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The Anti-Bubbles

Name: The Anti-Bubbles
Author: Diego Parrilla

Diego Parrilla

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121 pages
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eBook - ePub

The Anti-Bubbles

Diego Parrilla

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About This Book

The Anti-Bubbles is a contrarian framework that challenges the status quo and complacency of Global Markets towards the false belief/misconception that central banks and governments are infallible and in full control. A forward-looking analysis of the opportunities, risks, and unintended consequences associated with testing the limits of monetary policy, testing the limits of credit markets, and testing the limits of fiat currencies. This book presents both sides of the story, including Larry Summer's "prudent imprudence for fiscal expansion", George Soros' "reflexivity theory applied to monetary policy", Mohamed El-Erian´s "T-juction and diplomatic neutrality", along the "Lehman Squared" and "Gold´s Perfect Storm" investment theses, and coins innovative ideas such as "anti-bubbles", "the acronyms", or "monetary supercycle", which join a series of innovative concepts such as "The Flattening of the Energy World", "The Energy Broadband", or "The Battle for Supply", from Diego´s first book.

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Information

Publisher

Business Expert Press

Year

2017

ISBN

9781631579837

Topic

Betriebswirtschaft

Subtopic

Finanzwesen

CHAPTER 1

Bubbles and Anti-bubbles

Market bubbles don’t grow out of thin air.
They have a solid basis in reality,
but a reality distorted by a misconception.

—George Soros

The Greatest Bubble in History

On June 5, 2014, following in the footsteps of the Scandinavian Central Banks, the European Central Bank (ECB) became the first major monetary authority to introduce negative interest rates, smashing the limits of the almighty Zero Interest Rate Policy (ZIRP) and perpetuating the monetary snowball inflating the greatest financial bubble in history.

My head was spinning. A reduction from zero to −0.1 percent was arguably small, but for me was a game-changer, a quantum leap from the years of controversial unconventional monetary policies of zero interest rates. A step too far into the unchartered territory of monetary experiments without limits.

“Mario Draghi has broken the floor in interest rates. Time to rewrite the rules of finance and asset valuations” I told myself, as my engineering mind prompted nerdy analogies such as “Mario has just broken the upper boundary speed of light. Time to rewrite Einstein’s Relativity Theory” and “Mario has just broken the lower boundary of zero Kelvin. Time to rewrite the laws of Thermodynamics.”

To me, the implications were that enormous.

The ECB announcement was a “Fukushima moment” for me, a sudden realization that something truly major had just happened.

“At 2.46 pm on the 11th of March 2011, the largest earthquake in the history of Japan triggered a giant tsunami wave that would change the energy world forever” read the opening lines of my first book, The Energy World is Flat: Opportunities from the end of Peak Oil, which I had just finished cowriting at the time negative interest rates were introduced by the ECB announcement.

The parallel between both book openings is not a coincidence. Both books present contrarian frameworks inspired by game changers that challenge the status quo and complacency of the markets, at the time of writing.

The Energy World is Flat argued that “the collapse in crude oil prices was a matter of when, not a matter of if” and “the last barrel of oil won’t be worth millions, it will be worth zero,” ideas that were highly contrarian to the then prevailing beliefs, and sounded like science fiction at the time. Not anymore.

Some of the ideas of this book, such as “Lehman Squared,” the “Monetary supercycle,” or “Gold’s Perfect Storm” may sound as crazy as the ideas and coined concepts of the energy book—when we first published them.

I belong to the school of “no-free-lunch economics” and caution against the complacency of the markets. Time will tell if my fears are unjustified and we can solve all problems by simply printing more money and borrowing more money. Wishful thinking in my humble view. Time will tell.

Testing the Limits of Monetary Policy

The ECB rate cut into negative interest rates was not a first. The experiment of negative interest rates had been in place in Scandinavia since 2009, but most people, myself included, agreed that these relatively small economies did not pose a threat to the financial stability of global markets per se, at least directly.

It turned out that the Scandinavian experiment was considered a success by some influential Central Bankers, including the president of the ECB, who eventually decided to adopt it, turning a local experiment into a global risk.

The decision had been telegraphed to the market via the media and analysts, but was nevertheless very controversial. Mario Draghi delivered the announcement with his usual conviction and decisiveness, reminding the historic and overwhelming success of his famous “We will do whatever it takes to save the Euro… and believe me, it will be enough,” that earned him the nickname of “Super Mario” and the respect and fear of the markets. The motto “never fight the ECB” now carried as much weight and respect as the widely accepted “never fight the Fed.”

In turn, the European experiment of negative interest rates was considered a success by other influential global policymakers, including Haruhiko Kuroda, the Governor of the Central Bank of Japan, who on January 29, 2016 surprised the market with the introduction of nominal negative interest rates for the first time in the history of Japan, the country that had been pushing the boundaries of monetary policy for decades. The Japanese experiment is in my view, without any doubt, one of the greatest financial time-bombs in the making.

But it is important to note that the recent wave of monetary incentives and experiments originated in the United States in 2008 when, in response to the Global Financial Crisis, the U.S. Federal Reserve, led by Ben Bernanke, cut interest rates to zero and printed unprecedented amounts of money to buy government bonds via a process known as Quantitative Easing (QE), opening a new era of unconventional monetary policies.

