A Financial "Perfect Storm" May Be Brewing

The "Perfect Storm" of 1991, as described in the best-selling book by Sebastian Junger, resulted from massive weather systems converging to create the storm of a century.

In the financial world at this very moment, we have eight different "weather systems" that are all developing in real time. While the defenses in place may be able to easily withstand any one or two of these concerns in isolation – the danger is the increased power of a "storm" that can result from the merging of multiple systems together.

Using a weather analogy is appropriate, because there is little predictability at this point, everything is still developing (the "storm fronts" are still building), and while some of the factors are long term, others have just been emerging in the last few days and weeks. However, if several of the more powerful components were to converge – and reinforce each other – then we could very rapidly reach the point of greatest financial instability that the world has seen since 2008.

In the following sections we will assemble a step by step description of each of these eight "weather systems" and how they interrelate.

1) Very Low Interest Rates

Because of the openly stated policy of central banks such as the Federal Reserve and the European Central Bank, we currently have very low interest rates around the world.

2) Artificially Elevated Asset Prices

As explored in my recent article, "Mazes, Mice And Investor Perception Management", one of the several intentions behind forcing these very low interest rates has been to drive asset prices upwards, thereby creating artificially high market prices in the hopes of generating a "wealth effect" that is intended to change investor behavior and stimulate the economy. The economic stimulation has not occurred, but a fundamental mismatch has been created around the globe between overpriced bonds and equities, and what can be justified by the underlying fundamentals.

3) Developing Fears Of A Liquidity Crunch

As stated in a recent speech by Steven Maijoor, chairman of the European Securities and Markets Authority (ESMA), global central banking actions including quantitative easing and other forms of unconventional monetary policy have created the risk of a liquidity crunch. The central banks have created risks of "over-valuation" in the bond and equity markets that are "considerable", and are "raising risks for the non-banking sector".

And when liquidity is an issue, a shift in investor sentiment that could otherwise be easily contained in a large and healthy market can instead set off a stampede for the exits, which can dramatically change markets overnight – possibly in a matter of minutes or hours.

The relationship between the two financial "weather systems" is that the same central banking action – that of creating massive sums of money to buy government bonds – also creates two separate but tightly intertwined risks that can feed off each other.  One is major market overvaluation, which creates the risk of a sharp drop to levels that can be rationally justified, and the other is a reduced supply of bonds, which exacerbates the chances of any correction of prices occurring in a disorderly manner that could create a market collapse.

4) A Current Global Bond "Rout"

First, we need to keep in mind that despite its recent frequent usage by the mainstream financial media - the term "rout" is a relative one. Yes, we have over the last ten days or so seen some of the largest and most rapid price shifts in global bond markets in some years, and when we compare this to the artificial placidity of government and central bank-dominated bond markets of the recent past, this is a remarkable rout. From a longer term historical perspective we're still not there yet – but a global sell-off is in process, and this combination of circumstances could yet get us to the real thing.

5) The Dangerous Combination Of Falling Bond Prices & Bond ETFs

Much of the financial markets have transformed since 2008, and while the emphasis by regulators has been on "fighting the last war" by attempting to reduce bank risks, in many ways total risk is higher than ever – but it's just been transferred to other places.

As covered in this Reuters article, this transfer of risk can be seen right now with the measures by Vanguard, Guggenheim Investments, and First Trust, as some of the largest bond exchange traded funds (ETFs) in the US scramble to secure lines of credit.

The fear is that if the bond rout continues to develop, and large numbers of investors start redeeming their ETFs, then these massive companies must immediately sell their bond portfolios into a thin and plunging market – thereby exacerbating liquidity risk.

So these firms are scrambling to pay for lines of credit from major banks that will allow them to meet redemptions without flooding the market with bonds – but this also brings two concerns. One is the price of the line of credit, and the other is that in a true crisis situation – will the banks be able to make good on their promises? That is, will the money be there to fund the line of credit if the banks are facing liquidity crises of their own?

This risk directly feeds into and exacerbates the previous two risks.  Absent sufficient lines of credit, ETF redemptions translate to forced sales, regardless of market prices.  If markets correct to more rational levels, and investors in large numbers head for the exits to get out of bonds, and this leads to massive quantities of forced sales to get the money to make the redemptions, and this happens in a thin market where buyers have evaporated – then we have a near perfect recipe for a financial storm of extraordinary magnitude, and which could develop with blinding speed.

6) A Potential Sea Change In Institutional Investor Perceptions And Behavior

One of the key underpinnings of market stability in recent years has been an effective "retraining" of institutional investors. What these investors have been taught over recent years has been more or less to ignore market fundamentals, and instead follow the leads of the central banks. Because acting on economic fundamentals rather than following the leads of central banks has been a very poor career decision for some years now, with markets that have moved with central banking actions.

And this is why so many otherwise highly intelligent and trained financial professionals have been buying bonds and stocks at what might seem to be irrational levels – for they effectively have had no choice.

What is happening with this developing global bond "rout" (again keeping in mind this is a relative term) is that we are seeing investors moving against the central banks in large numbers for the first time in years. Which shows a very real fear on their part that the central banks could lose control of their artificial stability.

This is a particularly serious danger because it can be a self fulfilling prophecy, where compliant and trained investors who were the source of much of the previous stability are now behaving more independently.  This danger of 1) a major source of stability not only being lost but being flipped into 2) a major source of instability can acutely exacerbate financial stability risk – particularly in the environment with the other risks previously described.

Part II

The seventh and eighth "weather systems" are individually powerful, but also act to substantially increase the risks from the first six "systems". They are explored in Part II of this article.

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Contact Information:

Daniel R. Amerman, CFA

Website: http://danielamerman.com

E-mail: dan@danielamerman.com

This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.