A “liquidity regime” – the condition we now have as the Fed and other central banks douse markets with liquidity to manipulate asset prices higher – is “far more dangerous for investors” than when markets are left to their own devices. Under the current liquidity regime, asset prices are determined by central bank policies and move together. And there is “no possibility to diversify portfolios or hedge.”
That’s how a very inconvenient analysis by Natixis, the investment bank of France’s second largest megabank, Groupe BPCE, pulls the rug out from under the self-satisfied complacent markets of today.
Six years after the Fed and other central banks have imposed zero-interest-rate policies and waves of QE on their respective lands for the sole benefit of investors, investors now get what they really don’t like: undiversifiable risk – hence, real danger!
Since the Financial Crisis, monetary policies have been designed to create a tsunami of liquidity that would purposefully inflate all asset prices. Ben Bernanke called it the “wealth effect” in 2010. “Strong and creative measures” – QE and ZIRP – would lead to higher stock prices, which would boost wealth, spur spending, and crank up the economy. The latter, of course, is precisely what did not happen.
The strategy was supposed to make investors very, very rich. The more money investors had in the markets, the richer they’d get. Our favorite uncle Warren Buffett, whose financial and insurance empire got bailed out by the Fed during the Financial Crisis, came out on top. The prices of stocks, bonds, homes, classic cars, farmland, art… they all soared together, on cue, and as planned, under the Fed’s “liquidity regime.”
Natixis explains in the report:
A “liquidity regime” corresponds to periods when it is monetary policies and expected future monetary policies that determine financial asset price trends.
When there are expectations of a very expansionary monetary policy and massive creation of liquidity by the central bank, the prices of all financial assets rise, and the opposite holds in a liquidity regime when there are expectations of a more restrictive monetary policy.
Under a liquidity regime, assets that are touted as “risk-free,” such as 10-year Treasuries, move in tandem with higher-risk assets such as high-grade corporate bonds, junk bonds, or stocks. They all move together in the same direction: their prices rise when there is an expected or actual expansionary monetary policy; and their prices decline when there is an expected or actual restrictive monetary policy.
But when markets are left to their own devices, they operate under what Natixis calls the “risk-aversion regime.” Changes in risk aversion drive asset prices. The animal spirits either go in search of risk or flee from it in their unruly and unpredictable manner, and each time they do, the prices of assets in different risk categories move in opposite directions.
Investors fleeing risk will head into “risk-free” assets, such as Treasuries, and drive up their prices, while the risk assets they’re fleeing, such as junk bonds or stocks, decline. When investors change their mind and seek risk once again, the process reverses. This “provides diversified portfolios with a natural hedge,” the report explains.
It’s the most fundamental and the most important portfolio diversification strategy. But it doesn’t work under a “liquidity regime.”
The problem for investors under a liquidity regime is that their “diversified” portfolios are in fact not diversified. Sure, the risk posed by an individual company can be diversified by having stocks and bonds from a variety of companies in the portfolio. But market risk cannot be diversified. Having stocks and bonds in the portfolio merely gives the appearance of diversification.
But it’s an illusion: “There is no possibility for diversification or hedging in a ‘liquidity regime,’ since prices of all financial assets move in tandem.” And the inconvenient conclusion:
In reality, investors do not like a liquidity regime.
In a period of abundant liquidity…, the prices of all financial assets rise. One could believe that investors would like such a situation, but that is not the case. Investors know that if there is a turnaround in monetary policy expectations, all asset prices will fall. Accordingly, they cannot diversify their portfolios or hedge against the expected downturn in liquidity.
This issue apparently never occurred to any of the geniuses at the Fed, neither at the time these policies were hatched out in secret, nor as they’ve been pushed forward relentlessly. It boils down to this: The exit will destroy some of the capital that the “wealth effect” so laboriously created out of nothing. A diversified portfolio of financial assets won’t protect against it. Some hard assets might, and cash will, but real estate, art, classic cars, etc. won’t because they too are a function of the liquidity regime. It’s only a question of whose capital will be destroyed, and when.
