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Wolf Richter: Making Sense Of The Recent Market Gyrations

Which triggers are driving the action? What's next?
Monday, October 15, 2018, 2:37 PM

Every week at PeakProsperity.com, we record a podcast exclusive for our premium subscribers titled Off The Cuff, where Chris and a weekly expert discuss the notable developments of the week. Every once in a while, we'll share one of these episodes with the general public, which we're doing this week. Here's Chris Martenson in discussion with Wolf Richter, evaluating the causes and repercussions of last week's violent drop across the stock and bond markets.

Recorded last week as the market was in full melt-down mode, Chris and Wolf Richter decode the underlying drivers of the sudden reversal, and peer into the future to predict what is most likely to happen next. Both agree that, whether stocks are briefly 'rescued' in the ensuing days, the long-awaited downward re-pricing of the 'Everything Bubble' is nigh.

As Wolf puts it:

The emerging market stock index is down 22% from January. So they have gotten hit pretty hard. There’s this trend from the outside toward the core. So when something deteriorates, it starts at the outside and moves toward the core, the core being the higher quality US financial instruments. So that’s probably a dynamic that has already started. And I agree with you. The central banks removing liquidity is a big thing, and it has a big impact.

And people have said, for years, well, QE didn’t cause stocks to go up. So when that goes away, it’s not going to cause stocks to go down. But that’s just not true. The purpose of QE, as Bernanke himself explained it in a Washington Post editorial in 2010, is to create the wealth effect, to bring asset prices up so that the wealthy feel wealthier and spend more money and then this someone trickles down. So this was an explicit central bank policy that other central banks, especially the ECB and the Bank of Japan, imitated. So now, this is being unwound.

We’re in a new era, I think, and the financial markets have to come to grips with it. And the central banks have expressed concerns about high asset prices, repeatedly, for two years now, and especially at the Fed. Including high commercial real estate prices, there’s some problems in the housing market.

They occasionally mention the stock market. They have fretted publicly about the leveraged loan market and some parts of the bond market. So they’re purposefully trying to bring down those asset prices. That’s something that investors will have to keep in mind. It’s not that the Fed has stepped away from supporting the markets. The Fed is actually trying to tamp down on asset prices because that’s gone too far and because these leveraged assets are putting the financial system at risk when the prices are too inflated.

So they’re trying to drain some of the risk out of the market. This is a big recognition. Once market players realize that this is going on I would imagine that they are somehow preparing for this.

Transcript: 

Chris Martenson: Welcome, everyone, to this Peek Prosperity Off the Cuff recording. I’m Chris Martenson, your host. It is October 10, 2018, and, wow, a lot of action in the markets today. Here to discuss that with all of us is Wolf Richter. Wolf, welcome to the program.

Wolf Richter: Thanks, Chris, for having me back.

Chris Martenson: Well, I’m really glad to have you here today because as I stare at my screen, I don’t know where this is all going to finish out. Sometimes, it gets wild at the end, but I’ve got the DOW down--I don’t know, close on 700 points here at this particular moment. And this has been setting up for a while. What I’ve been tracking is that bonds and stocks have been falling for a while, and that really looks to me like--oh, wait. Make that 800 points on the DOW. So that to me looks like a "sell everything" kind of moment, and you and I have been talking about that, sooner or later, the central bank tightening was going to begin to bite at some point.

And we now have a little bit of tightening, or that is a little balance sheet reduction by the Bank of Japan. I want to talk to you about that because you had a great article on that. And the Fed, with the European Central Bank down to, I guess, maybe 15 billion, (that’s all), euros a month. But just that alone seems to have maybe contributed to where we are today, and just interested to gather your thoughts on this.

Wolf Richter: Well, I’ve been saying for a year now that markets are completely brushing off the movements by the Fed, including the rate increases and the QE unwind or balance sheet normalization, as he calls it. Except for the treasury market on the short end, especially, and the high-grade corporate bond market, pretty much everything else has continued to perform really well, including junk bonds. The bigger the risk, the better they did, and stocks, too.

That’s not atypical for the early stage of a tightening cycle, and actually a rate hike cycle. We’re not really tightening yet. We’re just, as the Fed says, removing accommodation. So we’re making financial conditions a little bit less accommodative every month or so. So really, the tightening hasn’t started yet. We’re just taking away accommodation. At the same time, when you think about it theoretically, it should have had an impact on junk bonds on the riskier things, and on stocks, but it really hasn’t.

Today, the selloff was just pretty nasty. I’m looking at it now. The NASDAQ is down just over 4% at the close. This is getting back to where we were, in terms of the size of the selloff, in late January, early February, we had those kinds of days, but we’re still very close to the peak. The NASDAQ’s just off--it was at 8,000, so now it's at 7,400. So it’s off less than 10% from the peak.

I’ve been saying eventually these markets are going to get the drift that the Fed is removing accommodation, that it will be tightening, the financial conditions will tighten, and this will impact all kinds of things.

