By way of analogy the current rally in Gold stocks looks a bit early. Even after the 2016 January rally put in an interim high the index lost another 20% before it finally turned higher. Peak to trough Oct to Jan the GDX lost over 30%. One trader commented after this weeks swoon in the equity markets, that the rotation into gold was really money that “wanted” to go into stocks. Right now I am buying that with a caveat. The money that wants to go into stocks is going to disappear when the system closes up. I want to suggest that what would take 30% out of the gold stock market is not something your 401K will like.
The current downdraft in the S&P is about 5%. Perhaps this won’t be as bad, but something happened in 2016, I call it the crash that never happened, the silent heart attack. I don’t why, but the selloff never materialized into bear market status. Is this time different?
But let’s skip the boilerplate the stuff you already know, and try to sketch a few outcomes. The massive global liquidity bubble is not going anywhere. Doug Noland hinted at it last week in his CCB, Contemporary Finance’s Defect.
It amounted to the greatest transformation in financial and market structure in history, all backstopped by the “activist” Federal Reserve and global central bankers. It was a New Era – a New Paradigm – that worked miraculously until its 2008 malfunction risked bringing down the global financial system. Most importantly, this incredible system of ever-expanding speculative leverage, seemingly endless liquidity and powerful asset Bubbles has a fundamental Defect: it doesn’t function in reverse (with deleveraging). Yet rather than addressing what went so terribly wrong in 2008, global central banks resuscitated and then bolstered this deviant financial apparatus, sending it on its merry way to reflate global markets and economies.
Let that sink in. You can’t DELEVERAGE this liquidity bubble. What happens when the system freezes? The Central Banks rush in with new liquidity and rules to prevent mark to market accounting. The market resumes it’s previous course. We got through the 2016 problem with a mix of easy money global policies which created this bubble. Achieving that level of cooperation this time will be more difficult, while the IMF is doing its part, the abundance of EM dollar denominated debt is a problem. How does it happen we allow small countries with shaky economies to issue debt denominated in OUR money, compromising the dollars solid financial foundation. They then must enter the market to buy dollars to service that debt and the cost is rising you see?
For years we sold 30 year Treasury bonds like they were currency through the BIS to solve our trade deficit. Bernanke called the process “sterilization.” These bonds were money reserves, but foreign buyers who wanted US products could never recycle those reserves causing inflation in US assets. Then the real estate market bubble returned when Chinese nationals with cash started buying US and Canadian real estate. Officially China put limits, or restrictions on capital flight. Inflation in the US puts upward pressure on bond yields and makes the bonds that China is holding in reserve worth “less.” Then China and Russia started dumping their US bonds in the secondary market. They reduced their reserves, the regulations on capital flight then become an after thought. US assets, including stocks are the beneficiary. We became a hot money destination.
The Fed chief says many things, few of them true. The Fed raises rates in order to attract foreign buyers of US bonds to fund our gargantuan deficits, and preserve the value of the dollar for those who have to exchange their currency in order to buy US bonds, assuming they don’t run a trade surplus. Most of the bonds currently being issued are being purchased by US investors and institutions. While foreign bond buyers pull back from new bond purchases, money comes out of stocks as well. Borrow from Peter to pay Paul. Liquidity shrinks at the margin, causing a crisis, but the stuff underneath us is massive, global monetary excess funds in the aggregate never vanishes.
The matter is never resolved. The system freezes up, we unstick it, and each time more liquidity is left over because that money never really disappears. There is of course a shortage of US products for export, if we had these products to sell inflation would return. We may soon see a return of US manufacturing. Beyond the moment when the car sinks into the lake, what happens? Massive inflation?? More to come….