QE, put simply, is a process whereby the left pocket (the Central Bank) lends money to the right pocket (the Government). QE was highly controversial at first, and questioned the principle of Central Bank Independence and risks to inflation and financial stability, but was gradually accepted and eventually embraced with full force.

QE was conveniently positioned by Central Bankers as a domestic policy, but it had a direct impact on devaluation of the USD (and therefore the CNY via the peg) against the EUR and the JPY.

QE became the latest weapon in the currency wars that export deflation and problems to other economies. Without any doubt, the QE program by the U.S. Federal Reserve, and the subsequent devaluation of the USD and the CNY, had a direct major impact in the European Government crisis of the following years, which put the Euro near the brink of collapse in the summer of 2012.

Europe and Japan were forced to defend themselves and adopt aggressive unconventional monetary measures that would help counteract the aggression from the U.S. Federal Reserve. A vicious cycle of monetary easing that pushed Europe and Japan to adopt monetary policy “without limits,” whereby the objective justified the means, sending interest rates into the unchartered territory of negative interest rates.

The implications were enormous. To start, negative interest rates broke the theoretical ceiling in bond prices, perpetuating the already exuberant bubble in fixed income.

Ever-increasing bond prices was a new paradigm that squeezed-out short speculative positions, squeezed-in underweight positions, and incentivized the speculation that is feeding the greatest bubble in government bonds in history, blessed by the complacency of the markets.

The epicenter of the problem is the artificial demand from Central Banks, which has incentivized—if not forced—investors to lend for longer and longer maturities in exchange of lower and lower yields, feeding the greatest bubble in duration in history.

Testing the Limits of Credit Markets

The duration bubble has created unprecedented problems for savers and investors, who in order to generate income, are incentivized—if not forced—to lend to weaker and weaker credits, and for longer and longer maturities, in exchange for lower and lower yields.

A “desperate search for yield” that behaves like a steamroller that crashes yields and inflates valuations across asset classes, starting by government bonds and spreading to risk assets such as credit markets.

The desperate search for yield applies to all borrowers. The demand for high-quality borrowers, known as high-grade, has pushed yields to historical low levels, which has once again incentivized—if not forced—investors to lend to weaker and weaker credits for longer and longer maturities.

The desperate search for yield has benefited the weakest borrowers the most, inflating parallel bubbles in high-yield credit and emerging markets, among others.

As a result, the desperate search for yield has inflated the entire capital structure, directly impacting not only the valuation of debt instruments, but also valuation of equity, adding yet another parallel bubble to the list.

The epicenter of all these parallel bubbles is the belief (in my view misconception) that Central Banks are infallible and in full control. The synchronous appreciation of all these markets creates a risk of synchronous depreciation as and when the belief is proven to be a misconception, which creates a risk of false diversification, as a portfolio composed of government bonds, high-grade credit, high-yield credit, emerging markets, and equities are just the exact same trade.

Testing the Limits of Fiat Currencies

Central Banks and Governments tend to respond to crisis with two simple and easy solutions: print more money and borrow more money.

These easy solutions seem to have worked well in previous crises, but the reality is that they do not resolve problems: they simply postpone and often enlarge them.

As a student of the school of “no free lunch economics,” I worry about the current path and try to understand how and when the consequences of these excesses will manifest themselves.

We need to be mindful that while Central Banks and Governments may have already gone too far with their policies, it can get much worse as they will do “whatever it takes” to keep the wheels spinning. A double-up, triple-up, and quadruple-up of bets that are enlarging, not resolving, the problems.

Monetary policy and fiat currencies are two sides of the same coin. As Central Bankers know well, during the gold standard they could not print gold to control the monetary base or interest rates. The global system was much more rigid, which has its pros and cons.

And with great power comes great responsibility, goes the saying, and why Voltaire claimed that “paper currencies eventually converge to their intrinsic value: paper.” A reflection that giving Central Banks and Government the power to “print their way out of a problem” is a slippery slope. A path that will ultimately result in a loss of confidence in the currencies and institutions that created them. A process of competitive devaluations that does not solve problems and that will conclude in a “monetary supercycle” leading major winners and losers in the process, as we will discuss later in the book.

Exuberance versus Complacency

Financial bubbles are often associated with exuberant market behavior, a sense of excess and market craze that drives a surge in asset prices unwarranted by the fundamentals.

As a corollary, any apparent lack of exuberance can be misunderstood as a new paradigm, as it gives the perception of stable equilibrium, instead of the unstable equilibrium that characterizes bubbles.

Indeed, I believe the most dangerous bubbles are driven by complacency, a sense of conformism that makes us believe that unstable equilibriums are stable.

The crude oil bubble, for example, was inflated by complacency that OPEC was in full control or that crude oil could maintain its monopoly in transportation unchallenged forever.

I believe the parallel monetary bubbles are being inflated by complacency too. Complacency with monetary policy without limits, complacency with credit expansion and fiscal policies without limits, complacency with the desperate search for yield, and the parallel bubbles in government bonds, duration, credit, equity, but also complacency that Central Banks can keep volatility artificially low, exposing hidden risks in correlation and liquidity. These dynamics are closely interlinked and could lead to a chain reaction where if any of the previous bubbles is exposed and bursts, it will most likely expose and burst the others too.

Central Banks are aware of these risks, which explains their obsession with stability and low realized volatility. A dynamic that feeds the beast called complace...