It just really hasn’t set in yet. Even after today’s selloff, I’m not convinced that markets are really reacting to the tightening. I don’t know what they’re reacting to right now, but I think this will drag out a little bit. For us to really see the impact of the tightening on the markets, I think we’ll have to wait a little while. And there will be an impact. There always is. Today was ugly, but it’s just the first really ugly day in a few months. I’m not sure that that’s really an indication that the markets are reacting to the Fed, yet.

Chris Martenson: You know the old saying is that you get a sharp movement in the opposite direction of the trend, so some bulls might be tempted to say, “Yeah. Well, we’ve had a sharp pull back, but that’s what happens.” And when you look at, really, what’s happened since the May lows that we had—and by the way, we turned around in the middle of the day. I think it was May 29th, if I remember correctly. And that was in the wake of the Italian elections that really spooked the markets, but somehow, the markets got unspooked the middle of the day. And that was the end of that, and we just went almost at a 55-degree angle up since then.

So here we are, and some might say, “Well, you get these sharp pullbacks.” But when we look underneath it a little bit, Netflix off 8% today. I think when the story stocks finally take it in the shorts, that’s when you have a big change in the trend. That’s a story stock to me. Come on, Netflix, right? You and I’ve talked about it.

Here’s a company with a lot of competition that hemorrhages free cash flow every single month. They seem to lose more money with every subscriber they put up, if you look at it from a cash flow basis, and yet they’ve just marched higher and higher and higher, except for today. That’s a pretty dramatic pullback there.

Wolf Richter: Yeah. I’m going to throw Tesla into that equation.

Chris Martenson: Yeah.

Wolf Richter: It is amazing how this works because today it came out that T. Rowe Price raised its stake in Tesla and that it bought another 17 million shares. These companies are owned by large funds to a pretty good extent. The large funds have written Tesla up all the way. So they’re sitting on tens of billions of dollars’ worth of shares and gains that they want to protect. The way they’re protecting it is by buying more than they’re selling off. This is particularly the case with Tesla because there’s very small float out there on Tesla.

It’s just Musk owns about 20% and then large funds own a whole bunch more. When you see these funds stepping in and throwing more billions at these shares to keep them from dropping further, it tells you that, number one, they’re pretty scared that this might turn sour on them. They’re hoping for a way to get out of it, I would think, but that’s really tough now. And number two, they’re playing with other people’s money, obviously, so it’s not that crucial to them.

When you have an environment like that where large funds try to protect the value of their stake by buying more when they head south, you still have a market that’s not coming to grips with reality. It’s like, okay, so we’re going to buy a whole bunch more, and Tesla’s going to go to $500. And then we might be able to sell or maybe Apple’s going to buy at $500, whatever. And there’s all these rumors out there. But what’s the exit strategy here? Tesla has a good chance of going bankrupt if it can’t fund its operations.

So these funds are trying to make sure that the same can continue like it has been, that the stock stays high and that, therefore, Tesla can fund its operations by selling more shares or by selling more bonds. As long as the share price is really high, Tesla is not going to go bankrupt. So if the funds are able to keep the share price high, their own stake is being protected that way. This is an amazing mechanism that I’ve seen with Tesla where time after time—and it was just confirmed today by T. Rowe Price.

So this is just a lucky moment that I’m able to throw this out, but this is how it constantly works with these companies. Until that turns around, I don’t think the stock market really has a chance of selling off properly because there’s too much of this game tactic going on still.

Chris Martenson: Well, I have to ask, T. Rowe Price bought those 17 million shares for whom?

Wolf Richter: Well, it’s a fund manager.

Chris Martenson: But they’re buying it for a fund that they’re managing? This isn’t like they’re doing it for a pension, or they’re not doing a share repurchase. This is for some sort of a fund that people are investing in?

Wolf Richter: Yeah. It’s not for a mutual fund, or maybe it could be for a mutual fund that they’re managing. I really don’t know what fund they stuck this into, but it’s not everybody’s portfolio. That’s what they do.

Chris Martenson: Yeah. Well, now, another thing I’ve been tracking, too, is that Russell 2000 was sneaking out the back door for almost a month now. Since the beginning of October, which isn’t that many days, right? How many trading days in are we? Like maybe seven or so trading days in. But the junk bond, the JNK junk bond fund, that’s been down pretty much every single day of October here.

So that’s where I’ve been looking to see this weakness finally show up is over in the bonds. It’s showing up. We’re seeing some pretty dramatic outflows in the bond universe. So this is what’s different about this to me is this isn’t the Jell-O moving around the plate. We move out of bonds into stocks and back and forth because one’s going up while the other’s going down.

I’m looking at this and I’m thinking “I am so thankful that I’m not running one of those so-called risk parity funds, which balances risks across stocks and bonds thinking it’s achieved some sort of risk neutrality,” because that works when, and only when, as I understand it, bonds move up and stocks move down and vice versa. But when both are moving down together, you’re going to have a lot of structural forced selling out of those funds, which they have to do just to try and keep things balanced according to their models. This is just the perfect storm for those people, I would think.

