The increasing power of the large central banks around the world has been seen by some as a necessary consequence of increasingly intense boom-bust cycles, and by others as the actual cause of the observed increase in intensity. Economist Claudio Borio of the Bank for International Settlements (BIS) proposed in 2014 that the international financial system, as it is currently structured, amplifies financial imbalances and causes systemic banking crises (2014; BIS). The chart below shows both the business and financial cycles over the last few decades; note that the amplitude of the financial cycle has gotten progressively larger with time.
The Business Cycle, With Inverse Sornette Wave in the Financial Cycle for the US:
Source: Claudio Borio, 2014, BIS Working Paper 456; csinvestments.org
Curiously, this increase in the amplitude of the financial cycle over time looks a lot like the inverse of a phenomenon in mathematics that analyst John Hussman has evaluated for the markets, called a Sornette log-periodic function, or wave. Normally one sees ever-decreasing amplitude and increasing frequency over time, as shown below, but in this present case involving the financial cycle, it is running backwards, so we see the inverse effect (i.e., we actually see amplitude increasing and frequency decreasing within the financial cycle over time, like the downside trend of a stock market crash). And indeed, the point of Borio's analysis is that an ever bigger financial crisis and associated market crash are the expected outcomes at the end of each sequential cycle.
Standard Sornette Log-Periodic Function for the Markets in 2013:
Source: St. Louis Fed; Note that Credit/GDP ratio is increasing rapidly.
This systemic growth of financial imbalances has been exacerbated by what Borio called "overly accommodative aggregate monetary conditions" set up by the PBOC, BOJ, ECB, and US Federal Reserve over many years. In the economy, debt has increased almost logarithmically as interest rates continued to decline below historical averages. However, the economy has grown less and less responsive to credit formation over time (i.e., the credit multiplier is shrinking). Perceptions of value and risk also vary through the business cycle, i.e., they are highly pro-cyclical, and this means risk-taking increases as we move to the later parts of the cycle.
Source: Claudio Borio, BIS Working Paper 456
The restraint on this late cycle risk-taking is normally provided by the central banks when they end the business cycle by tightening. However, it seems likely that there will be no tightening of policy beyond what the Fed has already done this time around. In spite of only one rate hike though, the financial conditions indexes at various firms suggest considerable tightening has already occurred, mainly as a result of markets front-running Fed guidance.
Easy money has continued well into the late stages of the business cycle, and looks set to remain that way almost indefinitely. Indeed, virtually all central banks are loosening policy except for the US, which appears to be on hold now based on Chair Janet Yellen's recent statements. What are the implications of this? It appears to me that the monetary policy divergence that so many have commented on (including myself recently) is now unlikely to get worse, and may end up collapsing over time. This means that the next financial crisis, which according to the BIS charts might be expected when the financial cycle peaks between 2017 and 2020, will probably occur in an environment of ZIRP and NIRP on a global basis. It is possible that by that time essentially all restraints will have been removed again, and central banks may essentially be out of ammo, or reduced to even wilder experimentation than we already observe.
But if the financial cycle ends anyway, despite no monetary restraints (probably as the result of a shock to the system), it is reasonable to conclude that a financial crisis even bigger than the one seen in 2008 will occur, if we accept the implications of Borio's work at the BIS. Central banks will have very little chance of mitigating the damage under those conditions. Indeed, as John Hussman has shown, when risk tolerance is very low during a major sell-off, even when starting conditions included normal interest rate levels, drastic Federal Reserve easing measures have had virtually no impact for many months, as was seen in both 2000 and 2008.
Fed Rate Reductions Had No Impact in 2008:
I believe that this leaves investors with some very tough choices. For one thing, there is no guarantee that the periodicity we observe in Borio's Inverse Sornette wave pattern for the financial cycle will not be truncated by some kind of economic shock, e.g., war, currency devaluation, or sovereign default. In that circumstance a lot depends on the relative stability or fragility of the financial system. I am afraid the system can hardly be described as stable; rather, it appears to be extremely and increasingly fragile, as I have mentioned elsewhere. Borio has in effect given us a timely warning about the potential for extreme crisis, but there appears to be no way to avoid it without major economic reforms (which are unlikely), or to predict it with any real accuracy.
The flip side to this is that if the cycle really doesn't peak until around 2017-2020, then our current troubles will be, comparatively speaking, rather minor, and the secular bull market will run a few more years after our current market problems are resolved, even if we have a cyclical bear market right now. Which way you go on this, bull or bear, will of course have a very big impact on how you should allocate your assets in the markets. Bulls will want a little protection in the short run (e.g., higher than normal cash levels, higher than normal bond allocations EDV, TLT, IEF), but can rest assured that their stock bets will eventually bounce hard and go up for a long time.
Bears will really be stuck, because not only do they face a cyclical bear at least, but the potential for a cataclysm is also present, given the fragility of the system. There will be a tendency to stay bearish given the above arguments, and to go heavily into defensive allocations with high cash levels, very high bond allocations (WHOSX, EDV, TLT, IEF) and minimal allocations to risk assets. I am still leaning towards the benign interpretation, but I am increasingly concerned about how easy it would be to upset the apple cart. Therefore I am more conservative in my stance than current circumstances warrant, if one assumes that the end of the financial cycle is not yet upon us. This is due to my belief that a shock to the system is not only possible, but quite likely in the next year or so.
Disclosure: I am/we are long TLT, IEF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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