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Olduvai III: Catacylsm
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Playing for All the Marbles

Playing for All the Marbles

Global Plunge Protection Teams must be ordering take-out food; every night is a long one now.

The current stocks/bonds game is for all the marbles, by which I mean the status quo now depends on valuations and interest rates remaining near their current levels for the system to function.

If interest rates soar and/or stocks plummet, the game is over: pension funds collapse, tax revenues drop, debt based on high asset valuations defaults, employment craters and the much-lauded “wealth effect” reverses into a “negative wealth effect” (i.e. everyone looking at their IRA or 401K statement feels poorer every month).

Let’s scan a few relevant charts to understand why this game is for all the marbles. Given the systemic fragility of the global economy, a crash in one asset class or a rise in interest rates trigger defaults, sell-offs, etc. that forcibly revalue other assets.

So the Powers That Be can’t afford to let any asset crash, as a crash will bring down the entire system. Why is this so? The resiliency of the system has been eroded by permanent central bank/central state intervention/stimulus. Withdrawing the stimulus means markets have to go cold turkey, and they’ve lost the ability to do so.

Permanent stimulus creates dependencies and distortions, and both the distortions and the dependencies introduce a host of unintended consequences. What’s the “market price” of assets? You must be joking: the “market” prices assets based on policies of permanent stimulus and asset purchases by central banks.

In effect, markets have been hijacked to function as signaling mechanisms(everything’s great because your IRA account balance keeps going up) and as floors supporting pensions, insurance companies, IRAs/401Ks, etc.: all these financial promises are only plausible if asset valuations keep rising.

Fly in the ointment #1: equity valuations have lost touch with the real economy, as measured (imperfectly) by GDP:


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Here Is The IMF’s Global Financial Crash Scenario

Here Is The IMF’s Global Financial Crash Scenario 

Hidden almost all the way in the end of the first chapter of the IMF’s latest Financial Stability Report, is a surprisingly candid discussion on the topic of whether “Rising Medium-Term Vulnerabilities Could Derail the Global Recovery”, which is a politically correct way of saying is the financial system on the verge of crashing.

In the section also called “Global Financial Dislocation Scenario” because “crash” sounds just a little too pedestrian, the IMF uses a DSGE model to project the current global financial sitution, and ominously admits that “concerns about a continuing buildup in debt loads and overstretched asset valuations could have global economic repercussions” and – in modeling out the next crash, pardon “dislocation” – the IMF conducts a “scenario analysis” to illustrate how a repricing of risks could “lead to a rise in credit spreads and a fall in capital market and housing prices, derailing the economic recovery and undermining financial stability.”

* * *

From the IMF’s Financial Statbility Report:

Could Rising Medium-Term Vulnerabilities Derail the Global Recovery?”

This section illustrates how shocks to individual credit and financial markets well within historical norms can propagate and lead to larger global impacts because of knock-on effects, a dearth of policy buffers, and extreme starting points in debt levels and asset valuations. A sudden uncoiling of compressed risk premiums, declines in asset prices, and rises in volatility would lead to a global financial downturn. With monetary policy in several advanced economies at or close to the effective lower bound, the economic consequences would be magnified by the limited scope for monetary stimulus. Indeed, monetary policy normalization would be stalled in its tracks and reversed in some cases.

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oftwominds-Charles Hugh Smith: In Uncharted Waters

ftwominds-Charles Hugh Smith: In Uncharted Waters.

What I see as extremes that must necessarily end badly, others see as mere extensions of recently successful policies and trends.

A long-time reader recently chastised me for using too many maybe’s in my forecasts. The criticism is valid, as “on the other hand” slips all too easily from qualifying a position to rinsing it of meaning.

That said, given that we’re in uncharted waters, maybe’s become prudent and certainty becomes extremely dangerous.
 I have long held that the financial policy extremes that are now considered normal are unprecedented in the modern era: extremes in debt, leverage, risk, complexity and willful obfuscation of these extremes.

Consider the extent to which sky-high asset valuations and present-day “prosperity” depend on extremes of leverage: autos purchased with no money down, homes purchased with 3.5% down payments and FHA loans, stocks bought on margin, stock buybacks funded by loans, student loans issued with zero collateral, and so on–an inverted pyramid of “prosperity” resting precariously on a tiny base of actual collateral.
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Olduvai IV: Courage
In progress...

Olduvai II: Exodus
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