It's all one trade
Cracks have appeared in the Japanese bond market, and potentially ours as well, as the world's finances may be reaching critical stress-points.
Buckle up because we have a lot to cover. The past 10 days have seen some very important action in several markets that is worth delving into in detail.
First, I want to talk about the crack in the Japanese bond market that occurred on May 23. I believe that was a very important moment in recent and longer-term financial history. In the near-term, I believe it marked the end of the "sweet spot," a term I have used to describe the environment we've been in where people believe that central banks could create an easy-money nirvana at the push of a button.
You can check out anytime you like
In a recent column, I mused about which bond market -- Japan's, Britain's or ours – would crack first. Now we know: Japan's. The reason I say the sweet spot has ended is because on May 23, the very early stages of a funding crisis hit Japan.
This is demonstrated by the fact that Japanese government bonds traded through 1.00%, which is two-and-a-half times their rate when the Bank of Japan's huge quantitative easing efforts began. One can imagine the carnage that would occur here if our 10-year rates leaped higher in a similar fashion.
It was also a mini-demonstration of a point I made last week: Once you have entered ZIRP (a zero-interest-rate policy) you can never leave, unless you have a funding crisis and the market drives rates higher, despite central bank commands/demands.
In terms of a timeline, I believe the action in Japan is analogous to first-payment defaults during the mortgage meltdown, which began in early 2007 and were a sign that the subprime market had cracked. However, it wasn't declared "contained" until six to nine months later. During that period, fallout from the bursting of the housing bubble was not only not contained, it was spreading.
The storm after the calm
The Federal Reserve is trapped and -- as May 23 demonstrated -- so is Japan. The choice central bankers are facing is the same one that has confronted them since the money printing inspired by former Fed Chairman Alan Greenspan began. Once trouble starts, they have to decide if they are going to allow their economies to fall into a depression or go down a path that seems painless but leads to inflation.
My belief has been that central bankers -- as they have already demonstrated -- will always choose the path that leads to inflation because they think they can easily stop it. And for a long time (most especially recently), people have believed that the money-printing path was essentially painless. I believe that view peaked on May 23 (even though no real inflection point can ever pinned down to one day, or even one week).
In other words, the macroeconomic and financial environment cannot get any better than people already thought it was. It was not as good as people thought, but "the best has been seen/imagined." From here, warts will begin to appear, and we will start to go from all news being good to all news being bad. But that is a continuum and will take some time.
Turning to this week, worldwide volatility continued, this time centered -- for once -- in the U.S. bond market. That may or may not be meaningful, but in this case, and in light of Japan's bond market, I think it is.
The $64 trillion question, however, is: "Why are bond markets sinking?" Is it (1) just noise; (2) too much liquidity; (3) not enough liquidity; (4) too much leverage/too many people short volatility; or, most importantly, (5) the beginning of a funding crisis?
The recent declines in U.S. and Japanese bonds (I will restrict my comments to those two, since what happens elsewhere will be an extension of what happened with those) are most likely due to a combination of factors, primarily some noise, but also too much leverage/too many who are short volatility.
When rates are held artificially low, with the promise that they will be kept there for an even longer period of time, it is easy for careless, greedy and/or naïve investors to get in over their heads trying to turn what is available from the bond market -- i.e., nothing -- into something that might actually be called "yield." As the saying goes, more money has been lost reaching for yield than at the point of a gun.
As for the underlying root cause, is there insufficient money printing (which could easily be solved by central banks), or is there too much (which would be the early days of a funding crisis)? I believe that for Japan the answer is a combination of points 1, 2 and 4 above, which lead to point No. 5.
Though it isn't articulated as such, the combination of leverage and monetization promises have precipitated a selloff and a gigantic increase in volatility, which will be very hard to get under control. Even if this is ultimately going to create a funding crisis (which is quite likely), nobody would be able to articulate exactly how and why right now. Just as it would have been almost impossible in late 2006 to extrapolate the final collapse of the economy, stock market and financial system at the end of 2008 from the initial first-payment defaults, even though they were all part of the same process.
Such is the case today in Japan, though I believe there are going to be many vicious crosscurrents along the way.
As for the U.S. bond market, which was really roughed up on May 28, the blame has been laid at the feet of Fed chief Ben Bernanke (i.e., point 3 above) and the other Fed heads trying to talk out of both sides of their mouths. It is understandable that Bernanke & Co. would want to prepare the markets for the eventual end to quantitative easing. They have never understood that they are the problem, and they continually think that money printing will solve everything, so every now and then, when the stock market gets frisky and the economic data get better, they contemplate that they will be able to stop someday. I don't believe that, as when the end comes for QE, it will be because the bond market has forced it to stop.
