Risk Returns to the Markets




As has been stated on The Hungry Money Badger previously, there is absolutely no way for the Federal Reserve to back out of their artificial manipulated marketplace, without popping the debt bubble they created.  If the Federal Reserve ever attempts to normalize the markets after pumping it full of excessive debt and mal-investments the markets will take a sharp turn downwards. If they allow interested rates to move higher than inflation, markets would react negatively.

Even after yesterday's sizable selloff, the current market valuations are not based in reality. Let me repeat. The current markets are NOT based on reality, in any way. The current market valuations are no where near what they would be if not for the massive monetary manipulation of the Fed and other central banks. It has all become a fantasy market built on what the big brains call Quantitative Easing (QE). Central bank actions have resulted in wave after wave of free money pushing debt and equity markets to ridiculously high levels, have instilled a seemingly risk free outlook among market (Non-Central Bank) participants and have ramped up debt levels within the economy to all time highs within government, corporate and consumers. This has brought us to extraordinary levels of real, yet unpriced risk, within the markets.

Over the past 10 years the world's central banks have taken it upon themselves jointly print up over 17 trillion dollars (and counting) and rammed it into what was formerly the free market system, in a synchronized move. This unprecedented action by central banks to socialize much of the world's debt markets and relieve the free markets of their primary roll of price discovery mechanism has warped market valuation of debt and equity securities and nearly muted market risk premium, which is suppose to keep valuations in check. The Central banks have overridden the invisible hand of free markets with blunt force.

Institutions are utilizing investment models that are using the manipulated treasury rates as the defacto market rate to calculate the present values of future earnings. Large institutions are more than willing to overlook this valuation error, as it certainly makes the markets look cheaper than they would otherwise. Who cares about reality, when we can use manipulated numbers to drive things higher. Of course when this bubble does blow up they will claim they could not see the valuation errors, which is because they choose not to look, but they will not be alone.

The Federal Reserve completely fails to understand the damage they have caused to the markets with their massive money printing, creating a massive debt bubble, while they have said continuously they see absolutely no risk.

It was all about pumping up the debt markets with cheap/free money, in order to encourage the growth in debt financing and removing any sense of fear. It been a free money panacea for the big players who have spent massive sums of borrowed money as no real cost, while they can borrow money below the rate of inflation, the principal sum will remain static. They can buy back their shares, or pile even more borrowed money into the markets, while not worrying about the cost to borrow.

Volatility valuations, which measure the perceived levels of risk in the markets have been pushed down to ridiculously low levels over the past number of years, as the markets were lead to believe the Fed Put was firmly in place. It has been 10 years of what the Fed initially called "emergency measures". They said their QE plan and free money was only to last a short period of time, but that has not been the case. The Fed is still holding 4.5 TRILLION of securities, much of it toxic waste from the last Fed bubble and that was 10 years ago.

The perceived Fed Put has opened the door to many institutions and individual investors to short volatility markets. It seemed like a great investment at the time. The markets could only go up in a world of free money sloshing around. Many large institutions have piled into this trade. Their was only one problem.

Chart from Yahoo Finance

As the overnight interest rates started to rise and the realization that the free money party might be coming to an end, bond rates started to climb. They kept climbing until those shorting volatility saw the writing on the wall. If rates go up those equity valuation models don't look anywhere near as good as they did before. Corporations which are saddled with massive levels of debt are suddenly forced to pay higher interest expenses. Once the markets realized that there was in fact actual real risk on the table, the VIX shot up and those shorting volatility took a huge hit. One example of this is in an exchange traded note, XIV. It closed yesterday at $99.00, down 14.32% for the day, but then fell another 84% overnight to a low of 15.43. As would be expected there has been some serious damage to some major institutions and individual traders as a result of the short volatility positions.

Now the market is left wondering, "How could this be??" Just last week the free money party was alive and well and just like that someone noticed the boat was leaking. Headlines of the normally blind financial media are suddenly warning of excessive debt risk.

Bloomberg News, Feb 5, 2018
(Read Here)

How long the sell off continues is anybody's guess, but whether the market bounces up or keeps falling, there is no doubt that we have a long way to go before market valuations reach some form of true equilibrium in a normalized market.





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