How This Central Bank Bubble Ends

Posted by Bill Bonner - Diary of a Rogue Economist & Chris Hunter

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I sometimes get the feeling that somewhere across that huge puddle, in America, people sit in a lab and conduct experiments, as if with rats, without actually understanding the consequences of what they are doing.

– Vladimir Putin, 4 March 2014

We promised to explain how it ends. The world, that is. The world we live in now. The one in the middle of a rapidly inflating central bank bubble.

First, we need to understand that this is a very different world from the world of the 19th and early 20th centuries. It is a world where central bankers play a role somewhere between con artists, mad scientists and God Himself.

They deceive and cheat. They conduct their experiments without any real idea how they will affect people. And they move almost every price in the world – sending investors, householders and business people all running in one direction.

Their experiments change not only prices quoted on the Big Board and the supermarket. They also change the physical world. Jobs are lost to machines that – without such low interest rates – would not have been built.

Monetary Fantasy

Those in the 1% are only as rich as they are today thanks to the Fed’s manipulations. America’s super-sized houses also are largely the result of the Fed’s 2002-07 real estate bubble. And many a mansion has been built in Aspen or the Hamptons with money from Wall Street bonuses, which wouldn’t have been possible without central bankers’ grand designs.

And China is the way it is today – with its gleaming towers, its mega-factories, its empty cities and clogged roads – largely because US officials made it easy for Americans to buy things they didn’t need with money they didn’t have.

Central bankers – along with central governments – have created a kind of monetary fantasy… which depends on ever increasing amounts of credit.

But where can all this new money go? Real output can’t keep up with it. So prices must adjust. In the event, they bubble up… first one market, then another… first one sector, then another…

And after the bubble, what?

The bust!

That’s what we’re waiting for. A bust in the biggest debt bubble of all time.

When the credit inflation ball bounces off the ceiling, it produces an equal and opposite reaction in the other direction. Asset prices fall. This is deflation. It begins with asset prices… and then makes its way into consumer prices.

Making Volatility Your Friend

Most investors think they need to protect themselves from this kind of volatility.

Academic studies show that more volatile stocks under-perform less volatile stocks – they call it the “volatility anomaly.” And it is obvious that if your stock goes down 50% you need 100% on the upside to get back to where you started. Losses and gains have “asymmetric” effects on your portfolio.

But at our small family wealth advisory, Bonner & Partners Family Office, one of our principles is that you need to “make volatility your friend.” Because volatility is not the problem. The real problem is risk. There is risk that you will buy the wrong investment at the wrong price. Then you’ll get whacked.

EZ money policies – low rates, QE, paper money – produce an apparent stability. As long as the money flows freely, even some of the worst businesses and the worst speculators can borrow to cover their losses.

Stocks go up and up and up. It looks good. But it masks real risk. As the bubble in credit increases the risk of a major blow-up increases… until it becomes a certainty.

This is where volatility can be your enemy and your friend. Just as Fed policies have made stocks too expensive… the equal and opposite reaction of the financial markets will be to make them too cheap. (Stay tuned.)

So, there you have it. The first stage of “the end” will be a major selloff of stocks. At present prices, of course, they’ve got it coming anyway.

But the implosion of the debt bubble and the collapse of asset prices are not likely to be the end of the story. Not as long as we have delusional activists running central banks and central governments.

Tune in tomorrow for the second stage of the end.



Market Insight:

Distorted Markets Are Dangerous Markets 

From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

Investors continue to hang on the words of central bankers.

They are focused on the doctor (central bankers), not the patient (the economy).

Further evidence of this came on Friday, when the S&P 500 plunged following Janet Yellen’s comment, made during her post-FOMC press conference, that the Fed would consider raising short-term interest rates “something on the order of around six months” after the end of QE.

This was sooner than the roughly one-year gap the market had anticipated. Investors reacted by hitting the “SELL” button.

Here’s a look at the effect Yellen’s “six month” comment had on the S&P 500.

Source: Bespoke Investment Group

A market that reprices stocks so quickly based on the utterances of a Ph.D. is a highly distorted one in our view. And highly distorted markets tend to be highly dangerous markets, too.

That’s because they are based on a fiction: that central bankers can perform miracles.

This fiction may explain why investors have been so sanguine about rising geopolitical tensions around the world: in Ukraine… Thailand… Venezuela… Turkey… Syria… Iran… and North Korea.

The logic goes that, sure, geopolitical tension may be on the rise. But central bankers “have investors’ backs.” If something major goes wrong, investors can expect even more dramatic credit easing from central banks… and a resumption of the uptrend in stock prices.

This is a dangerous fallacy.

Ignoring rising geopolitical tensions has been profitable of late. But nothing is more dangerous to your wealth than extrapolating past trends into the future.

Unhedged portfolios will suffer greatly if this trend reverses and underlying geopolitical tensions trigger a major selloff.

We recommend you hold plenty of cash and gold in your portfolio to offset potential stock market losses.