It can happen here
But whereas Ben's threat to someday print less money has been blamed for the backup in U.S. yields (and I'm sure that had some role in it), part of what is at work, in my opinion, is the same process that is occurring in Japan. And since the fact that the Fed may someday buy fewer bonds doesn't impact Japan, it is clear its problem is a case of "too much." (That said, teasing out the precise reasons for why markets move on any given day is usually close to impossible, and when you are trying figure out what might be causing a massive inflection point, it can be even more difficult.)
The bottom line, I believe, is that Japanese authorities have "lost the bond market" (i.e., rates are much higher than authorities want, despite their best efforts) and the Fed has as well, but, perversely, Japan may be further along in the process, even though its powers that be started much later to really get serious about QE-powered monetary debasement.
As far as markets go, the crosscurrents emanating from the macro consequences of money printing (and associated socialistic government policies) are going to be treacherous, and that is unavoidable. One needs to understand that essentially the macroeconomic environment has been all that has mattered for the last decade.
Money printing precipitated the stock bubble, which led to a bust, and nothing mattered but the macro, in both directions. Ditto during the housing bubble: Nothing mattered on the upside or downside except money printing or its consequences. (Reckless policies caused the bubble, but as it unwound, nothing mattered until enough money was printed to turn it around again.)
One-lane road ahead
In the last four years, nothing has mattered except how much money was printed. When the consequences of that are felt, that is all that will matter. That doesn't mean individual security research is meaningless, because you have to know what you are involved with, but if I were to pick one motto, it would be: "All macro, all the time; it's all one trade."
As for our stock market, folks are still concluding that Goldilocks was not a fairy tale and is, in fact, exactly what the Fed has engineered -- i.e., economic activity that is not too hot, nor too cold, with interest rates rising ever so gently. The same delusions that allow one to think that also indicate that rising interest rates are actually bullish because they theoretically mean the economy is getting better. Historically, pre-Greenspan, that was the case most of the time. But now, since we live in a world with make-believe interest rates picked by the Fed, assets are much more likely to be mispriced -- something stock bulls fail to comprehend.
Thus, our stock market feels bulletproof, as we are the leaders in the Goldilocks propaganda. The recent carnage in fixed incomes in Japan, the violent equity selloff there and the bond market decline here have done almost nothing to dent the enthusiasm of that camp in America.
Save the last dance for QE
However, following the crack in Japanese bonds, my friend the Lord of the Dark Matter said, "I would expect in the coming days (and given the violence of this selloff, it is days, not weeks) that central bankers will reaffirm their commitment to liquidity and that they are 'all in.' They will make their intentions both clear and unambiguous. If the markets don't stabilize after that, then it is '1987 time' for equities."
I totally agree. Eventually, even the really slow learners should be able to understand that the central banks are trapped and that their only choice is between depression and easy money.
Yet what has the average Worker gotten as a consequence of the all the Global Fed Printing, little if next to nothing. You can't really invest if you don't make a living WAGE. You can't retire if the Government steals all the money you poured into Social Security. So as Corporations Hoard Record Profits and Cash on Hand, the plight of the average Worker continues. Eventually, many will wake up, after the fact.
it was all just an illusion, brought to you by the tricksters at the central banks. however, some individuals never fell for it, some did. those who did may have to do some heap big splainin.
I disagree with you bill. The fed can manage it way out of this. We don't have to have a depression or inflation. What the fed needs to do is put real money in the hands of the consumer. The fed needs to keep the real inflation rate between a deflationary 1% and 0% inflation. Any real inflation is a tax on the consumer. Also, it has to be real CPI not this BS their feeding us now, and it must include gas and food. If saviors can make real money on interest, that also, will aid consumers. Interest rates may increase but not that much because saviors will be making real money.
The biggest problem is congress and fiscal policy. We need to cut taxes on business and reduce government spending. Final Consumption sales tax - no person or item exempt - then give the American people the direct right to decide what they want to buy thru government (bypass congress). The American people need to understand by reducing government they will also, increase their standard of living. Congress is the enemy.
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ABOUT BILL FLECKENSTEIN
This column is a synopsis of Bill Fleckenstein's daily column on his website, FleckensteinCapital.com, which he's been writing on the Internet since 1996. Click here to find Fleckenstein's most recent articles.
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As the devil-may-care bravado of Wall Street marches on, history warns that -- in the end -- there will be the devil to pay.
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