The single dominant belief for investors since 2008 has been that the world’s Central banks will not permit the markets to fall to pieces.
There are primary two primary reasons for this:
1) The Fed and other Central Banks managed to hold the system together in 2008-2009.
2) Central Banks have stepped in time and again to prop up the markets every time they staged a significant correction since 2008.
The most obvious culprit here is the Fed, which has stepped in following every market correction in the last four year, either with the promise of a new round of QE or outright announcement of a new round of QE.
Other Central Banks have mirrored these moves. Indeed, since 2007, Central Banks have cut interest rates over 512 times. They’ve also expanded their collective balance sheets by over $10 trillion.
The problem with this is that all of these strategies were not fully thought through.
Consider the following. The Fed has only $50 billion or so in capital. With the Fed now owning over 30% of the ten-year market, every time bonds drop and yields rise, the Fed will erase ALL of this capital. Indeed, Mark Hussman of Hussman Funds notes that even a 100 basis point increase in yields will wipe out the Fed’s capital six times over.
And therein lies the core problem: by expanding its balance sheet so dramatically, the Fed has in effect spread the financial crisis from a private banking level to a public/ sovereign level. Put another way, when the next Crisis hits, it will not be Wall Street banks that go bust but the Fed itself.
Anyone who believes the Fed can “exit” this position is delusional. The single biggest trade for the last four years has been frontrunning the Fed’s asset purchases. When the Fed reverses course and begins selling assets, everyone will dump Treasuries in anticipation.
Indeed, we are already witnessing this with foreign nations selling Treasuries in record amounts in June when the Fed first hinted at tapering its QE programs. Japan and China alone dumped $40 billion that month (of a total $66 billion sold by foreigners that month).
By the way, this was the single largest Treasury dump by foreigners since August 2007. We all remember what followed that (the first round of this Crisis).
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