To QT Or Not To QT? Irrespective, Buy Black Swan Insurance Now

by: Sunil Shah

The natural homeostatic balancing mechanisms of markets have been utterly disrupted. There’s been a virtual absence of a negative feedback loop for a decade.

The delicate trade-offs between risk and reward that ought to regulate the market’s animal spirits have been blindsided to scorn risk and pursue reward with a singular focus.

How? Simple! Oceans of money, printed in the basements of the main central banks, gushed into markets at the slightest sign of frailty since 2009.

Supported by the Federal Reserve, the US investor has been conditioned to simply "buy the dip," an unassailable investment strategy for a decade. Alas, "BTD" is in vogue again.

However, like any homeostatic system that has been disrupted, there will be a day of reckoning to restore nature’s order. Buy catastrophic insurance for a systemic crash. Now.


A short digression is necessary, to support the central thrust of this article and tie it into the stock market.

Homeostasis refers to the ability of an organism or environment to maintain stability in spite of change. The human body is full of examples of homeostasis. In every micro organism or stable ecosystem, equilibrium can only be achieved amidst change via self-feedback loops.

For example, if our body recognises toxins in our blood stream (as blood passes the kidney), a hormone (erythropoietin) is produced that instructs our bone marrow to produce more warriors or white blood cells (positive loop)…and when the white cells have done their work in eliminating the toxin/alien (some white cells "dying" during the invasion), the lower level of erythropoietin detected (i.e. the negative feedback loop because the erythropoietin decomposes once the message is passed) instructs the bone marrow to produce less white cells…until the normal equilibrium level has been restored. Here we have a perfect example of impeccable design: Self-feeding positive and negative loops that restore equilibrium in a system of flux. (I hope you’re in awe, this sophistication innate in your own body - not just ours but even the tiniest amoeba - works like clockwork despite your blissful ignorance.)

The crux of the matter

Well, that preamble had a purpose: To direct the narrative as to why markets have lost ALL capability of self correction, and the culprits are none other than G4’s central banks (CBs) whose quantitative easing (QE) policies that prevailed for a decade have resulted in abnormal markets without any negative feedback loop to restore normalcy.

If one hoped that CB’s would spur homeostasis to find equilibrium in an orderly manner - via a policy of quantitative tightening (QT) - your hopes have been dashed by their capitulation in the initial weeks of 2019 (evidence for US Fed here and ECB here). Now, markets are obliged to find their own solution, to clear the decks of about $11tn of wasteful capital allocation. It is impossible to identify how and when that correction will take place (we are definitely in black swan territory), but order will be restored, and the unfettered animal spirit of greed will be tamed, as risk is repriced and financial assets borne from QE diminish materially. In what form and when will nature re-instil the negative feedback loop, neither I nor anyone knows. The uncertainty stems from NOT knowing how long the rubber brand stretches (CB incompetence via QE(n) and abnormally low interest rates rather than QT) before it snaps, but snap it surely will. Just as surely as night follows day in the homeostatic equilibrium of temperature on our planet.

Conclusion: Buy catastrophic long-term insurance now.

This article draws its rationale very much from the Mise’s Austrian School of Economics and the Minsky Moment. Professor Minsky, who died before the 2009 Great Financial Crash, has received much notoriety posthumously.

A Minsky moment is a sudden, major collapse of asset values which follows a credit cycle or business cycle. The rapid instability occurs because long periods of steady prosperity and investment gains encourage a diminished perception of overall market risk, which promotes the leveraged risk of investing borrowed money instead of cash.

These ideas have been converted into a successful investment methodology by Mark Spitznagel of Universa Investments. His ideas are well articulated in this YouTube video. However Spitznagel has been intimating a major crash since 2016, clearly an expensive prognosis.

To QT after QE? The folly of central banks

It’s worth getting some perspective. In the aftermath of the ’08 Great Financial Crash (GFC), central banks (CBs) deemed the best way out of the liquidity squeeze was to inject money into the system. The long-term graph below of CB balance sheets portrays the exponential expansion since the 2008 Global Financial Crash.

