Cooking Up A Crash

Includes: JNK, TBT, VXX
by: Harold L. Vogel, CFA

The Fed and other central banks continue to run scared of deflation and to be criticized for not doing even more than has already been done to stimulate economic growth. And mainstream economists appear to be totally befuddled as to why the already massive quantitative easing amounting to trillions of dollars, yen, and euros has at best only generated a feeble rebound in the U.S. and none whatsoever in many other countries.

The "why no-growth" mystery is, however, relatively easy to explain. The central banks have on one side warned commercial and industrial lenders to be careful not to repeat the mistakes made in the housing market of 2005 or in the savings and loan scandals of the late 1980s. No more systemic failures will be permitted.

But then again, we've got to get the economy growing. So, ultra low interest rate policies have been everywhere designed to spur spending. Consumers, do you hear: Take out car loans and mortgages. Splurge on vacations. Charge credit cards!

We central banks encourage you to do so by inflating financial assets like stocks and bonds with such a large wealth effect that you will feel better about borrowing - even if you can't quite yet afford to carry a new loan's burden. We've got your back. It's OK to buy stocks on margin (now at an NYSE record of $384 billion). Our yield-chasing bubble even extends to the sovereign debts of the many economically impaired and still greatly distressed eurozone members.

Such mixed messages not only sow the seeds of the public's mistrust and confusion about money and policy makers but also about prospects for growth. If, after so much effort -- that includes jawboning and political posturing in the U.S, Japan, and Europe -- there is still a tepid response, then the inescapable conclusion is that underlying conditions must be really bad or that something has gone terribly awry. Willingness to borrow cannot be forced from above. People will only borrow if they can confidently see a return that is greater than the prospective obligation that is to be incurred.

The widespread but mistaken notion that central banks are "printing" with abandon is tied into this because money is only "printed" through the credit creation process of banks extending loans to entities holding collateral of sufficient value. Given that nations implementing policies of austerity do not experience net credit creation through bank lending, there is then no "printing" in the way that the term is generally used (and also applied by gold bugs to justify their investments). Central banks are, more precisely, "pumping" with the hope that loan demand for incremental purchases of goods and services and for fresh capital investments will be ignited.

Central banks are walking a tightrope of their own making, as even whispers of tapering bond purchases now cause immediate market convulsions. But to all except diehard Keynesians, the evidence is already convincing that the pumping approach has not produced the desired results. Arithmetically, the only way for central banks to avoid any tapering at all is if bond purchases continue to pace proportionately to an ever enlarging base. It seems the Buzz Lightyear character from "Toy Story" has grown up to be a cornered central banker left with no other choice but to pump "to infinity and beyond!"

If some Frankenstein-like economists had purposely decided to cook up a recipe for a crash, they'd be hard-pressed to find a better way to do it. In the U.S. and Japan, the central banks are already buying more than 70% of government issues at high prices. And in the U.S., yields on 10-year treasuries have already risen from around 1.66% to 2.2% in six weeks. This reveals that there are relatively few marginal buyers at the low rates proffered.

With at best only modest global economic growth on the near-term horizon, the world's increasing inability to service already outstanding and also prospective debt obligations will sooner rather than later lead to concerns about what more and what else central banks can do. Because long-term borrowing costs are implicitly embedded in all government spending, negative feedback effects, not "pumping," would then likely be first to go infinite.

It isn't too early to worry.

My recommendation is to play a crash by being long the VIX with VXX, to be short the 10-year treasuries with a long in TBT, and to short high-yield issues via a short position in JNK.

Disclosure: I am long VXX, TBT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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