Wolf Richter: Yeah. I want to add a word of warning about bond funds in a moment.

Chris Martenson: Okay. Good.

Wolf Richter: Because they’re the most treacherous creatures out there, especially ultimate bond funds, such as mutual funds. But I’m looking at the junk bond index for CCC rated bonds and below, and the average yield is now 9.9%. These are bonds that are not too far away from default, so they’re very risky. This is a relatively low yield for them, and they’ve been as low as 7%. But they’ve been as high as 22% during the oil bust in early 2016, and the yield was over 40% during the financial crisis.

So 9% is really sanguine still in that arena, and these are the riskiest bonds out there with a significant chance of default. That end still hasn’t reacted properly yet. When the Fed started tightening, as soon as they started tightening in December 2016 and when they had one rate hike in December 2015, and then nothing for a year. And then they did another one in December 2016, and that’s when the cycle really started. At that point, these bonds were trading for like 12% yield. So they have come down, even though the Fed has, in terms of yield, even though the Fed has raised interested rates for the same time period.

I’m looking at these and there’s still a huge amount of risk appetite out there. At the riskiest end, corporate bond on the high-grade side, they have been selling off. There’s been a pretty good selloff there, as well as on the treasury side. Which brings us to bond funds. A bond fund can blow up. When you hold the bond outright, you own it outright, the only way you will lose money on it, if you don’t trade it, if you just hold it, is if the company defaults and goes bankrupt. Otherwise, you get paid face value and you come out okay.

If you own a bond fund, they can experience a run on the fund, and then they have to sell bonds, they’re forced to sell bonds into an illiquid market. They’re getting pennies on the dollar, and they can lose 60, 70%, and these funds shut down. Several big bond funds with Charles Schwab with billions of dollars in it blew up during the financial crisis. Many others did, too. This is a typical thing. You don’t read it often in the media, but it’s a typical thing for a bond fund to do. When it comes under stress, the unit holders will try to sell, and the bond fund is in an illiquid market on the other side and can’t really dump those bonds very easily.

There will be hedge funds out there, but they’ll buy them for 10 cents on the dollar. Nobody else wants to buy, but the bond fund is forced to sell. So this is the forced selling you’re talking about that’s coming from bond funds. There is a first mover advantage, and everybody knows this. So when you own a bond fund and you see it’s getting in trouble, before it really gets in trouble, you need to sell it. And everybody knows that, so the door is very small.

Everybody’s trying to get out at the same time, and these are just terrible, terribly, horrific, awful investments when bonds come under pressure. I would warn people. I love bonds. Bonds are good investments, but own them outright. If you own bond funds, it should be a closed-end bond fund that protects you somewhat more. An open-ended bond fund like that, it’s just a high-risk instrument when bonds come under pressure.

Chris Martenson: That’s really good advice, and it’s reminding me that back in the 2008-9 crisis, I remember that people were very disappointed in some of their bond funds, including people who were in what were billed as and marketed as treasury only. You know those prospectuses you get when you buy a fund? Like Charles Schwab will send you like this 80-page booklet? You don’t read that. Who reads that?

But if you did, these people would have discovered that "treasury only" meant, "yeah, you know, but from time to time, we reserve the right to invest in other things, including junk bonds, if we feel it’s appropriate up to a certain percentage of the fund." So some of those funds were 20, 30, 40% not in treasuries, and they were getting shellacked for the same reason. I thought that was not right, that people were being sold what were called treasury funds and they were not. They were hybrid funds with some treasuries and some other stuff in there.

Wolf Richter: This is, with bond funds, always the case. The descriptions are misnomers. One of the biggest—or the biggest—bond fund that Schwab had that blew up… And these became class action lawsuits and individual lawsuits, so this is all documented out there. This was a huge issue for Schwab and they settled all this stuff. I had a friend who didn’t participate in the class action who did a private lawsuit against Schwab, and they settled with them for much higher than the class action people got.

But when I was watching this happening, it was really interesting because, at first, it was billed as a money market equivalent bond fund, so a very liquid bond fund. And they paid a yield of 5.5%, which back then was pretty good. It was corporate paper and high-quality stuff and very liquid stuff and some treasuries, so when they show you in disclosures, they show only the top ten holdings of those funds. This was high quality stuff, at first. When you saw the top ten holdings, you felt pretty good.

Then as the financial crisis started to appear, and this is we’re talking late 2006, early 2007, people started selling off. The bond fund sold the most liquid assets first, the treasuries, the things where they actually weren’t losing money that they could sell in a liquid market. So the value of the bond fund didn’t go down, and they were selling the best, most liquid stuff. So the people that sold first got out with their skin intact.

Then what was left was the stuff for which there was no liquidity in the market. You couldn’t sell them. Mortgage backed securities… Now, suddenly, the top ten holdings were all kinds of mortgage backed securities and junk rated companies and god knows what else started showing up in the top ten. And they couldn’t sell those. The market had just evaporated for them, and that’s when, suddenly, the net asset value of that bond fund started plunging by percents a day. It was just terrible to watch, and you saw more and more of this crap showing up in the top ten holdings.