CB’s grew their balance sheets incrementally in rough lockstep with their economies (GDP) for decades (first chart above) until 2008. Then suddenly, we embarked on an entirely new experiment. It was called Quantitative Easing (QE). In summary, QE limited the depth and duration of the GFC recession. Alas the new drug was irresistible - CB's have persisted in the quest of rekindling the real economy with a sea of liquidity for a decade after the 2008 crisis (second chart).

The dangers of NOT reversing QE with QT are evident

There's little doubt that both Bernanke and Yellen were unabashed QE converts. The International Monetary Fund issued repeated warnings on the lack of CB’s shrinking their balance sheets, but they remain unheeded:

In Oct 2018, the IMF repeated

The sequence of aftershocks and policy responses that followed the Lehman bankruptcy has led to a world economy in which the median general government debt-GDP ratio stands at 52%, up from 36% before the crisis; central bank balance sheets, particularly in advanced economies, are several multiples of the size they were before the crisis; the fund warned there is an urgent need to reduce the burden of debt in both the private and public sectors to improve the resilience of the global economy and provide greater firefighting capability if things go wrong.

Personally, I find the volte face performed by current Fed Chairman Jerome Powell the most alarming. In order to access Powell’s natural instinct, his unhinged narrative, one has to revert to the Federal Open Market Committee (FOMC) meetings before he was appointed chairman. Here we have access to Powell’s honest opinion, the minutes from their 2012 meeting. His comments came as the Fed was embarking on what effectively was the fourth leg of its asset purchase program, this one named QE3:

I suspect that the channels that we're using now, which principally are asset prices, may not be working at all as well as our models say," he said at the July ‘12 meeting. "On the list of potential costs, I would include inflation, the difficulty of exit, the risk of creating expectations we can't meet, the prospect of capital losses, market function, and the grab bag of stability issues.

In December 2012, Powell expressed additional worries.

I'm concerned that the actions contemplated in this meeting are setting us on a path to a much larger balance sheet with likely benefits that are not commensurate to the risks that we're bearing...

At the risk of stating the obvious:

-Powell was very aware that there were risks with expanding the CB balance sheet, even in 2012.

-He was acutely concerned about the diminishing marginal utility of QE(n). He was mindful that the tapering will have unintended consequences, but he was willing to shoulder the risks, in the interest of a Fed whose toolkit regains some of its potency to manage future problems.

Alas, how dramatically his opinion changed as the fed chair! Was his independence and integrity so unduly compromised by rumours of a dis-satisfied President Trump? Irrespective of the rumor’s truth, it's patently clear that both the Fed and Powell made a volte face. This was the official Fed narrative, according to the script, interest rates were raised by a quarter point in early December.

During its two-day December meeting, the Federal Reserve elected to raise interest rates for the fourth and final time in 2018. “Information received since the Federal Open Market Committee met in November indicates that the labour market has continued to strengthen and that economic activity has been rising at a strong rate,” the FOMC said in its statement. “Job gains have been strong, on average, in recent months, and the unemployment rate has remained low.”

Then came the stock carnage in December 2018. I repeat, the monetary authorities were fully cognizant that QT would have some unexpected consequences. After all, it doesn’t take a genius to realise that the act – however gradual – of withdrawing trillions of dollars of liquidity from the financial system is going to have some market consequences. Surely as Powell foresaw in 2012, one must concede if the QE experiment was uncharted and resulted in the unintended consequence of edifying "buy the dip" and unprecedented valuations, then QT, the mirror reversal, may well embody unintended consequences.

However all caution was thrown to the wind after the ghastly carnage during December 2018! Remember the Dec. 23 emergency meeting Mnuchin had with Bank CEOs, which set the stage for the Fed Pivot. Well, the stock market correction induced a wholesale capitulation in the Fed, where the transformed monetary stance showed negligible resolve to implement QT or normalise interest rates.

From the Fed Reserve on Jan 30 2019 (my bold italics):

The Federal Reserve on Wednesday signaled that it will throttle back its plans to raise rates this year amid rising economic uncertainty, despite the underlying health of the US economy. The Fed said in a separate statement it's prepared to use a range of tools to steer the US economy, including changing its plans to normalize its balance sheet by size and composition, "if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate."

