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Wednesday, December 10, 2014

Central Banks and World Stock Markets

With few exceptions, the world’s stock and bond markets continue making new highs, all the while listening for the tiniest of clues that Central Banks (CB's) might be reversing gears or curtailing their apparently endless backstopping of securities.

But so far at least, any time things seem to get a little wobbly, especially after some slightly concerning remark from one or other mouthpieces of the world’s main CB's, one of their members steps up to the plate with news of new “liquidity injections” and soothing words.

But of course, propaganda notwithstanding, the underpinning economies and fiscal situations of most nations continue to deteriorate. So the pricing of securities and their actual free market values continue to diverge ever wider.

What is worse, the whole concept of risk seems to be disappearing. Take a look at sovereign bonds. It used to be that the bigger the risk that a nation could not repay its debt obligations, the higher the interest rate demanded to lend to that nation. Logical, huh? Well take a look at Spain's debt situation since 2008:

Now take a look at the yields on Spain's bonds!

Spain Government Bond 10Y Yields (courtesy of http://www.tradingeconomics.com)

So the divergence is pretty clear! Sometime in 2012, the markets began to let go of all pretense that there is any risk whatsoever in holding toxic debt, provided that CB's could be counted on to buy it up whenever things start to look dicey and real buyers had disappeared. This is the essence of "ZIRP", the so-called Zero Interest Policy espoused in one form or another by most of the world's CB's, which, in some cases has become "NIRP" or negative interest rate policy.
Of course, this engenders precisely the opposite behaviour by indebted nations to that required to reduce their reliance on borrowing. After all, if you can borrow for next to nothing, what the heck, right?

Of course, this moral hazard has spread throughout the world's economies, as subordinate interest rates for almost everything have been driven lower. Consumers continue to buy on credit, especially for big ticket items such as vehicles where interest rates are often next to zero. In the meantime, savers and pensioners are being ravaged. A yield of 2.5% on $1million in savings will only bring $25,000 annually. It's hard to live on that. And how many have saved a million, anyway?

Interestingly, when CB support becomes questionable, the markets begin to work again. Look at these charts of a selection of Government 10 Year Yields. What is the only one that makes any real market sense? Well, Greece, of course. And why? Because it is not certain whether Greece will remain a part of the EU. So in that case it could not depend on being backstopped by the European Central Bank (ECB). So Greece's bonds get priced accordingly.

The bottom line is that in an attempt to rescue the banking system (remember that most CB's are run to a large degree by bankers) and the economy, central banks have created enormous investment bubbles in securities that are artificially priced on a variant of the greater fool theory, where the greater fools to whom you can pitch your investments are the CB's.

But CB's may be slowly coming to be in fear of what they have created and increasingly, concerns are being expressed that the divergences between markets and reality can not continue indefinitely.

I urge all to observe the markets carefully as the day will come when CB's can't or won't continue to madly print and buy everything in sight in an attempt to keep it all glued together. When things get unglued this time, the carnage will be much worse than anything we have seen in recent history.