The Midnight Sun - Pt 1 - Are You Ready?
Summary
- This bubble dwarfs the last two combined, and would seem to be much more "combustible" in nature.
- Today's markets exhibit systemic structural deficiencies, internal liquidity issues and many potential market stressors.
- The synergism of systemic issues and multiple stressors could spawn large systemic collateral problems, leading to disorderly: deleveraging, portfolio rebalancing, pricing regimes and overall market instability.
You're traveling through another dimension, a dimension not only of sight and sound but of mind. A journey into a wondrous land whose boundaries are that of imagination. That's the signpost up ahead - your next stop, the Twilight Zone! - Rod Serling
I recently visited with old friends, some whom I had not seen in 4, 8, 15 and even 43 years. It was a pleasure reuniting and in my excitement I was remiss for not sharing this with them... Of late amongst other things, I've been Nattering about: repo, reverse repo, euro dollar, required reserves, Basel III, the ill effects of ZIRP and quantitative easing, and a seeming dearth of "moneyness" or market liquidity. Things might just be starting to get a little hotter under "The Midnight Sun" where it's usually prudent to pay attention to the signpost up ahead...
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Comments
Thank you very much for your articles. They are excellent. Your sense of humor also makes for entertaining reading.
From your articles I gather you are leaning toward door number one on your connecting the dots series which is essentially an old fashioned debt deflation dirty deleveraging. Ok- I'm in agreement.
What confuses me is your other two scenarios. In the second door scenario, which seems to me to be Jim Grant's concern of the excess reserves eventually finding their way into the economy, I don't understand why you spend the first half of the article discussing the over extended level of the equity market. How is that in any way related to the risk of the excess reserves finding their way into the economy? If the risk markets sell off, that will simply add fuel to the fire for a debt deflation spiral. If the excess reserves find their way into the economy that should in fact be equity market positive. Though bond negative.
In your third scenario, which seems to me to be a situation in which the Fed loses control of the yield curve, you expect a dirty deleveraging -ok- accompanied by hyperinflation... What?! Are you describing a loss of confidence in the dollar scenario? This scenario makes no sense to me at all.
If you have time, I'd like you to please clarify these other two scenarios.
Thanks again and please keep up the good work!
Door 1: Equities Melt Down - Overleveraged
Door 2: Supply Side (Collateral) Melt Up - market forces cause risk aversion/rising rates without the Fed raising, more stagflation, possible hyperinflation.
Door 3: The Pile of Debt is Too Big - too much debt in this world, rates can't go up much, ZIRP is here to stay. Balancing act required in the extreme. If it gets out of control, a combination of Door 1 & Door 2 TBD
Please clarify how a rise in risk aversion is hyperinflationary. I understand the causality of high inflation leading to high interest rates, but you seem to be suggesting scenarios in which the opposite occurs, which is not in any way mainstream financial wisdom. A rise in long term rates should eventually lead to a bifurcation in financial markets where we begin to see a dirty deleveraging, which is deflationary.
Have you read all of Ray Dalio's thoughts on this situation? I think framework is the best way to think about the current environment.
Thank you again.
"Please clarify how a rise in risk aversion is hyperinflationary."
Rising rates, rising monetary velocity, rising potential for inflation or hyperinflation depending. One caveat due to QE ZIRP there could be a muted effect or affect, please see http://naybob.blogspot.com/2015/04/the-transactional-velocity-effect-of.html
After rereading the linked post, I respectfully believe you are confounding correlation with causation.
To be specific, I think as type 2 transactions have increased the quantity if credit in the system, the yield curve has rallied in understanding that future returns, or further prospects of expansion of appreciative credit are limited.
As the system begins to deleverage, and it appears to be on the eve of doing so based on the developments you have highlighted in the ED market and the nominal declines in emerging market real estate, I think we will find that contrary to the expectations of nearly all market participants, long rates will continue to rally.
On this topic I believe Lacy Hunt has written some good notes.
Please provide a rebuttal if your time allows. I remain an open minded speculator only concerned with the truth and not my ego.
Thank you again for reading my messages.
Thanks for the pointers. No confounding here, my posit was confirmed ex ante, please do read one of the many proofs here: http://naybob.blogspot.com/2015/05/transactional-velocity-effect-proof.html
I know that some of what I posit would seem contrarian or counter intuitive, and it is for good reason. As you say, long rates could rally in a flight to quality or safety as the system deleverages.
At the moment, the system and its zombie investors and economies are dependent on QE and ZIRP, this is why any triggers are more likely to be rate sensitive. If rates remain low, its less likely to deleverage, unless the bond holders suddenly feel that they have been misdirected and inflation is not what it has been advertised as. Another possibility widening spreads on other types and grade of debt could led to the perception that risk premiums should be higher on government debt. With the bond holders huddled at near zero and negative ($3 trillion) this could get ugly.
Too much debt out there, small increases could be tolerated, but a series of hikes would have a cumulative effect (read Fed) and anything sudden or large would be a disaster. The balancing act that has to play out for a goldilocks ending is not highly probably. This is why many believe that QE and ZIRP are here to stay in perpetuity. That perception and CB QE side effects have the masses huddled into bonds and the yield curve artificially suppressed. Nothing in this witches brew of QE ZIRP is born of a normal market, hence, there is something in this more than natural.
In the future, please post to the respective missive you are referring to, i.e. Connecting the Dots comments/ questions should be directed to that missive, Transactional Velocity to that missive, etc. The Ministry of Information prefers it this way, easier to keep tabs on you.
Keep fighting the good fight.