Central Bank Heroin

The central banks have abused and overused their powers to try with all their might to avoid a recession. Not even a deep recession, but a garden variety cyclical recession.  We had plenty of them from the 1970s to the 2000s when secular growth was much higher.  But since 2008, we haven't had one, even with the worst global demographics and debt overloads in the past 80 years.

In the process of avoiding a recession, they have made the financial markets dependent on artificially low interest rates and asset purchases.  A move of 20 bps in 10 year yields to over 1.74% over one week in September was enough to cause nervousness in the equity market.  That is the definition of being hooked on low interest rates.  The stock and bond market are heroin addicts.  The central banks are the heroin dealers.

What we saw in September is a prelude to what will pester this market in 2017.  You had the ECB and the BOJ both refuse to give the market what it wants, which is more heroin (QE and more negative rates).  Instead, they decided to kick the can.  They have shown their reluctance to go even more negative with their NIRP.  Draghi is taking a wait and see attitude even with Brexit and Kuroda has disappointed market expectations in consecutive meetings by not expanding QE purchases and has adopted a yield control tactic, which effectively admits that they can only lower long term interest rates further by cornering their JGB market and making it even more illiquid, something they don't want to do.  With the 2 year yield in Germany touching -0.70%, we are hitting the limits of how low rates can go before you have many putting cash in safes.

Don't believe the paper napkin economist/fixed income experts that say NIRP is bad for equities and the economy.  If it wasn't for NIRP, the eurozone would be in even worse shape.  Sure, the banks' difficulty in passing on the costs of negative interest rates to their customers hurts their profitability, but it is a net benefit for their customers, which is much more important than the banks.  The lowering of corporate borrowing costs and mortgage rates is a definite boost that is ignored under the paranoia that negative interest rates hurts savers.  It only hurts savers who don't hold stocks or bonds or real estate.  Which is a small minority limited to poor people, who frankly, don't matter to the financial markets.

During the next recession, monetary policy will not be of much use.  It has distorted asset prices enough that they have created bubbles which make the economy even more vulnerable when the cycle takes a downturn.  Economic stimulus will be almost solely dependent on fiscal policy, which we saw in 2009 as being too little and too delayed in its implementation to be of much help to the economy or the markets.

The ingredients of a coming bear market are the following:

1) S&P 500 overvaluation.
2) Global government bond overvaluation and limited room to lower rates further.
3) Real estate overvaluation and speculation based on artificially low interest rates.
4) Deteriorating fundamentals as profit margins are no long expanding and revenue growth is in the low single digits.
5) Potential financial crisis in China based on overissuance of cheap credit and a gigantic real estate bubble.
6) Limited benefit that further monetary stimulus will provide in a future recession or crisis.  The heroin addict has built up a huge tolerance for the drug, it will take enormous amounts to see an effect, which could lead to overdose and disastrous consequences.

As for the current market, and the flavor of the week, Deutsche Bank, it is a nonissue, because there is no systemic risk from having to pay Justice Department fines.  It is paid and over with.  $5 billion these days is like a drop in the bucket when you consider that is what the ECB is buying on average in government debt in one trading day.