Aftermath (Part 2): The Domino Effect
Members of the FOMC continue to come out with statements that suggest that the Federal Reserve stands at the ready to back up the truck with additional QE if things turn south. This being weakest economic recovery ever seen over the past century, even while the federal funds rate has remained significantly below the CPI measurement of inflation. It is alarming to note that the Fed sees little evidence of the economy moving forwards the point that it will allow true price discovery to return to the broader market. Before the big brains at the Fed even begin quantitative tightening they are already considering the possible of an economic downfall from releasing the air from their debt bubble. Perhaps they realize what they are attempting is not likely to be successful, but consider the risk of not moving towards normalizing things before the next recession hits to be even more problematic.
The primary support of the market is now being threatened by Janet and friends and things could get very ugly in short order. After multiple rounds of market manipulation by the Fed known as QE1, QE2, Operation Twist and QE3, we witnessed over $3.5 trillion pumped to the markets, plus trillions more in additional government debt, while the flow of easy money has allowed the creation of many other debt bubbles throughout the economy, we are about to witness how well gravity works.
Of course if there is no relation between the record highs in the S&P 500 and the Fed's balance sheet than all should be fine. Quantitative Easing was great at inflating the economy with massive debt, but Quantitative Tightening won't be an issue, says the Fed. This requires some form of suspension of basic economics relating to supply and demand, but this is just the start of the Fed's delusion. As the Fed decreases their holdings over time the demand of debt securities will alter market pricing and corresponding interest rates. As prices decline, the inverse movement of interest rates will climb.
The true question is how long will investors sit while the profitability of their holdings decline, as debt servicing costs climb on the many debt ridden equities. How comfortable will highly levered equity funds be holding positions and waiting as they begin to turn downwards. How will record levels of margin impact the markets if margin calls occur during a downturn. How will bond holders react to declining bond prices. How about the long list of highly indebted retail outlets having difficulty managing things at the current low rates, drowning in red ink cope. The economy is loaded by numerous debt bubbles, from commercial real estate, student loans, auto loans, consumer credit card debt. Delinquency rates are climbing at alarming rates, but none of that seems to be a concern. The markets don't have a worry in the world as VIX remains at extreme low.
Yes, the markets have done a good job ignoring market risk, as the Fed Put has been firmly in place. Everything is great when you have the major central banks across the world telling you they will eat up the risk. Just printing more money is how they still do it in Europe and Japan, which are monetizing huge levels of debt and supporting increasing numbers of zombie corporations. In essence their economies are completely reliant on endless amounts of quantitative easing, or asset purchases, or market manipulation. Its really all the same thing. They are completely bankrupt, but the markets have yet to turned out the lights. It's all fun and games, until market risk returns and price discovers finds its way back into the markets.
Now in the United States we have the largest purchaser of debt securities over the past ten years saying they want to decrease the size of their book and think it won't impact the markets and the economy as a whole. Market mechanics suggest that as the future profitability outlook of corporations decrease, due to increased debt servicing costs, the valuations of those corporations will also fall. If valuations start to be hindered by increasing debt servicing costs, we won't have to wait long before highly levered funds will be at the switch looking to unwind. From there the domino effect will begin.
This will bring us to the start of the a market correction. Considering the size of this debt bubble, the correction could easily be multiple times larger than the one in 2008/09. There is a ton of excessive debt tied to the current economy and the investment markets as a whole.
Former chairman of the Federal Reserve Alan Greenspan has come out and stated:
" By any measure , real long term interest rates are much too low and therefor unsustainable. "
Those who thought their bond investments were completely safe will face a new world of hurt, once the market starts moving and bad debt starts to default. Just as we saw the last time the Federal Reserve created a massive debt bubble, there will be significant pain felt throughout the economy. The last collapse of the economy has also shown us the Fed will move mountains to protect many of the biggest players, while allowing many of the smaller players to fall at the weigh side.
Moving toward the next Fed bubble economic collapse Janet Yellen has stated the Fed will look to utilize it wide range of tools (manipulation) to further artificially stimulate a very weak and debt dependent economy. We can be fairly certain that the Fed will look towards more money printing to "support" the markets and biggest banks by buying the bond market back up.
If the United States follows Europe and Japan with endless money printing then a much bigger currency problem will face the economy. The current decline of the US dollar is just a small sample of what is around the corner. Once the Fed begins QE Endless Infinity the value of US dollar will be driven down, as investment funds will move out of American markets. Endlessly money printing to cover debt is the behavior of a defaulting economy, but the backwards Keynesians still try to suggest it as some form of intelligent stimulus measure. At the end of the day the Fed's hands will be tied, as the markets will not accept for endless QE. The last time it was all defined as temporary measures.
A decade later and we are still living within the same temporary emergency measures. The temporary measures were not temporary after all, not in the least. The markets seem to have overlooked this point as trillions of dollars were poured into the markets by the Fed. The world is at 325% debt to GDP and the biggest central banks are still pumping 1.5 Trillion dollars of new money into the black hole every year. The Keynesian experiment has been an epic failure. The economy is crippled by record levels of debt, while the individual savings have paid the price. Many pension plans are on the cusp of default and the bubbles keep getting bigger and bigger. The tipping point is drawing near.
The only thing that has changed is the size of the bubble. Once the Fed starts it quantitative tightening and the market support is taken away, the domino effect will begin. One way or another true price discovery will return. When the Federal Reserve moves back towards more QE in a desperate attempt to stop their bubble from collapsing it will be the start of the decline of the US dollar. This decline in the dollar will drive up costs on imported goods and thus result in a major expansion of inflation. Inflation is a killer especially if it is not accompanied by strong economic growth. Raising rates is tough enough while the economy is running hot, but it is much more painful for the average person when the inflation is driven by a declining dollar, within a weak economy, as we saw in the 70's.
It will not be just a declining stock and bond market hurting the US financial psyche. The declining purchasing power of the US dollar will be a very painful pill to swallow. The next domino to fall will be the rising costs on government to service their debts, while many government pension funds face collapse. The result of out of control inflation due to loss of purchasing power, as we saw in the 70's, and the eventual rising interest rates to follow will put government in a very bad position.