One of the largest junk-debt deals ever takes shape in this environment where investors think there are no risks, even as the largest junk-debt deal ever is now in bankruptcy. Read… Junk-Debt Apocalypse Later
Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.
“There is no possibility for diversification or hedging in a ‘liquidity regime,’ since prices of all financial assets move in tandem.”
Actually this comment is incorrect. Physical precious metals have been actively and obviously suppressed by the US/Western central bank tag team since 2011, to help maintain the illusion of global financial stability. As well as being dramatically undervalued, physical precious metals also have no correlation to other asset classes and therefore would act as a perfectly good safe haven during the next chapter of this financial crisis. Precious metals if held outside the banking system also have no counter party risk.
Natixis was talking about financial assets (stocks, bonds of all kinds), and diversifying within financial assets. Other assets have gone up with financial assets as a consequence of the liquidity regime, such as real estate. Hence, they’re also not able to hedge against a downturn in stocks or bonds.
But you’re right, PMs and some other assets are not part of the liquidity regime, and I pointed that out at the bottom. I called that group “hard assets” because they include all kinds of things beyond PMs. But they don’t move counter to stocks or bonds. They move independently. And in theory might go down as financial assets go down. But a good hedge would go up as the hedged asset goes down. So PMs help in diversifying, but they’re not necessarily an effective hedge.
I think you are hinting that PMs and other hard asset stocks will also be vulnerable when financial assets drop. If you are, I agree.
I believe they will be vulnerable because portfolios and funds that have financial assets generally also have hard asset stocks and bonds. When, not if, their financial assets prices drop and they need cash, they will have to sell whatever assets they can. In that event, as previously, almost all asset classes will fall, although some will drop more.
“Physical precious metals have been actively and obviously suppressed by the US/Western central bank tag team since 2011, to help maintain the illusion of global financial stability. ”
Agreed as PMs for thousands of years had been used as money until Bretton Woods agreement killed by Nixon in 1971. All currencies of the world are FIAT based in full trust of the sovereignty that issues at. Funny thing about history of money is that pretty much all empires like Roman empire were forced to dilute the PM content as it declined till it was shaken down.
Anyway – interesting reading here – http://dailyreckoning.com/fiat-currency/
We learn history so as to rinse and repeat touting that it’s different this time.
Rome had a hard money currency …
… and that didn’t change much in the long run either. I recall a story of one emporor who called in all the coins of the realm, stamped a two on them, and used the “seigniorage” to pay debts.
On the upside, after a great deal of research and reading and thought, I think I found the root cause of our problems …
Hi, Vespa, interesting comment. I just wanted to point out that it wasn’t the value of the PM that past governments have diluted, but rather the value of the currency. They did this by diluting the amount of PM in the currency.
I’m pretty sure you already knew this. Its interesting, because past governments have had a stake in increasing the value of their PM in order to gain more wealth. Can the dilution of a currency do this? I think so. Less of the stuff floating around decreases supply. So when a government needs money and that money has PM in it, the value of PM goes up as they attempt to use less of it. Value of the currency does not go down as quickly though, otherwise their little trick wouldn’t work. Does that sound right to you? I am no expert. I’m just shooting from the hip on this one. :D
One last thing. I’m pretty sure that this fiat situation can’t last forever. What is different about this fiat currency than all the other ones that collapsed? Is this a Brave New World or are people just drinking too much Kool-Aid?
Found this interesting article. Note the 2nd paragraph which states the obvious: “This allows unlimited credit creation. Initially, a rapid growth in the availability of credit is often mistaken for economic growth, as spending and business profits grow and frequently there is a rapid growth in equity prices. In the long run, however, the economy tends to suffer much more by the following contraction than it gained from the expansion in credit. This expansion in credit can be seen in the Debt/GDP ratio.