It was brutal. But this is where the disclosures are insufficient. You don’t know the top hundred holdings; you know the top ten. And when they’re sold, when they’re gone, yeah, usually, you’re okay up to that point. Then the illiquid stuff starts showing up. By that time, it’s really late to get out. So I just dislike bond funds with a passion. I love bonds, but I don’t like bond funds.

Chris Martenson: I’ve never traded in the bond market, so I don’t know much about the inner workings. I know what I’ve been reading, and I’ve been reading that, based on a bunch of rule changes that happened post great financial recession, that a lot of the primary dealers, a lot of the big banks, the market makers in bonds have stepped away. So I remember reading like a year, year and a half ago some Bloomberg articles that talked about extremely illiquid bond markets.

You’re talking about illiquidity, lack of bids that happens during a crisis moment, but they were talking about otherwise normal times when you’d put a corporate issue up and it would sit all day without a single bid. That there were days when the whole Japanese government bond market—of course, just a construct of the Bank of Japan—would go a whole day without any trades in a multi-trillion dollar market. Just crazy, right? So I’m wondering if that liquidity in the bond market itself is now lower than it should be because of changes that got made and all the big players sort of walking away, leaving almost like an empty market to trade in.

What happens when that suddenly gets hit with a bunch of redemptions and other attempts to sell? That feels like--again, I talk about broken markets. That’s an example to me, a broken market. These multi-trillion dollar bond markets with really thin liquidity just sounds like a recipe for disaster.

Wolf Richter: Yeah. Bonds were never designed to be traded like that. That’s an even bigger issue because we have a loan market, and they’re even more illiquid. But you have loan funds, leveraged loans. There are now more leveraged loans outstanding than junk bonds. Each leveraged loan is a unique contract, and it takes weeks to get one of those settled, one of those sold. They’re done by faxes and stuff. You’re talking about a market that was never designed to be traded like that, and yet these loans have shown up in mutual funds.

People trade in and out of these mutual funds on a daily basis, but the underlying assets can’t be sold for a week or two. That’s a, now, $1.2 trillion market, the leveraged loan market, which is a little bit above the junk bond market. So these are very large numbers, and each junk bond is a different deal. It’s not like a treasury bond where every treasury of the same maturity is the same thing. So the treasury market is very liquid. It’s the most liquid bond market in the world, and it’s really easy to trade them. But these corporate bonds are all different, all different risks and different issues.

So this market was never designed to be day traded, and that’s what we’re having now. We’re having a mismatch of liquidity. On one hand you have the day traders, people that invest in a junk bond fund because they think it’s going to go up 10% over the next week or two, and then you have the actual junk bonds that you might not be able to sell for a week or two, like you pointed out. This liquidity mismatch is a real issue today, and it’s kind of by design.

We should have never allowed bond funds to come into existence, to trade securities for which there isn’t enough liquidity to where it can be matched with the buying and selling on the front end of the fund. I think this is a fiasco waiting to happen. I’m just really worried about the bond fund market that we’re looking at because, on one hand, you have the lack of liquidity as you pointed out. And the big players disappeared during the financial crisis, so, today, they’re already gone. So I don’t know if that part is going to get a lot worse.

Bonds are always, unless there’s a rally of--unless the market is really hot, bonds are just always slow. It’s not easy to trade a corporate bond. Then, I’ve bid on corporate bonds, and you wait for the broker to call you back. And then two days later, he calls you back and he found one. And then the prices are opaque. It’s really hard to figure out what they’re actually worth. So I think when the market gets into trouble, we’ll have pretty good fireworks in the bond end of things.

Chris Martenson: Yeah. And I mentioned potential fuel on that fire which is some of the trading strategies that exist out there. You’re talking about investors, like you and me, somebody--I buy a bond fund, and then I decide I want to get out. So I contribute to a sell pressure where that fund has to match its assets to its redemptions and all of that. That’s one side, but then you’ve got these big, giant highly levered, very powerful funds out there running really sophisticated strategies, that one I mentioned before, like the risk parity strategy.

So they’re wading in and out of bonds and stocks just based on an algorithm that they have, and if the algorithm says sell, they sell. What you’re talking about is, okay, sell to who? Now we have to wander over to this market of bonds and discover that it’s not really liquid, a lot of losses can come up pretty quickly. Bid-less markets are truly terrifying because sometimes you have to—you’re in the position of having sell a position in order to meet margin or reserve requirements or whatever sort of—if you’re carrying leverage, whatever sort of terms are carried on that leverage.

So we have here, at this point in time, super leveraged markets. In the stocks and the equities, the NYSE, the debt, the margin position is huge, but all of these funds that are running these really sophisticated long/short strategies are usually pretty leveraged up.

It’s all fun and games on the way up. On the way down, it gets to be less fun. Again, how much of this do you think is due to the markets finally deciding that the music stopped several months ago? They finally all heard it, which happens to be the shrinking of the central bank balance sheets. How much do you place on that as being the actual trigger here?

