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Since 2009, the global markets have been largely steered by Central Bank
policy, NOT organic economic growth. With the debt-based monetary system
dangerously close to shutting down during the 2008 meltdown, Central Banks
stepped in as the “buyers of last resort” to provide a backstop to the
system.
The problem is that the individuals running the Central Banks are prone to
human hubris, specifically overconfidence in the validity of their opinions
and abilities. Since most Central Bankers are Keynesian economists at heart,
they believe that granting Central Banks MORE power is always a good thing.
Thus, rather than stepping back once the Crisis had passed
(2011-2012), Central Banks continued to prop up the markets and push for
greatest Centralization of the global economy.
As a result of this, the initial distortions in the capital markets
induced by QE and Zero Interest Rate Policy (ZIRP) became systemic in nature.
Investors no longer bought assets based on perceived value relative to the
real economy. Rather, they bought based on perceived Central Bank actions and
promises.
The most egregious example of this pertains to the sovereign bond market
where investors began to front-run Central Bankers QE programs.
Indeed, the promise of “more QE” was one of the most powerful tools in
Central Banks’ belts. Mind you, it was the promise of QE, not the QE
itself that had the biggest impact on bonds.
Consider what happened in 2010.
QE 1 ended in June 2010. Soon after, the Fed began to hint at launching a
new program, QE 2. Bonds rallied hard throughout this period as investors
bought bonds to front-run the upcoming program. Once QE 2 was actually
launched, bonds FELL.
This was a classic case of “buy the rumor, sell the fact.”
In plain terms, the bond market’s risk profile was skewed not only by
Central Bank policy… it was skewed by the promise and hope
of additional policy. Indeed, the largest bond moves occurred BEFORE
QE 2 and Operation Twist were announced.
Below is a chart showing the performance of the 10-Year Treasury. Periods
in which the Fed was actively engaged in QE or Operation Twist are white.
Periods in which the Fed was hinting at or promising additional policies are
in green. Note that the largest bond rallies (meaning yields fell) occurred
during periods in which the Fed was PROMISING to do more, as opposed
to actually DOING anything.
And since the Fed began hinting at additional policy soon after any actual
policy ended, the bond markets became permanently skewed as investors were
continuously reacting to hype and hope more than economic realities.
The implications of this are tremendous. Modern financial theory dictates
that sovereign bonds, particularly, US Treasuries, are the only true “risk
free” rate of return in the current financial system. ALL other asset
classes trade based on where sovereign bonds, particularly US Treasuries
trade.
So if the US Treasury market’s risk profile becomes skewed by Central Bank
policy (and verbal interventions in the form of promises of additional monetary
policy), the entire financial system’s risk profile becomes
skewed.
Stocks (both developed and emerging), commodities, corporate bonds, muni
bonds… EVERYTHING was skewed based on the fact that the sovereign bond market
was pricing risk based on Central Bank policy rather than economic reality.
We’ve already gotten a taste of what happens when asset classes finally
“adjust” to underlying “demand” with the commodity markets: having operated
based on Central Bank money printing for five years, they then wiped out ALL
of those gains in six months as they adjusted to the economic realities of a
weak global economy.
Developed stock markets have yet to make a similar adjustment, but they
will… and when they do, it will be a DOOZY.
Smart investors are preparing now.
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Crash Survival Guide.
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