In a fiat money system, money is not backed by a physical commodity (i.e.: gold). Instead, the only thing that gives the money value is its relative scarcity and the faith placed in it by the people that use it. A good primer on the history of fiat money in the US can be found in a video provided by the Mises.org website.
In a fiat monetary system, there is no restrain on the amount of money that can be created. This allows unlimited credit creation. Initially, a rapid growth in the availability of credit is often mistaken for economic growth, as spending and business profits grow and frequently there is a rapid growth in equity prices. In the long run, however, the economy tends to suffer much more by the following contraction than it gained from the expansion in credit. This expansion in credit can be seen in the Debt/GDP ratio. We track the bubbles created by this expansion of debt at the inflation / deflation page.
In most cases, a fiat monetary system comes into existence as a result of excessive public debt. When the government is unable to repay all its debt in gold or silver, the temptation to remove physical backing rather than to default becomes irresistible. This was the case in 18th century France during the Law scheme, as well as in the 70s in the US, when Nixon removed the last link between the dollar and gold which is still in effect today.
Credit is a tool. It is neither inherently good, nor evil. This is not unlike the argument made for guns or any other subject where it is ultimately the user of the tool which creates the outcome.
Credit is essential for trade and growth in businesses. If a farm can buy a tractor, on loan, he might be able to increase production by some amount, use part of that increase to pay the loan, and have a surplus at the end. This is a healthy and productive use of credit; it makes us collectively wealthier by providing more goods/services at lower prices.
However, if a loan is used simply to bring forward consumption, such as taking a vacation on a credit card, then there is no associated increase in production and thus the loan must be paid from existing cash flow/production. This use of credit is unhealthy as one is simply consuming tomorrows paycheck today.
While folks can opine on fiat or PMs, the truth of the matter is that it is ultimately the wielder of the tool which creates, or solves, the morass of problems we face today.
That said, my biggest concern with our present situation is that a dislocation in any market will cascade into a currency crisis and interrupt trade. As I have commented before, if you buy commodities from Country A in Currency A, manufacture in Country B with Currency B, and sell the product in Country C/D/E in Currency C/D/E, at margins of a few percent in each situation, it doesn’t take much movement to completely undermine the ability to plan, produce, and sell your product.
That leads to very serious (and hard to solve) problems which is why wars are associated with those situations in history.
“That leads to very serious (and hard to solve) problems which is why wars are associated with those situations in history.”
Indeed recessions lead to currency wars (often via depreciation to boost export) which in turn lead to trade wars/embargoes resulting in real wars. What we are seeing today reminds me of the roaring 20’s, Weimar republic, market crash ushering in depression, lot of sable rattling and trade embargos (like US at the time top oil exporter stop selling oil to Japan) resulting in horrendous war.
Here is another interesting article on the value of the Roman Denarius. Its silver content was dilluded from 100% down to less than 1% over a period of 200 years.
“Indeed there is no possibility for diversification or hedging”.
This is true in an ultimate collaps of markets, where the law defines a new currency.
In collapsing markets any storing and trading precious metals may and will be forbidden. Those who make the laws will tell you the prices of all financial assets…
Fed and the CBs of the world’s use to temporary liquidity infusion spigots during the market and economic meltdowns make sense.
Alas, the CBs drunk in their “power” resorted to QE to oblivion strategies thinking they rescued the financial meltdowns contrary to real capitalism where there are consequences to bad investments. This is nanny capitalism akin to socialist central planning. Using debts that are never be paid off, money printing and ZIRP/NIRP policies to inflate assets of all kind AKA Keynesian wet dream experiments may have ugly downside sooner than later.
I mean it’s like giving drunk another drink to keep him in drunken stupor rather than face the nasty hangover and the drunk becomes more of alcoholic and may resort to violence if flow of alcohol is stopped. So the inept CBs not sure of this Keynesian wet dream experiments go on hoping it will keep them in their jobs.
Every tool is a weapon, if you hold it right.