The Big Bet By Central Banks
The recent report on GDP continues to support the idea of a market driven by liquidity and artificial supports rather than economic strength. While the mainstream analysts and economists keep hoping with each passing year that this will be the year the economy comes roaring back – the reality is that all the stimulus and financial support available from the Fed, and the government, can’t put a broken financial transmission system back together again.
However, while the economics and the fundamentals don’t support the financial markets – the divergence between fantasy and reality can continue as long as the Central Banks are willing to continue flooding the markets with liquidity, and as we have long suggested, continue outright equity purchases for their balance sheets. From Bloomberg:
“Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk- averse investors toward equities.
In a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland Group Plc, 23 percent said they own shares or plan to buy them. The Bank of Japan, holder of the second-biggest reserves, said April 4 it will more than double investments in equity exchange traded funds to 3.5 trillion yen ($35.2 billion) by 2014. The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves.”
The reality is that we now live in a world where “freely traded markets” are an
anachronism and fundamentals rules simply no longer apply.
However, the problem is that such actions continually leads to asset bubbles,
and eventual busts, that not only impact economic stability but destroy the
financial stability of families. The risk is not lost on the Federal Reserve as
Minneapolis Fed President Kocherlakota recently stated:
“Unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability…[the FOMC] may only be able to achieve its macroeconomic objectives in association with signs of instability in financial markets. These financial market phenomena could pose macroeconomic risks.”
In other words the only way for the Fed to achieve its goals of inflating the economy is to create an asset bubble. Of course, the insanity is that once the goals are achieved the asset bubble busts and then the process must be started again.
Of course, through the long course of the Federal Reserve’s ongoing interventions into the economy they have never witnessed an asset bubble before it burst. It is unlikely to do so this time either.
However, the Financial Stability Oversight Council, which features leaders of the Treasury, Fed and other regulators, highlighted a number of potential risks for the financial system. These are the seven themes around which the council organized its recommendations and findings:
- The vulnerability to runs in wholesale funding markets that can lead to destabilizing fire sales;
- The housing finance system that continues to rely heavily on government and agency guarantees, while private mortgage activity remains muted;
- Operational risks that can cause major disruptions to the financial
- The reliance on reference interest rates, which recent investigations
have demonstrated were manipulated, particularly in the case of the London Interbank Offered Rate (Libor);
- The need for financial institutions and market participants to be
resilient to interest rate risk;
- Long-term fiscal imbalances, as the absence of bipartisan agreement on U.S. fiscal adjustment has raised questions about whether longterm fiscal problems may be resolved smoothly; and
- The United States’ sensitivity to possible adverse developments in
It just doesn’t make much sense if you think about it. The Fed is pushing interest rates to levels that impede economic growth – hoping to get economic growth. At the same time a bubble is being created in the asset markets as they chase equities to get a yield higher than what they artificially created. More importantly, they recognize the risk that they have created. Is it just me or does this whole setup just seem terribly flawed?
Eventually, the current disconnect between the economy and the markets will merge. My bet is that such a convergence is not likely to be a pleasant one.
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