Although the intricate details of the Fed Pivot are not yet fully divulged, here's a graph, illustrating the probable severity of the capitulation. From a Balance Sheet that started at $1tn in 2008, the Fed intends to halt QT around $4tn, leaving a surplus ocean of $3tn that's been a major contributor to the unhindered upward trajectory of markets and that's highly vulnerable to nature's cleansing as 'she discovers' a new negative loop to restore order.

source: Goldman Sachs Source: Goldman Sachs

Unsurprisingly since the Fed Pivot, the US stock market’s greed has been rekindled. 2019 has kicked off with a smart bounce that’s virtually erased December’s pain. Once again, December 2018 can now be viewed as a temporary blip of the BTD infallible strategy, grâce à the Fed's intervention reassuring their monetary support. And thus investors have been re-conditioned to revere BTD, and to simply ignore any negative loop that incorporates fear and risk.

December '18, a mere blip in BTD

The decade-long bull has reasserted itself, with gusto

Pain deferred for a bigger more painful correction

The reader should be reminded that it was the very homeostatic forces intrinsic in nature that, when suppressed, caused the massive 1988 Yellowstone fire. Paraphrasing the founder of Universa's Spitznagel, the forestry policy implemented a zero-tolerance of fire for a century. This led to an excessive overgrowth of all species, where resources available were unconstrained without any negative feedback loop to distinguish the hardy from the frail. When fire eventually struck a century later, the result was a tinderbox that burned 1.2 million acres to a cinder. The conclusion: When nature’s homeostasis is tampered with – even with the best of intentions – man is simply suppressing nature’s forces that periodically purge the system of (malinvestment) frail vegetation. There will ultimately be a day of reckoning.

I cannot overstate that the Fed Pivot only sets the stage for a bigger correction, where nature will find its own negative feedback loop to purge the system of about $12 trillion (cumulative CB largesse since 2009) of wasteful capital allocation. There’s no prizes for guessing a major casualty will be significant corrections in stockmarket prices to erase that wasteful and unproductive capital embodied in stratospheric valuations. This dynamic system of creation and destruction of capital (see Mise’s Economic Explanation here), where prices serve as a major information signal to direct capital to its most productive use, siphoning it away from wasteful projects and companies has been redundant for a decade, and any hope of its resuscitation via central banks shrinking their balance sheets meaningfully can now be jettisoned. Alas, at the onset of some turbulence in December 2018, we have witnessed a total absence of central bank resolve to restore normalcy. This almost guarantees we’ve set the stage for a bigger homeostatic correction in the future.

The Valuation Argument

Without a preamble concerning how stretched stock valuations are, I leave you with one quote made last week. Jeremy Grantham, the legendary value investor and co-founder of Boston-based asset manager GMO (who’s lauded with calling the 2000 and 2008 crashes), told CNBC in a rare interview.

“In the last 100 years, we’re used to delivering perhaps 6%, but the United States’ market will be delivering real returns of about 2% or 3% on average over next 20 years.”


Spitznagel of Universa investments provides catastrophic insurance to large pension funds and hedge funds. It’s time his ideas are implemented into the mainstream investor’s portfolio. Exactly how and when the rubber band reaches breaking point is unknowable, as one is not sure exactly how long CB’s will continue the merry mirage with QE(n) rather than QT. So keep your long positions, enjoy the rising (but precariously fragile) bull run, but buy black swan insurance. It’s worth noting in early March, The European Central Bank followed the Fed with its own version of moderating QT.

Something odd took place that day: the world's biggest central bank, the ECB - whose balance sheet is 40.5% of Europe's GDP - unveiled massive monetary easing... perversely EU bank stocks - typically the greatest beneficiaries of a dovish rates move - actually slid sharply!

European Banks on Dragh

Is this a sign that fragile European markets realize that the rubber band is so stretched that we're reaching a breaking point...where further monetary easing is futile…

If you agree, it’s time to implement some black swan or catastrophic insurance in your personal portfolio. The easiest way is it buy (SPY) put options with a short expiry date that are about 10% out of the money, where the nominal value is equal to your long positions. The delta of the option will rise disproportionately if/when there is a correction which exceeds 10%. And if that option expires worthless (mine are currently dated June 21 2019), then you simply replace them using the same criteria - 10% out of the money for a six-month duration and in nominal terms equal to your long exposure. The cost is small, but you won’t regret it if the black swan lands.

Ignore nature at your peril.

Disclosure: I am/we are short SPY. 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.