Anatomy Of A Market Selloff

Tonight's offering for your acceptance, submitted by a Naybob of IT, and approved by the Nattering One, regarding Anatomy of A Market Selloff - by Mohamed El-Erian.  Mr. El-Erian's comments italicized.

What triggered the global selloff? "A repricing of global growth prospects." 
A generalization. IMHO, twin daggers, PBOC lowered, $ based debt proceeds were invested in China markets, already teetering RMB carry unwind, (margin calls) collapsed it. The contagion hit all global correlated assets. Why?

Yen? Euro? Franc? Up. Dollar Down. Why? Currency hedged carry trades... Long Nikkei, Short Yen, Long Euro Stoxx, Short Euro, Long SIX, Short Franc. What happened? Those equities tanked, the hedgers covered their currency positions. Further down the global path...

EM corps and the shadow banking system (the new market makers) had to liquidate anything (UST, Bonds, Equities) to make margin calls, while EM CB's (PBOC) liquidated reserves  to: sterilize dollar carry trade debt; support their markets; and currencies. All others were swept up in the ensuing tsunami of global asset correlation (domino effect) and the markets liquidity dysfunction.

"The result was the conventional mix of price air pockets, valuation overshoots and contagion." 
More accurate but with broad strokes. This time it is different, think impaired flows and smaller exits. Preface,  the IOER (interest on excess reserves) 0.25 % remuneration rate exceeds all money market wholesale funding rates in the traditional carry trade (borrow short to lend long investment savings paradigm) . Risk free IOER as paid by the Fed has made it unprofitable for the commercial banks to lend within the short end segment of the yield curve. This is where MMF's money market funds and the short end of the carry trade gets made.

Always follow the money. Where's the money? Show me the money?  Not in banks like 2008, but $40T globally in mutual, bond fund and ETF's. Since the commercial banks vacated market making at the short end, who filled the gap? Non banks or shadow banking utilizing cash, T-bills, repo, ETF's and derivatives for hedging. The latter three are less liquid and have been known to suffer asset freeze. It isn't the first, nor shall it be the last time.

Market makers live for the turn, and when there is none, they don't have to play. When there's a run on the bank, there are backstops, cash vault, required reserves, Fed window, repo, sell debt, FDIC. When there's a run on a fund, which are now reliant upon shadow banking, there are fewer backstops with less liquidity. When the funds minimal cash on hand is gone, they face forced asset liquidation potentially into an illiquid market with a dearth of buyers. On Monday, when the underlying assets of the funds and the hedges crumbled, what little liquidity there was vaporized in the markets, halting trading and resulting in a flash crash fiasco.

"Longer-term asset price stabilization could also come from a reinforcement of the markets’ economic and policy underpinning."

Asset price stabilization cannot occur when all quantum fluctuations are magnified and distorted. This is a rule of physics and applies to the surface of a bubble while inflated or during inflation. Translated, everything on the bubbles surface (perceived demand and supply) is distorted and true price discovery is impossible. This leads to overproduction and a world awash in overcapacity, which will eventually reverse the process through deflation. The economic and policy underpinnings are serial asset bubbles (2000 dot.com; 2008 housing; 2015 QE (quantitative easing) all created by monetary policy which has encouraged financial engineering over productive economic activity.

"But with economic growth consistently failing to take off,"

Why does the economy refuse to improve? Whats all this secular stagnation of media narrative? Why has US real household income declined 8% since 1999? The banks are no longer in the lending business, they are in the saving business. Fed paid IOER induced disintermediation for non banks. Prior to Oct 2008 non banks (financial intermediaries, MSB, S&L, CU), comprised 82% of credit market lending, with the introduction of monetary policy paying them not to lend, this destroyed non bank lending and investing.

In QE, when a CB (central bank) buys their own bonds, they reduce the supply, raising the price, lowering the yields, and driving down rates. The money created electronically or money from circulation, to buy the bonds is parked on the sidelines. Concomitant, when real rates are made negative via ZIRP, this creates a self reinforcing loop. In a flight to safety and search for yield, more money which was in circulation and could be invested as capital in productive economic enterprise, becomes sequestered in risk free assets (UST's), artificially suppressing rates and the rate of turnover or velocity of the monetary supply.
From above, risk free IOER 0.25% induced commercial banks to park the money in the form of excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves.  What do QE, ZIRP and IOER have in common? They are monetary policies which siphon off market liquidity (cash and assets with moneyness); artificially suppress interest rates and monetary flows (the pulse of the economy); subvert the flow of capital (the life blood of the system) to non productive (non PCE & non GDP) activity; and contrary to Keynesian dogma based upon false doctrine; are contractionary in nature to the economy.

"The best that can be hoped for right now is short-term market stabilization through another series of liquidity-driven Band-Aids." 
If you believe in this kind of mirage, then you can slap all the band aids you want on a corpse, see what you get? A mummy. More inappropriate monetary policies (QE, ZIRP, IOER) are not the answer.

All the contractionary policies have led to the transactions rate of turnover (or velocity) approaching zero, so monetary flows which are the pulse of the system and act as proxies for everything, have been choked off. Post crisis, the patient (economy) never recovered, Bernanke never loosened, the Fed kept tightening. Monetary policy choked the life out of what was left of the economy and smothered any chance of new growth by disincentivizing the proper allocation of the systems life blood, capital. It is called capitalism for a reason you know.

"This approach would provide much-appreciated immediate relief; but it wouldn't be sufficient to deliver the longer-term anchor of stability that the global financial system is searching for."

"Here" we find common ground. What got us here? Instead of making mid to small business loans and starting businesses, the banks and investors have been engaging in financialism (financial engineering) through asset speculation (commodities, currencies, equities, bonds, house flipping, etc.) None of these financial speculative activities add any significant measure of real PCE or GDP to the economy. Globally, we have traded real economic advance for financially engineered or speculative profit. Worshiping false profits can lead to serious consequences.

What could happen here? With the bubble deflating, we are currently facing global overcapacity (resultant of serial bubble reflation) turning to liquidation with a dearth of buyers and liquidity. Given limited upward and downward price and wage flexibility, unless monetary flows exceed the rate of change in real output by 2 to 3 percent, output can't be sold, production will be cut back, incomes will decline, and layoffs will ensue. Bad news, the above is axiomatic and self reinforcing. Good news?

What do we need to get out of here? We are lacking a durable and stable economic foundation based upon the economic advance of increasing wages, properly allocated capital and healthy monetary flows. Lacking this, any hope of recovery is an illusory mirage founded in false doctrine.