Upside Down and Backwards: Here We Go Again

October 10, 2014

"There are some ideas so wrong that only a very intelligent person could believe in them."

-George Orwell

In a recent widely distributed associated press article, Bond Market Bubble is Looking Fragile, Bernard Cohen correctly (remarkably) identifies the financial bottleneck threatening to once again freeze credit markets a la The Lehman Crisis.

Cohen paints the portrait of a bond market panic; the very sort that could easily trigger the type of crash that could "get away" from policy makers and morph into a full blown currency crisis.

And it then proceeds to miss the entire point all together. It's no wonder they are called the Associated Press.

Early in, he frames a difference -mainstream investors who “poured trillions into the bond market over the last 5 years.  This is opposed to the "fund managers and regulators" who are fretting over there not being enough buyers when everyone decides to sell at once.

It implies responsibility of the mainstream investor versus the prudent manager and regulator. He describes a situation known as "liquidity risk" and some bond pros are scrambling to prepare for it.

Portfolio managers are hoarding cash. BlackRock, the world's largest fund manager, is suggesting regulators consider new fees for investors pulling out of funds. That distinction is a crucial one. Modern propaganda is most effective because it uses our natural deference to authority - the more obscure the better.

The flip slide to that authority is our inferiority - the more obscure the subject.

Finance is the perfect example. Most average people are quick to claim ignorance; while they defer to the most powerful who paint it as some massively complicated mathematical science. When in fact, while finance is an attempt at science, it is beholden to basic behavioral principles that are quickly reduced to "common sense" or basic civility.

This one is especially rich:

Mohamed El-Erian, former CEO of bond fund giant Pimco, thinks ordinary investors are too blasé about the flaws in the trading system.

“Investors today are like homeowners who only discover there's a clog under the sink when it's too late and they're staring at a mess.”

"It's only when you try to put a lot of things through the pipes that you realize you've got a problem”, says El-Erian, now Chief Economic Adviser to global insurer Allianz. "You get an enormous backup."

The key above is that investors - "who have poured into bonds" - are "like" homeowners.

The Fed Risk

"Now the U.S. central bank, which has done so much to lift prices, is threatening to knock the market from its perch.

The Fed plans to end its own bond buying program after its next meeting in October, and is widely expected to raise short-term interest rates it controls next year. Bond investors have occasionally sold in a panic when these rates have risen in the past.

Today the Fed is telegraphing its every move. Most investors think it will raise rates in slow and predictable increments.

And all that cash that fund managers hold will help, too. Cash comprised 8.8 percent of assets in August, versus 6.3 percent before last year's sell-off in May, according to the Investment Company Institute.

The Fed is ending QE because, as the TBAC warned, it was competing (buying up "good" collateral) with REPO and clogging overnight liquidity - the mainline leverage conduit...

The Feds were already well on their way to creating the next liquidity crisis. They had no choice to slow down QE to free up collateral.

The dollar denominated Treasury paper is considered good collateral, and yet also has elasticity issues when it comes to crisis - which we are still very much in given the level of interest rates and state of ongoing emergency intervention. This is kind of funny if it weren't so tragic...

It is not possible to make massive bonuses or keep shareholders happy by truly accounting for long-tail risk.

As Bill Black said in his recent Bill Moyers interview: For the too big to fail, "loose underwriting guarantees short term profits and bonuses".

Worst case, they get bailed out, keep their bonuses, and blame it on the little people (who bail them out). A lot of people think the Fed can't raise interest rates.

But "can't raise rates" makes the underlying assumption that they CAN control "events".

Yet, black swans exist! The Fed is not omnipotent.  The article frames the end of QE as threatening to "knock the market of its perch". By ending QE the Fed now has new political leverage to intervene in the next, inevitable, crash.

The Fed will continue to be the buyer of last resort until the population and culture wake up to "bank holidays, runs and/or "bail ins".

Grandma Yellen won't let you starve.

It seems the next downturn in equities, housing, and bonds is meant to bring the masses under the big circus tent of control once and for all.

Fire breaks out in a crowded theater, once heralded as the safest place to be. But all the exits are closing, except for one. And then it closes too.

Everyone burns.


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