The Wall Street Journal this morning echoed many of the questions we’ve raised over the past several years about the sanctity of global markets. How are equity markets signaling economic strength while bond markets trade at the tightest levels ever? Why do gold prices soar while inflation remains “stubbornly” low? The answer, of course, lies in the Central Banking grand experiment that has distorted almost every corner of global markets. Per the WSJ:
What exactly is the market trying to say about the state of the global economy? Do the recent record highs in U.S. stock markets signal growing confidence in the recovery, or do soaring government borrowing prices and flattening yield curves as borrowing costs tumble at even long maturities signal market fears that the global recovery is a distant dream?
How does one reconcile this year’s 30% rise in the price of gold—usually considered a hedge against inflation—with long-term swap rates suggesting inflation will remain low
for years? And how does one explain the strength of European markets as many banking shares are trading at more distressed levels than at the height of the global financial crisis?
One answer to these disparities is that the markets have become so distorted by central bank activity that they are no longer transmitting very useful information about the economy at all.
As we’ve discussed on several occasions, low interest rates have created a number of distorted incentive structures that render typical market signals useless. Perpetually declining interest rates have forced pensions to indiscriminately buy the long end of the the government bond curve in a desperate attempt to match asset duration with their liabilities (see our post “Pension Duration Dilemma – Why Pension Funds Are Driving The Biggest Bond Bubble In History“). Meanwhile equity markets continue to soar to all-time highs, despite lackluster or declining earnings (see “The S&P Is Now Set To Report Its Second Consecutive Annual Earnings Drop Since The Financial Crisis“), on the premise that low-single-digit earnings yields are somehow adequate compensation for equity risk…an assumption they base on the low yields of the completely manipulated long-end of the curve. The circularity of the many arguments is truly mind numbing.
And meanwhile, proving the pure lunacy of global equity flows, Chris Chapman of Manulife Asset Management recently pointed out that equity prices are blatantly being determined by the market’s interpretation of what Central Banks may or may not do. Per a recent Bloomberg interview, Chapman pointed out:
“The message from the Fed has been conflicting and often not very clear. So, it seems when the hawks talk up the possibility of a hike, the market discounts it as just trying to get more priced in to give themselves the option to hike rather than actually being interested in hiking.“
But, at some point, of course, the madness will all end. As the WSJ points out, Central Banks around the world have made just about every accommodation they can make (we tend to agree given the staggering $13 trillion of negative-yielding debt around the world, see our post “With Over $13 Trillion In Negative-Yielding Debt, This Is The Pain A 1% Spike In Rates Would Inflict“) yet there is no end to the number of pending crises that can bring it all crashing down.
The prognosis is therefore likely to be more of the same: a lackluster recovery, kept alive by increasingly extravagant central bank action—but with one proviso: The biggest risk to the markets is political.
This has been true for several years, of course, but the difference now is that with monetary policy approaching its limits, there is little central banks may be able to do to offset future shocks.
With a packed political agenda—including referendums this year in Hungary and Italy and elections next year in the Netherlands, France and Germany, all of which could raise fresh questions about Europe’s cohesion—there is no shortage of events that could throw the recovery off track. Perhaps that is why the price of gold, the ultimate safe haven, has been rising.
At some point we’ll revert to a world where good news is good and bad news is bad but we suspect that a lot of pain will have to be endured to get form here to there.
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