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The Central Bank Bubble: How Will It Burst?

The Central Bank Bubble: How Will It Burst? thumbnail

Alberto Gallo of Algebris Investments steps up to take his shot at the $64,000 (more like trillion) question in a report published this week “The Central Bank Bubble: How Will It Burst?”

Gallo manages the Algebris Macro Credit Fund described as “an unconstrained strategy investing across global bond and credit markets, and with lead responsibility for Macro Strategies” on the company’s website.

Gallo sets the scene as follows.

Most investors are still playing the game, and in the same direction. We estimate there are currently around $11tn in negative-yielding bonds and over $2tn in strategies that explicitly or implicitly depend on stable volatility and asset correlations. If low interest rates and QE have been the lever pushing up prices of dividend and coupon-paying assets, central banks are the fulcrum.

This fulcrum is slowly shifting: the ECB has just announced a reduction in its bond purchase programme, the Bank of England is likely to hike this month – even in the face of economic weakness –the Fed will likely hike rates again in December, and the PBoC has recently warned of asset overvaluation.

One of our favourite parts of the report is “The Magic Money Tree” infographic which explains how QE has benefited a plethora of investment strategies and created the current bubble to end all bubbles.

Now Gallo is obviously savvy because he doesn’t nail his colours to the mast on one factor which will prick the central bank bubble. Instead he offers four scenarios. The first threat is a rise in inflation, which he summarises as follows.

1. Inflation: after nine years of low-flation, the probability of a sudden rise in inflation is increasing, as job markets get tighter, globalisation leaves way to protectionist policies and liquidity reaches job-creating small and medium businesses as banks re-start lending.

Wage inflation aside, Gallo believes China could continue to export inflation based on a more resilient than expected Chinese economy. Gallo believes that China may have sufficient policy options to smoothly deflate its credit bubble. While we might disagree, it is a possibility.

The second threat to the central bank bubble is…central bankers.

2. Central bankers themselves: central banks appear to have shifted their tone to worry increasingly about financial stability. There are good reasons to do so. We are many years into a global synchronous expansion, and there will be little monetary policy ammunition to fight a new slowdown, with interest rates near record lows and $20tn in global central bank balance sheets. In some countries, like Japan and Switzerland, central banks have grown their balance sheets to sizes similar to their respective economies. The good news is some central banks are trying to curb stimulus before their mandate ends. The Federal Reserve is poised to raise rates again in December, the Bank of England will likely hike, the ECB has announced a reduction in purchases and the Bank of Canada has hiked too. The bad news is that markets have so far largely ignored this reduction in stimulus.

It makes sense…central banks created the bubble via QE and ZIRP/NIRP, so reversing that strategy might prick their own bubble.

The third threat is another merry band of miscreants.

3. Politicians: central bank QE has not only lowered yields and boosted asset prices. It has also artificially suppressed volatility. Yet volatility may come back as the consequences of rising inequality in the distribution of wealth, opportunity and natural resources across the world. The last decade has been great for billionaires, not so good for Main Street. Inequality of wealth and opportunity in developed economies has fuelled anti-establishment protest votes like the ones for Brexit or President Trump. Other populist parties are on the rise in Continental Europe and Scandinavia. In turn, domestic populism and nationalism in developed countries can increase commercial conflict and protectionism – see for instance the potential withdrawal from NAFTA, or the EU-UK tariff threat – as well as exacerbate militarism and geopolitical conflict. Populism has historically fuelled government spending and fiscal stimulus, higher taxes and aggressive redistribution policies, which could all re-price overvalued assets and/or target assets used as a store of value.

We have nothing to add.

4. The market: rising growth, low inflation and low interest rates have proven a boon to global markets. There are now $20tn in central bank assets globally, and around 10% of global sovereign debt is yielding negative. Investors have been buying equities for yield and bonds for capital gains, and have been selling volatility explicitly or positioned in strategies that are implicitly short volatility. These assume a stable volatility and correlation among the price of assets. For example, risk-parity strategies assume a negative correlation between risky assets, like stocks, and “risk-free assets”, like U.S. treasuries. But what happens if both decline together, and short volatility investors become forced to unwind their portfolios?

Exactly, this is what we’re waiting for, but what is the catalyst? Nobody knows.

If we were forced to guess what will prick the bubble, we would probably place more emphasis on China than the Algebris report does. However, putting aside what causes it, we share Gallo’s view on some of the key mechanics which will be “in play” when a crisis unfolds.

What will the next crisis look like?

The over $2tn in explicit and implicit short-volatility strategies could be the spark, similar to sub-prime for credit markets in 2008, which was $1.4tn. However, a future crisis would be very different from 2008. Growth in passive investing vehicles and in the mismatch between assets they buy and liabilities they issue, lack of risk-free assets and growing collateral chains, diminishing trading liquidity due to higher capital requirements for dealers point to more fragility in financial markets.