Wolf Richter: I would want to see that confirmed in the markets. The dip buyers have shown up in the past pretty strongly. There are these scares and then the dip buyers come in. It’s when the dip buyers get wiped out time after time after time that I think the markets have turned. They’ve already turned because, really, so far this year, the markets have been volatile, and they’ve gone up and gone done a lot. But really, they haven’t done much. We’re kind of back where we were in January.

January was very strong up to January 26th, but then the bottom fell out and dip buyers came back in. And then they brought it back up. So this year has been pretty brutal, but 2008-2017, the S&P 500 went up 18%. And this year it’s just a struggle. So the markets already have changed. This is not the kind of relentless bull market that we had. This is already a market that is struggling with all kinds of issues. In that sense, it has turned. And yeah, why has it turned?

There’re millions of explanations for that, but I think, sooner or later, with the central banks stepping back from their market manipulation efforts—that’s really what that was. Asset price inflation is what they wanted to cause—the wealth effect. Those are the things that they wanted to accomplish and they did accomplish, stepping back from this. So they’re allowing the markets to kind of sort things out on their own. So they’re pulling back the market manipulation efforts.

Now, the market has to say, okay, without those efforts… Everybody loves market manipulation, so long as it goes up. Somebody tries to manipulate a market down, everybody screams. But the central banks were behind, officially, well documented, and talked about this market up manipulation. So now they’re stepping back. You may be right. This may finally start to sink in. For that to be confirmed, I would need to see a much bigger selloff. We would need to go below the 20% and stay below that. The dip buyers would need to get wiped out for a time. They would need to wipe out several years of gains for the theory to be really proven, I think.

Chris Martenson: Yeah. I know it’s a little early and sometimes things just correct and then keep going. So we’ll just see what this is, but there’s a number of things, you mentioned a lot of factors in here. The other one I know you track pretty closely is housing and all of that, particularly out in the San Francisco area where you are. Mortgage rates just a day ago, according to CNBC, jumped past 5%. I see you can still get them for less than that.

But with that, mortgage rates are now a full percent point higher than they were a year ago. I don’t know if you’ve been tracking, but the homebuilder stocks have just been doing horribly, maybe pre-signaling this. So it feels like real estate is one of those vaunted and most important legs of the economy is not doing super hot right now. Maybe no surprise, right?

Wolf Richter: Yeah. The Mortgage Bankers Association reported today, they’re doing a weekly report, and everybody’s got their own numbers. So they reported that the average—that’s the average mortgage rate, not the lowest one or the highest one, but the average mortgage rate for a performing mortgage is like 5.05%, so just over 5%, for the first time since 2011, I guess. But they also reported that this past week, and this is a weekly report, the number of purchase mortgages was up by about 2% from the number of purchase mortgages originated in the same week a year earlier.

So the mortgages for purchases are still being originated, so I have not seen a decline in mortgages yet on that basis. Now, if investors are stepping back from the market, and that may be what we’re seeing, big investors don’t get individual mortgages for homes. They fund these purchases at the institutional levels, securitizing some of their assets or issuing bonds or borrowing large amounts from a bank. So they can buy a home without getting a mortgage on it, and we’ve seen a big part of the home sales in the last few years being to the investors that do exactly that.

In some markets, that’s 30 or 40% of home sales go to investors, and these are mom and pop investors to the biggest ones that are publicly traded. Maybe the investors are starting to slow down, but in terms of the purchase mortgages, we haven’t seen the slowdown yet. On one hand, there’s still buying going on, even though there’s more supply coming on the market. We’ve seen that all around. In some of the most inflated markets suddenly, the supply is just flooding the market.

Everybody’s trying to sell. We have seen some price declines and sales are down in markets, so supply up, sales down. These dynamics are changing. They’re changing on a month to month basis, but they haven’t really brought the prices down on a year over year basis. So the housing market’s still strong enough, but the fundamentals are weakening. Now, that’s at 5%. My theory is, and I’ve been saying that for a while, that the pain threshold for mortgages will be 6%. At 5%, you’re starting to lose some marginal buyers, but it’s still too close to 4.5% to be really that meaningful.

But I think the pain threshold will be 6%. Once mortgages get closer to 6%, it will be very tough for people in the median household income arena to be able to afford a home at today’s prices in most markets. That’s just suddenly they’ve moved out of reach, so maybe they will buy a smaller home. Or they will just completely leave the market and rent. Many people who own a home will be stuck in their homes. They won’t be able to move because they have a mortgage that’s 3.5 or 4% and if they try to sell the house and move to a new home, they will pay 6%.

They couldn’t afford that. They’re imprisoned in their homes now, so to speak. And there’s a big factor. You see volume coming down. People are unable to sell the homes because they can’t afford a new home. The home price may come down a little bit, but they still can’t afford it because now the mortgage rates are so much higher than what they had on their current home. So I think there’s a lot of complications in this housing market. It’s messing up the fundamentals. It really hasn’t shown up in the pricing arena yet, fully, but I think definitely when we see 6% mortgage rates, I think this will be a moment of pain.

Chris Martenson: That important point you mentioned in there, the affordability. That’s obviously a very important sort of metric to look at. House prices are still up year over year, and mortgage rates are now a percent higher year over year. The affordability has just gotten worse in this dynamic. So I’d be surprised if we don’t already start to see things begin to move down in some of the hotter markets, as you’ve mentioned. At least, maybe we’re going to see sale volumes begin to slow down.

We’ll get inventory back up. That’s always the pattern in these things, and we’ve already seen that, of course, in Melbourne, in Toronto, London. There’s a variety of places where I think we can say, clearly, housing has already rolled over. It may be each of those is individual; it’s the commodities for Australia. It’s Russians leaving London. Whatever the story is. But I’m starting to see a pattern here that looks like housing has maybe gone as far as it’s going to go here in a lot of key markets around the world.

So again, I don’t know what else to do besides talk about the fact that the central banks have inflated all of this with their funny money and they’ve inflated all kinds of things. Now, they’re just tip toeing away, and already we see the first tremors. I still think that’s the most likely explanation here. We could do trade wars. We could talk about China’s slowdown and maybe they're selling to defend the yuan, or lower the yuan even so that they can counter the trade tariffs and things like that, other explanations. But this is kind of what it feels like to me when liquidity is no longer flooding in.

It went stagnant a few months ago, and now it feels like the liquidity is on its way back out, which, of course, we saw with the emerging markets. You saw it with Argentina and Turkey and South Africa, all that. But now it feels like it’s coming to a market near you. It feels like it’s gotten all the way back towards nearer the center.

Wolf Richter: Yeah. It’s definitely playing out with emerging markets, with the emerging market stock index down 22% from January. So they have gotten hit pretty hard. There’s this trend from the outside toward the core. So when something deteriorates, it starts at the outside and moves toward the core, the core being the higher quality US financial instruments. So that’s probably a dynamic that has already started. And I agree with you. The central banks removing liquidity is a big thing, and it has a big impact.

And people have said, for years, "well, QE didn’t cause stocks to go up. So when that goes away, it’s not going to cause stocks to go down." But that’s just not true. The purpose of QE, as Bernanke himself explained it in a Washington Post editorial in 2010, is to create the wealth effect, to bring asset prices up so that the wealthy feel wealthier and spend more money and then this somehow trickles down. So this was an explicit central bank policy that other central banks, especially the ECB and the Bank of Japan, imitated. So now, this is being unwound.

First, it has to stop. First, you need to taper. There’s two movements here. One is to taper, so you reduce the amount of support. You’re still supporting, but you reduce the amount of support. That’s happening in Europe right now where the ECB is cutting back its support to almost nothing. It used to buy 85 billion a month in securities. Now, it’s down to 15 billion. It’ll go to zero by the end of December. The Bank of Japan has been pulling its support.

So they’re still supporting, but not as much. In the United States, the Fed has actually stopped supporting in 2014 at the end of the taper, and then it kept it level. In October of last year, it actually started reducing its assets. So this is the next phase. It’s not neutral anymore. Now, you’re actually starting to bleed the financial markets to take out the liquidity. Overall, we will reach the point here in the next month or two where the three major central banks—the Fed, the ECB and the Bank of Japan combined—will actually have a combined balance sheet reduction.

Now, the Fed is the only one that’s doing it, but it’ll be so big at the Fed that the flat part in the ECB and at the Bank of Japan will be overcome by the balance sheet reduction at the Fed. This will be the first time in ever that we will go into this phase, and nobody knows what this will do. We mentioned today it’s an indication that people are grappling with this, but this is a new era. We’ve had the era of QE for ten years, just about.

And when you think about this, it’s already been ten years. It's completely nuts. Time flies. It’s amazing how long this has dragged out. It wasn’t an emergency solution. This was something that was just played out for a decade. We’re in a new era, I think, and the financial markets have to come to grips with it.

And the central banks have expressed concerns about high asset prices, repeatedly, for two years now, and especially at the Fed. Including high commercial real estate prices, there’s some problems in the housing market. They occasionally mention the stock market. They have fretted publicly about the leveraged loan market and some parts of the bond market.

So they’re purposefully trying to bring down those asset prices. That’s something that investors will have to keep in mind. It’s not that the Fed has stepped away from supporting the markets. The Fed is actually trying to tamp down on asset prices because they have gone too far and because these leveraged assets are putting the financial system at risk when the prices are too inflated.

They’re trying to drain some of the risk out of the market. This is a big recognition. Once market players realize that this is going on, I would imagine that they are somehow preparing for this.

Chris Martenson: I wonder, Wolf, how much their market structure experts really understand. I think of the central banks, particularly the Fed, as being a little bit more like an academic institution. They like to draw their people from inside the organization or maybe from a noted university, in the case of Bernanke and Yellen and all of that. But I wonder if they have anybody like a Brad Katsuyama, who’s that Canadian financial services executive who set up the co-founder of the IEX, the investors’ exchange.

When you listen to him or you talk to guys like Sulosy or Ardunk, those guys who understand the market structure in terms of electronic trading, how rapid it is—or maybe Eric Hunsader over at NANEX—who really get that this is now a computer algorithm driven market and that these algorithms are remorseless. They’re really quick, and if they decide to, they can just pull liquidity at a moment’s notice.

And they often do when things go out of parameter. You just type in a little command into your computer trading program and it’s done. So it just goes away. I don’t think we have the market structure we used to have, and I’m just wondering if… My view, and I could be wrong, but my view is that the central banks have been kind of manipulative in these markets and that they’ve been intervening and doing what they can with word and deed to keep them going higher.

But if and when they really turn, I don’t know that they have the capability to put a finger in every crack in this particular dyke. Because, sure, you can by VIX futures and drive VIX down and cause the algorithms that are arbitraging that to go over and buy the cash market. Highly leveraged trade, works great, I think, but what if you’re doing that and the CCC debt is just cratering? What tools do they have to trundle over into that market and help support that? It’s not clear to me that they have the capability to be everywhere.

So in a liquidity crisis like this, when the liquidity goes away and it’s a "sell everything" moment, I think that's the moment that you discover that the central banks are really good at keeping the feather in the air while it’s not windy out. They can keep blowing under it and providing lift, but as soon as things get a little turbulent, it’s impossible for them to really control it all. And that’s the concern I’ve always had. The thing I’ve always wanted people to understand is there’s a chance that these markets could go essentially bid-less at some critical moment, and that’s why you have to be pre-positioned.

You can’t be in those bond funds you just talked about. You’ve got to be out of those before. You want to be the closest to the door. But everybody thinks they’re close to the door, right? Everybody thinks that. "Ah, I’ll get out." It’s very hard to do sometimes, and that’s just the risk I want people to know about.

Wolf Richter: The central banks, the Fed, yeah, they’re really worried about credit freezing up. So we have a credit dependent economy. And when credit freezes up, nothing goes. The supply chain freezes. People don’t get paid, and that’s what the financial crisis was starting to do. There’re companies like GE that borrowed in the paper market overnight and ultra short term to fund long term projects and to fund their payrolls. When the market froze up, that short term market, they couldn’t fund their operations anymore.

So these are big corporate entities that suddenly couldn’t meet payroll anymore. And that’s when the Fed stepped in as a lender of last resort. This is not QE. This was during the financial crisis, the many programs that it had, the alphabet soup of programs like TAF and many others were acting as lenders of last resort because credit had frozen up. When credit freezes up, this is really a treacherous situation. It brings an economy to a halt. This is when the real economy gets hit. So the central bank is pretty well equipped to deal with a credit freeze, and they can step in as lender of last resort and get this thing going again.

But I think what you’re talking about is the market. It’s up. So the stock market going down 20% isn’t even going to ruffle feathers at the Fed. They’re not even going to worry about that. The stock market going down 30%, the Fed might start paying a little bit of attention to it, but they’re not really concerned about the stock market, per se, because it’s not that leveraged.

There’s some leverage in the stock market, but it’s not that bad. The lenders are not at risk when stocks go down, and the overall economy tends to not be hugely impacted by stock market ups and downs.

The bond market is a different issue. When you have companies that can’t raise any money anymore, and suddenly, they’re starting to go bankrupt because the bond market has frozen up, then that starts impacting the real economy. This was happening during the oil bust. Credit froze up for energy companies. They couldn’t raise money any more.

A bunch of them went bankrupt, and this is when the Fed stopped its interest rate hikes. It started the first one in December 2015, and then the junk bond market for energy companies just froze up. So the Fed got worried about that, and they didn’t lower rates, but they stopped raising them. This is the thing that they will worry about first. When they see credit freezing up so companies can’t fund their operations anymore, I think they will step in with something. But if they see asset prices declining and credit doesn’t freeze up, I think they’ll let it go.

If it’s an orderly selloff in the housing market that drags out over five or six or many more years and if it’s an orderly up and down in the stock market where nobody makes any money for five years, I think they’re just going to let that go unless or until credit freezes up. That’s the big thing. Investors need to understand that during the financial crisis, the Fed really wasn’t that concerned about stocks. It was concerned about corporate America collapsing because it couldn’t fund itself anymore. And that’s when they stepped in.

Chris Martenson: Excellent points, and I just want to build on that last one, which is around this idea of if corporate America can’t fund itself. You started talking a long time ago in this podcast about junk bonds hitting a 9.9%, closing in on a 10% yield, I think. So for those companies that have to refinance into this rising interest rate environment, wasn’t it the BIS in 2016, I think, one out of eight companies across the OECD countries was a zombie, meaning that their ongoing operational income was unable to even fund their interest payments?

Wolf Richter: Like Tesla, for example.

Chris Martenson: Yes, for instance. So they were highly dependent on having to be able to go into the markets. So you said the Fed can really step in in the credit markets, and of course, they’ve replaced the business cycle with the credit cycle. We’re on our third iteration of that. First one was a bad idea. The second was worse. We’ll see how this one turns out, but how can the Fed really help if no bank really has any interest in loaning, say, Tesla another $3 billion at the prices that Tesla needs in order to be able to survive? Can the Fed really do anything about that?

Wolf Richter: Well, I think the Fed will distinguish between companies like Tesla and companies that have legitimate business models where they actually make money. It’s when a profitable company that can’t fund itself anymore, that’s one kind of problem. When a company that is super junk rated and has never made any money, will never make any money, is just a huge cash burn machine, the Fed might just say, okay, this should have gone a long time ago.

It should have never gone on this far, and this company--we have a bankruptcy system that takes care of these kinds of things in an orderly manner. And that’s what it’s for, so we’re going to let the bankruptcy court sort through this. Powell is a lawyer, Fed Chair Powell, and he came up through Wall Street as a financial guy. He’s not an academic like his predecessors, and I think he has a pretty good understanding that there is a reality out there that the Fed should not change.

So if a company like Tesla can’t fund itself anymore, the Fed should not do anything about that. That’s just a money losing company not able to figure out how to become profitable. The market should take care of that. That’s why we have markets. They should get rid of those zombie companies and allow profitable companies to thrive.

Chris Martenson: Yeah. Well, it’s been a while since that’s been allowed to happen. Here at 4:50 p.m. on this Wednesday afternoon, I see that in the aftermarket, we’ve got at least another 11 or 12 points on the S&P futures are down. So they’re down 109 on the day. But I need to close this out by talking about Hurricane Michael, which is now about 50 miles inland, still with a defined eyewall. It’s a monster of a storm. I know people who live in that region. I’ve done some fine work down in Pensacola, which is a little further away, but I know people who live in Apalachicola.

So my thoughts and prayers go out the them because I haven’t seen a storm hit with quite this intensity since Katrina, I don’t think. This is really powerful. I haven’t seen one have an eyewall like that that far inland. It’s going basically all the way to Tallahassee with a full-on eyewall. It’s intense. That certainly caught me a little bit by surprise because just two days ago, they were saying, ah, Cat 1, Cat 2. And this thing just mushroomed into something enormous out of nowhere. I hope people got out of the way, but it didn’t leave a lot of time, this one.

Wolf Richter: Yeah. I hope everybody will be okay. These storms are just terrible.

Chris Martenson: Yeah. It’s astonishing how quickly they blow up into these huge things. And I know the remnants of this are going to be over the Carolinas, and they’ve just barely finished sort of putting themselves back together after Florence. Again, I hope all goes as well as can go for all those folks there. So a couple of hurricanes out there, one in the markets, one on the ground, and it certainly seems like we’re going to have to keep very close attention to all this. Because this feels different to me.

I saw this in 2016. They rescued it. Of course, they threw tons more money into the markets through late 2015, ’16, ’17, the largest years of central bank printing on record. I don’t think they have the mandate to do that this time. If they do start printing again, they’re going to have to do it surreptitiously. If they do it out in the open, I think their credibility takes a hit. I think they’re kind of stuck. Unless the markets really freeze up in some way, I’m expecting this to run further.

Wolf Richter: I think the Fed expects that. It’s been talking about asset prices being high, so that means the Fed will feel comfortable if they’re coming down. So far, this is playing into the Fed’s hand, I think.

Chris Martenson: All right. Well, the DOW futures now down 1,000 on the day, so that’s a big day. And we’ll check this out next time. Wolf, your website, of course, is Wolfstreet.com. People, check it out. Great articles there and just really fantastic work. And thank you so much for your time today.

Wolf Richter: Thanks for having me, Chris.

Chris Martenson: All right. You’re welcome.

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3 Comments

cmartenson's picture
cmartenson
Status: Diamond Member (Offline)
Joined: Jun 7 2007
Posts: 5928
The most important chart in the universe

Look, the central banks are entirely responsible for the prices of bonds and about 99 and 44/100ths percent responsible for the dizzying hieghts of equities.

Remove all that stimulation, the thinking goes, and then we get to discover just how much air is under these "markets."

Which makes this the most important chart in the universe:

While central banks are still pumping money in, it's less than it has been in years.  That will also go to zero and then negative later in 2018 or very early 2019, depending.

How big of a deal is this?

Plenty big.  It also comes at a time when the US is busy pissing off China and is about to embark on issuing trillions of new debt, which will compete for liquidity at a time when it is already declining.

Snydeman's picture
Snydeman
Status: Platinum Member (Offline)
Joined: Feb 6 2013
Posts: 576
We seem to be

Trying to poke the Saudis with a stick too. That should go well...

Uncletommy's picture
Uncletommy
Status: Platinum Member (Offline)
Joined: May 3 2014
Posts: 623
Explanation; Please?

Who, exactly, are the "they" that the FED says are being accomodated? And what do those accomodations amount to? Are we talking about transaction fees that the "dip-buyers" brokers or hedge fund managers are making? Processing fees, bank fees, lawyers and accounting fees. I'm confused.

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