Financial Blowback, by Robert Gore

Blowback is a government action that leads to a result directly opposite the government’s intent, a manifestation of the Command and Control Futility Principle (see “Crisis Progress Report,” SLL, 1/29/15). Designed to reduce terrorism and terrorist infiltration, the US’s war on terrorism has created blowback: more terrorism and chaos throughout the Middle East, and a flood of refugees into Europe, some of whom are undoubtedly Islamic extremists.

There is another type of blowback, lurking within the global financial system, that may prove just as dangerous. Since the financial crisis, government debt and debt monetization have been embraced to promote economic growth. New regulations have been implemented to address financial risks.

The realization grows that governments borrowing money, and central banks buying it and other debt, have produced little in the way of economic growth (see “The Song Remains the Same“, from the Economic Cycle Research Institute, SLL 3/25/15). What is not generally recognized is the blowback potential: that the supposed remedies will ultimately make the disease worse. Artificially low rates lead to overproduction and leveraged speculation. Expanding debt increases the debt service burden.

The burgeoning oil patch disaster is a sample of blowback. The fracking boom was powered by debt, which may have made economic sense when oil was over $100 per barrel, but is a millstone now that it is below $50 per barrel. Wells are being shut down, investment slashed, and employees fired—economic contraction, the opposite of economic growth. Similar production cutbacks are happening in a number of other natural resources: iron, coal, and precious metals. Declining volumes of world trade and all-time lows in the Baltic Dry Index point to continuing shrinkage in production and further contraction.

That contraction impairs the ability of debtors to service their debt, and the margin of error for the most heavily indebted global economy in history is nil. Debt restructurings and bankruptcies in oil and other natural resources have already begun. Creditors are pulling in their horns. Shrinking credit and production will be a mutually reinforcing vicious cycle that spreads to other sectors, a ticking time bomb. Governments and central banks are encumbered with much more debt than they had in 2008, and will have little or no leeway to forestall the workings of this cycle through debt expansion and monetization.

Debt being the epicenter of the coming crisis, it’s no surprise that time bombs lurk in credit markets. Bond math is such that a one percent move up in yield produces a larger loss, in percentage terms, on bonds when yields are low than when they are high. Thus, when central bank interest rate suppression ends, either due to central bank policy change or market spasms, those owning government bonds will suffer substantial losses. Ironically, the largest owners of government bonds are central banks—they have set themselves up for their own blowback.

By sucking up much of the available float in government bonds, they have already inflicted damage on the workings of those markets. Those bonds are used as collateral against short-term loans in “repo” transactions (short for repurchase—the borrower sells the bonds and agrees to repurchase them; the difference in prices is the implicit interest) that allow the market to function. Without them, the markets seize up as collateral-starved lenders actually pay interest, rather than receive it with the government bond collateral they received for their cash. Many of those seeking collateral are short bonds, so removing bonds from the market reduces the number of shorts.

By “hogging” the bond market, central banks have crowded out the shorts that would provide bids and liquidity if the market were to drop. Diminished liquidity is exacerbated by new regulations that treat less favorably, in terms of capital ratios, bonds banks hold in trading portfolios versus bonds they hold to maturity, as investments. Banks were the primary market makers for bonds. At a time when interest rates are so low they have nowhere to go but up (and bond prices down), the pool of bond bidders has shrunk. The new banking regulations were intended to make banks safer, but the blowback effect will be to make the bond market considerably less so.

Shallow liquidity is a natural consequence of a high degree of leverage, in any market. Zero interest rate policies promote leverage. If a trade is crowded with speculators who have put up a tiny percentage of their trades and borrowed the rest at microscopic rates, at the first hint of trouble they look for a bid, which disappears. Leverage, as the old trading adage goes, is a two-edged sword. Cheap debt that has fueled the steady ascent of markets since the financial crises will be responsible for terrifying plunges as markets choke on government and central bank blowback and fire sale bids are the only ones available. Witness January’s Swiss franc debacle, recent vertiginous drops in oil and other commodities‘ prices, and the stock market’s “flash crash” back in May of 2010.

Another trading adage: sell when you can, not when you have to. Countless traders who thought they could get out in time when markets went against them have been carried out on stretchers. Liquidity can be as evanescent as a mirage oasis in the desert. Everything that central banks and governments have done since the last financial crisis guarantees a mouth full of sand when the next crisis hits. The financial blowback will be fearsome, a crushing reaction to what proceeded it, and the only way to avoid becoming collateral damage will be to get out of the line of fire before it begins.

HOW DID WE EVER SURVIVE WITHOUT A CENTRAL BANK?

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6 responses to “Financial Blowback, by Robert Gore

  1. Pingback: SLL: Financial Blowback | Western Rifle Shooters Association

  2. Is it time for me to convert my 401Ks to gold?

    Like

  3. I am but a lone fish in the market and I recognized nearly a decade ago that the markets were not operating in a market based fashion. So I got out. Cashed out everything. This is one fish that does not want to be lying in the skillet.

    Like

  4. That silly old mathematics, seems to be getting in the way of the movers and shakers.

    Like

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