Central Bank Exhaustion And Stupid Debt Tricks

Includes: JNK, SH
by: Harold L. Vogel, CFA


Central banks have exhausted themselves. Credibility, control, and effectiveness are already greatly diminished.

Massive creation of more debt to stave off debt deflation does not solve problems – it only makes for larger problems later.

Sell rallies and disregard “buy the dips” and “don’t panic” investment advisors.

Now that the Fed's January meeting is history, it's instructive to look at what all the central banking sturm and drang machinations have accomplished. All of the major banks - the Fed, BoJ, PBC, and ECB - have bought big time into the QE zero-interest rate policies and strategies.

And the result - drum roll please - is not much except an exacerbation of politically destabilizing income inequalities, destruction of middle-class retirement incomes, and total scrambling and undermining of bond, commodity, and stock market price-discovery functions. It's all akin to David Letterman's old shtick of Stupid Pet Tricks. But this time it should be called Stupid Debt Tricks.

The central bank nostrum for preventing debt deflation and another global recession is more debt. "Hey," says Super Mario at the ECB, "let's take interest rates to below zero… we'll do whatever it takes." "Ditto" says Kuroda-san at the BOJ, by this week going to negative interest rates (NIRP), and in late 2014, getting government pension funds to invest up to 50% in the stock market. "The BOJ already owns nearly a third of the Japanese government bond market and 43% of Tokyo's exchange-traded stock fund market," writes the Wall Street Journal of January 30, 2016. "Yo," says Professor Yellen, "not to worry because we're 'data-dependent'," as if in the Fed's 102-year history they've never before made an interest rate policy decision without looking at data!

As for China, as they say in Brooklyn… fugetaboutit. In China, the PBOC plays day-trading roulette by limiting short sales and manipulating the market in other ways, and the Shanghai Composite index still falls more than 20% since June. Given the aging demographics, their conversion to a middle-class consumer and service economy will likely be surprisingly slow to arrive. And those Chinese citizens fortunate enough to have any money and mobility have been fast getting out (reserves were down an estimated $700 billion last year) and buying real estate - in New York, Miami, San Francisco, London, Toronto, and Vancouver - everywhere but in China. Of late, a new-found lack of enthusiasm by Chinese buyers has apparently begun to pop the global art market bubble too.

The Fed should have raised rates, even by a measly little quarter percent, two years ago. So they instead wait, as is typical, until the world's economy is perhaps at the cusp of a recession. Over in Japan, the Nikkei has declined approximately 24% from around 21,000 to 16,000 since summer 2015. The Baltic Dry Index, which is a rough measure of demand for world shipping recently hit a record new low. And in the U.S. stock market ended the bellwether month of January 2016 in a steep decline (5%+) in the S&P 500 from where the index ended 2015.

For Q4 2015, preliminary estimated growth of real GDP was 0.7% (1.8% for the whole year) and below annual growth in 2014. Real median family incomes in the U.S. haven't risen since 2007. And the Fed wishing for 2% inflation plays a cruel joke on the middle class. At 2% average annual rates, on a compounded (i.e., geometric) basis, over 10 years, you wipe out more than 20% of retirees' purchasing power. Inflation is always silent theft, and the Fed is complicit. This is supposed to "help" the U.S. population recover its economic footing?

Having technically broken to the upside out of a 30-year downward triangle pattern, the dollar is also apt to remain strong for at least a year or two and maybe longer. This means that for issuers outside the U.S., dollar debt obligations will now be much more difficult to service. In effect, the dollar borrowing binge of the last three decades has left foreign companies and individuals short the dollar and needing to cover at higher prices. All of which suggests that if the dollar continues strong, many firms and individuals will be broke and defaulting on their debts and earnings of large international U.S. companies depressed.

Then there's $31 oil prices, which have likely already caused or soon will cause large bank loan write-downs and defaults for many failing exploration and drilling companies, which are, pardon the expression, too fracked up to much longer survive. European commercial banks also probably have many billions now at high risk in the shipping and tanker-related businesses.

In a way, you can't blame central bankers for trying to do "something." As bureaucrats near the top of their respective political pyramids, they cannot keep their jobs unless they pull and twist whatever monetary levers and dials that they can. The current approach and attitude is still: "We must not think we have an easy task when we have a difficult task... Money will not manage itself..." It was a critique written by the great banker/economist Walter Bagehot, in his masterpiece, Lombard Street, in 1873. From that time, Bagehot's second policy rule and prescription for central bankers acting as the lenders of last resort was to "lend on all good banking securities" and his third rule (to skirt around the problem of "moral hazard") was to provide emergency funds only at a high interest rates. Today's central bankers are definitely not following Bagehot's script.

Central banking policies and strategies - based as they are on faulty neoclassical and Keynesian models (including the Phillips Curve at the Fed) - are now totally exhausted. There's no where else to go, if and when a global economic contraction - the early stages of which we might now be entering - occurs. Issuance of massive more debt to prevent debt deflation only, by simple arithmetic, creates more debt to be ultimately deflated and defaulted upon.

And under such circumstances, what good do the well-intentioned but deeply flawed regulations like Dodd-Frank do? The answer is nothing, except to starve the markets of liquidity, which will always be in the shortest supply just when the world needs liquidity the most. Banks, like airlines and cable companies, are not lovable entities, but they all serve important functions without which modern economies could not exist. Yet banks remain the prime targets for venting political populists and demagogues.

What to do now? Unfortunately, there's no easy solution because debt has been piled on debt and the global economic house could be brought down by only a small slip that quickly re-prices risk upward and calls into question counterparty solvency. In a crisis, what's in short supply is not gold or bonds but trust and confidence. Recall from recent experience that it does not require a large default to start a chain reaction or avalanche. Bear Stearns in 2007, an important but not especially large investment bank, provided a good example of what can start a cascade. And recall that at the height of the crisis, even mighty General Electric, with a pristine bond rating - and having previously and regretfully burned through $25 billion in share buybacks at high prices - could not roll its commercial paper and went running for help to Warren Buffett.

There is no way to readily predict when large rallies, which are common in long bear markets, will ignite, but there are many ways to hedge so as to mitigate portfolio meltdowns. The easiest is to short the S&P SPYs or Dow-Jones Diamonds (DIAs). The many ETFs related to the volatility VIX series can and probably will eventually soar to much higher levels than currently, but except for the very short term, they are poorly designed, imperfect, and relatively risky instruments. Nevertheless, if trading volatility, I'd still be inclined to favor the VXX as this ETF seems to be the easiest to understand and most liquid of the bunch. As for bonds, the bubble has been blowing for a long time and I cannot see any reason to at this stage buy into it. Given what's happening, yields might not rise a lot, but neither are they likely to fall by much. The high-yield JNK, while perhaps a bit oversold near term, would after a bounce be my favorite bond-related short sale.

(See also SA "The Fed and Other Central Banks are Losing Control and Credibility," August 26, 2015 and "BOJ Marks the Beginning of the End for Central Banks," November 15, 2014).

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in JNK over the next 72 hours.

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.