectation/model – but that seems highly unlikely.

          My guess would be more QE and kicking the can further down the road. That is the drug of choice for Wall St, and Deutsche Bank, there have been few political ramifications of that strategy (no one seems to understand the implications of creating $12 Trillion out of thin air so why worry about it) and why change a winning formula now?

          Of course most of us on here believe that more easy money and debt will make the solution that much harder to reach eventually, but almost everyone else seems to want the circus to keep coming to town and to forget about an inevitably bleak future!

      2. This is perhaps the best short description of a way to get through what we all know has to happen that I have read since getting in to the gold market and the contrarian scene back in 2002! Short, concise and covers most of the bases – ultimately the food supply is the key – keep the people fed and you can possibly avoid a major loss of control.

        Fundamentally the system needs to be reset, and when restarted the system parameters need a complete upgrade to the 21st century.

        Growth economics needs to go out the window, it’s no longer close to feasible. A Sustainable Economic Model needs to be thought through and modeled until balanced and achievable. Major investments in clean tech and alternative energy need to be validated and implemented. Government needs a complete overhaul, almost all of the current batch of blackmailed politicians needs to be removed. Make membership in any secret society illegal if you are going to hold public office (that’ll clear many systemic problems immediately!). Shut down K Street completely!

        I could keep going but I think we think along the same lines.

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