It’s perfectly set up, if we only knew when.

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Full report below…


4 Comments on "The Central Bank Bubble: How Will It Burst?"

  1. onlooker on Mon, 6th Nov 2017 7:38 am 

    Yes, the question is not if but when and how. I think it will be either when the Central Banks raise interest rates creating a massive wave of defaults as the debts cannot be serviced. Or it will be a more planned synchronized wind down or bursting. This presumably occurring as the nations and central banks themselves decided to liquidate asssets and flood the world with liquidity inducting hyperinflation and ushering in a asset price devaluation period of discovery. In the aftermath of this, the Banks could then buy back assets at pennies to the dollars. I do not think the market per say can collapse the QE Central Banks bubble as the markets are too orcheastrated and controlled to be allowed to initiate this by themselves. And China needing the rest of the world Economy will go along with the prescribed action.

  2. Davy on Mon, 6th Nov 2017 7:44 am 

    It is almost daily I post financial articles of dangerous risks. These risks are global and interconnected. No region is immune from them. We are a late term civilization that is global. It is also digital and financial. Almost everything we do is influenced by a digital financialization. We are late term civilization with an amazing amount of rigid resilience. That is an incongruous juxtaposition and I love them because these explain very well so many catch 22 of or modern civilization. We are highly resilient but mainly because of our rigidities are tough and deep. Nature is tougher and deeper and truly resilient in a sustainable cycle. One species waste is another’s food. Our waste kills all. Nature is also cyclical and industrial man completely linear. Everything about us is about growth and destiny. There is little that is here and now. Little that is networked to nature in cooperative support. We have declared war on nature and it shows with mass extinction. We live in the future and extoll the past as we gut the present.

    The bubbles are more than central bank created. They are fake green techno optimism. They are failed modern economic policy. They are traditional brown capitalism that feels exceptional before a god when the real god is consumerism. The bubble is failed liberal democracy that is a farce to cover the wealth transfer of the poor and unconnected to the rich and connected in a morally corrupted market based capitalism. It is about private profit and the public and common’s expense. We are rigidly resilient bubbles of all kinds but remember this is a Ponzi arrangement and a house of cards. It will continue so long as the infrastructure can support it and the confidence of trust allows it. We also live under nature’s acquiescence. If climate or some other bad natural calamity would strike too hard it is doubtful our rigid civilization could cope. We can cope with status quo and we cope well. We somehow manage to cooperate despite the competition. It is a wonder we have not destroyed ourselves in war.

    If we can avoid self-destruction we still face limits to growth and diminishing returns to our techno solutions. One of the biggest near term risks are diminishing returns to financial repression and liquidity easing. The limits of debt and unfunded liabilities are real but they are very easy to pretend away because they are the future and the future is ephemeral. The fragility of human safety nets that we all take for granted are real. The ultimate test is food, water, and energy. Can we manage these with 80MIL new people a year all wanting to be more affluent?

    If humans were truly wise they would embrace less and be able to say no to our urges to growth. This would end our growth based system but maybe that wisdom would manage something else less driven to exploitation and more in harmony with nature. We would not lie to ourselves and would accept responsibility for past sins and seek redemption in sobriety and humility. In the mean time we lowly little sheeple humans struggle to survive and enjoy a little life. People hear that shit and they immediately shun that talk as religious when it is not religious at all. What is it is human and man today is unable to be human. We are now demons of growth and personal satisfaction. We are now everything bad and we call it civilization. What a joke.

  3. onlooker on Mon, 6th Nov 2017 8:01 am 

    People hear that shit and they immediately shun that talk as religious when it is not religious at all. What is it is human and man today is unable to be human. We are now demons of growth and personal satisfaction. We are now everything bad and we call it civilization. What a joke.—-
    Well said Davy. We simply went to far in our ambitions, in satiating our urges and wants, in yearning for power and material satisfactions. Especially us in the rich countries. The mass of poor, they are guilty of doing what comes natural procreating. If we are granted a second chance, surely we will have learned valuable lessons from all this Debacle.

  4. Ghung on Mon, 6th Nov 2017 9:37 am 

    onlooker; “ If we are granted a second chance, surely we will have learned valuable lessons from all this Debacle.”

    Second chance? Virtually every civilization has followed basically the same pattern. For thousands of years civilizations have risen, fallen, and learned little. The only difference is the technology they employ, how they rationalize/justify their actions, and scale. We are quickly running out of planet to exploit, have the capacity to quantify our consumption and likely consequences, yet move along as if this time will be different.


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