Friday, October 23, 2015

Suppressing Volatility with CBs

The global central banks (CBs) are doing their best to support asset prices, under the veil of deflation and growth fears.  There is an interesting research report by Artemis Capital Management, a volatility fund that blames central banks for creating shadow convexity and moral hazard with their market supporting actions.  It is a fun read, but I totally disagree about shadow risks and future mayhem due to central bank intervention.

The biggest risk for financial markets is the lack of money, or liquidity.  The next biggest is high inflation, which kills the bond market, the backbone for capital investment.  That is why you had many more frequent crashes when the world was on the gold standard, when money was always tight.  Even with fiat money, without QE and artificial suppression of interest rates, you get spectacular crashes like 2008, and VIX regularly in the 20s, like the late 1990s.

What you get with constant QEs is a VIX at equilibrium around 14, where we are at right now.  The liquidity is still overflowing.  That is why the 1% keep spending like crazy, making vanity purchases driving up the art and real estate markets.  The Fed is still reinvesting assets on its balance sheet, they are not tightening anything.  Yes, 25 bps is a big deal.  Tell me how you would feel being long ZN (10 yr T-note futures) and having it move 2 against you (25 bps).  You would be down $2000 for each contract, which has an initial margin of $1500.  Wiped out if you were on full margin.

It is a goldilocks economy, not weak enough to stop stock buybacks but not strong enough to cause the Fed to raise interest rates.  It won't be like this forever, but the bar is very high for the Fed to raise rates, so the economy has to get really hot for them to act.  And this economy just doesn't have enough organic growth to get that hot.  So basically ZIRP forever.  

Draghi is the Italian Bernanke, the BOJ will buy anything, including stocks, and the PBOC will go to ZIRP policy before their crisis is over.  It is much more likely that we stay in a range bound market for a couple of years before we get a bear market.  I don't buy the argument that we will melt up to ridiculous levels, just because the demand for stocks is not that high from a demographic standpoint.  The demand for bonds is high, however.  I expect a continuation of the bond bull market and the equity bull market to turn into a range market making marginal new highs.  So basically expecting 2015 like range bound trading to repeat itself again next year, at a slightly higher level.

No comments: