Yesterday’s move in the vix is likely a foretaste of what is to come…

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Jamie Caruana of the BIS

The chief of the Bank of International Settlements (BIS), Jaime Caruana, believes investors are continuing to ignore the prospects for higher interest rates in their hunt for returns given the extended ZIRP policies of the world’s major central banks. He added that “the world is now more vulnerable to a financial crisis than it was in 2007” and the danger for an implosion in now far bigger as debt ratios are higher and the woes in emerging markets like Argentina, Russia & SA have been thrown into the equation, as a consequence of super monetary easing and so skewing risk perceptions of their economies.

It is always interesting to read such comments, in particular when they come from the “central bank of central banks”. Of course, in the end, central banks may just pretend the BIS is not there and continue to flood the world with bank notes. But the fact that the “supervisor” reckons they have gone too far is enlightening.

While at first, monetary easing seemed the only way to solve the liquidity squeeze experienced after the Lehman collapse, the BIS has started urging central banks to put an end to it, as the main problem of bank balance sheets having liquidity mismatches has now been solved. But it seems no one is listening, and central bankers are continuing to keep the liquidity spigots open. The world has been flooded with freshly minted money at zero cost and as a consequence, many believe (including us here at SBM) that the Federal Reserve has in fact created a situation even more precarious that which went before. We are on the brink of runaway inflation and then potentially deflation.

As far as I understand economics, the price of money is reflected in the interest rate: the lower the interest rate, the lower the cost of holding money. That means that for Amazon, for the Government of the United States, and for almost any citizen of this world, debt has been turned into the cheapest financing source around. A few years later and with equities fully recovered from the collapse, equity has not been issued on a net basis by existing companies, with in fact net redemptions through buy backs. CFOs have been using debt to repurchase shares, in the process adjusting their capital structure as debt is so much cheaper. Obama’s administration is also happy with the current cost of debt, as the Federal Government can not only pay less for existing debt but also enjoy the additional demand created by the Fed. It has never been easier than it is now to get credit if you are creditworthy, so logically why wouldn’t debt ratios increase during these years?

The prolonged period of low interest rates created severe difficulties for pension and endowment fund managers however. How could they generate the same returns they were used to with yields near zero? The only option would be to assume more risk and invest in equities instead. Emerging markets also became attractive as the higher yield differential was deemed to compensate for the risk. Central banks achieved their goals of pushing people into riskier assets. Congrats!

But, when all central banks do the same thing at the same time, the problem is severely amplified. In 2007 leverage was a cause for collapse. In 2014 central banks are causing leverage to increase. Déjà vu is the word you are looking for.

Looking at the Numbers

Mr Caruana admitted that debt ratios in the developed economies have risen by 20% to 275% of GDP. We could add here that the IMF-driven austerity policy was a total disaster as it was unable to instigate a significant debt reduction and in fact prevented many European economies from growing and so reducing their debt burdens, it has merely contributed to a further deterioration of debt ratios.

Just as disturbing is the case of emerging economies like Brazil, Turkey and China, all of which have succumbed to private credit booms, partly because of the quantitative easing measures emanating from the West.

With almost no on the ground economic growth, European markets en bloc rose 15% last year. The S&P 500 has pushed on to record highs, while the CAPE ratio is now more than 50% above its historical mean. 

The prolonged monetary stimulus is now showing many cracks though. Central banks have succeeded in redistributing wealth from the poor to the rich, and in spreading the problem to the rest of the world including the emerging markets. This is one of the ugliest experiments ever conducted, and one that will very likely end with the toughest crisis ever seen. Yesterdays near one third spike in the VIX is a foretaste of what is to come as the year unfolds in our opinion…

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