Fed clearly points out existing systemic risks

It is worth taking a closer look at the Federal Reserve’s recently published semi-annual report on general financial stability. After all, in view of the current situation in the world, many observers may have rubbed their eyes at some of the statements made in this report.

Just a few days ago, U.S. Treasury Secretary Janet Yellen gave her thoughts free rein in public to suggest that the Federal Reserve might have to raise its key interest rate a smidge in response to the looming situation on the inflation and interest rate front.

Then, only shortly thereafter – and a huffy reaction from the Dow Jones Industrial Index – Yellen immediately withdrew her previous statements. The trading algorithms may have calmed down a bit for the time being, but among the players on the global financial markets, the question is whether the Federal Reserve and other central banks are really still masters of the situation.

Fed Half-Year Report: Global Markets Vulnerable to Large Declines
It is becoming increasingly apparent that central banks, taking into account their monetary policy, have embarked on a one-way street from which there seems to be no possibility of turning around, let alone escaping.

The Federal Reserve’s semiannual report on general financial market stability, which has now been published, takes exactly the same line. Among other things, the report states that prices on the global asset and capital markets are “susceptible to significant price declines,” which will be the case above all if the risk appetite among players on the financial markets should wane. Literally, the report states as follows:

“…should risk appetite decline from elevated levels, a broad range of asset prices could be vulnerable to large and sudden declines, which can lead to broader stress to the financial system.”

In conclusion, an indication is provided that such a development could lead to widespread stress in the global financial system. Such a conclusion would probably be reached by a majority among retail investors given the currently prevailing environment, but at least the warnings provided in the Fed’s report suggest that there still appears to be some sense of reality among Board members there.

There are a growing number of systemic weaknesses
Fed Governor Brainard said in response to the report that credit institutions had suffered losses, some of them substantial, due to transactions with the now insolvent family office fund Archegos Capital Management. Switzerland’s Credit Suisse Group is a prime example.

According to Brainard, further dangers emanate from the so-called meme stocks, in whose trading a high daily volume and sometimes extremely high volatility can be observed, and which are pushed via various channels in the social media.

The question may be allowed, with which financial means these trading activities are mainly operated? Are these not financial stimulus checks from the U.S. government (or helicopter money dropped over private households), financed by a massive issuance of U.S. government bonds, which are then in turn purchased and monetized by the Federal Reserve?!

The SPAC sector is also identified as a danger in the Fed’s report, although quite a lot of hot air has already escaped from this sector recently. According to Brainard, recent analyses of the general state of financial markets pointed to a growing number of systemic weaknesses.

This is especially true for areas and sectors of the asset markets whose prices had already reached lofty heights last year. Their rise has continued in the first three months of the current year. And while major indices have reached new record highs, earnings forecasts in the corporate sector are historically at the upper end of their valuation scale.

In the corporate bond markets, too, there is still a high risk appetite among investors, which is reflected in particular by the low interest rate differentials between junk bonds and government bonds. A historically extremely high level of debt in the corporate sector carries the risk of repricing (translation: in the course of a crash).

Moreover, the current events had not only caused commercial banks to incur high losses in some cases, but had also provided an indication that the non-bank sector and hedge funds were posing risks that could hardly be assessed and could ultimately lead to high losses in the international financial system.

For this reason, the thumbscrews would have to be tightened in the balance sheet and disclosure area among these players. Otherwise, serious imbalances among these players (hedge funds and non-banks) could lead to contagion risks that could negatively impact the overall stability of the international financial system.

Is the Fed starting to hedge its bets?
On this point, Brainard can be fully vindicated. We remember well that the global financial crisis was ushered in by those collapsing Bear Stearns hedge funds in 2007. Why should things be any different today, given that little has been done or changed in terms of leverage and (barely existent) regulation among these players since those days of the global financial crisis!

On Zerohedge’s site last night, the question was raised whether the Federal Reserve may have started “covering its own ass”? Along the lines of, don’t say we didn’t warn you….

This is exactly the way things and developments seem to be viewed by Tad Rivelle, Chief Investment Officer at capital manager TCW, who states that all fiat currencies backed by nothing were ultimately based simply on confidence in their purchasing power.

The necessary credibility of institutions is at stake
As soon as the trust in the social alliance, the economy, the government and other institutions behind these fiat currencies diminished, problems would become visible that had not been perceived before. US dollars, euros, yens, yuans and other fiat currencies are therefore worth no more in real terms than the paper they are printed on.

The economic problems that our world is now facing are unique and serious from a historical point of view. From this perspective, it is not surprising to have witnessed previously unseen packages of measures on the part of governments and central banks that are fighting the current crisis with all means at their disposal.

However, credibility and credibility among the world’s leading institutions are at risk of being severely undermined as a result. According to Rivelle, the current situation can be compared to a Faustian bargain, in the course of which the devil offers his support without specifying the price required for this, and which will have to be settled in the not too distant future.

QE programs are focused on driving up asset price inflation. A Federal Reserve with little oversight is buying trillions of U.S. dollars of Treasury bonds and MBS securities using electronically created money to keep interest rates as low as possible in the face of financial repression.

In this way, there would be purely artificial asset price inflation, in the course of which much of the excess liquidity had been absorbed over the course of the past decade.

The wages and salaries paid in the economy, however, have long been unable to keep pace with this development. This situation is therefore unsustainable from a purely logical point of view. Political and social upheavals and turbulence would be the result over time.

The chart above shows the current percentage of so-called zombie companies relative to the total number of companies registered in the United States.

More and more of the wrong medicine
This chart actually says it all, indicating that these companies are surviving largely only because of an extremely distorted financing situation in the junk bond and junk bond markets. At the latest when interest rates rise, this sector will experience an acute hailstorm of bankruptcy, if such an event has not already been triggered beforehand by an external shock of whatever kind.

In the world of science, theses, theories and solutions are usually discarded and revised if they do not prove successful. But in the world of politics, where no degree of common sense seems to prevail anymore, all those things that have proven ineffective over time or successful in the medium to long term are embraced even more strongly in order to administer more of the same to societies as a whole.

For more than ten years now, we have been hearing from central banks and governments that in the course of fighting deflation, there must be quantitative easing (QE), minus and negative interest rates, the imposition of all sorts of letter programs á la LTRO & Co. in order to “do whatever it takes” in this ongoing struggle.

The chart above shows the number of hours the average worker in the United States must work today to buy the S&P 500 Index. At the beginning, their number was below twenty, but today it is 166!

The result seems to be the view that “inflation” can be manufactured, which is now expressed in particular in the fact that young people can no longer afford houses and apartments, are increasingly putting off starting families or even refusing to do so altogether, and general consumption is stalling.

The latest data show that the government support share of average American incomes has now climbed to an unprecedented 34 percent (!), which means that people in the U.S. are generating an ever-decreasing share of their incomes from their own work.

In this way, inefficiency is fueled by politics and central banks, and the resulting imbalances in the system are accepted. Perhaps this is also one of the reasons why the Federal Reserve and other central banks are facing an increasingly strong headwind on the capital markets. Declining confidence = hopeless situation.

So if rising asset prices are not going to fuel growth and general inflation in the long run, is general prosperity to be achieved through even more debt with a permanent expansion of the welfare state, climbing tax levies and more of all those things that have proven inefficient and unsuccessful to date?

Skeptics correctly argue that such policy strategies have been pursued and tried in many places and numerous eras of human history – but always with the same result of bankrupting entire states and societies.

A look at the situation in the United States shows that the budget deficit of the Washington federal government has meanwhile climbed to more than thirty percent (!) in relation to the annual economic output of the country. Is anyone in Washington concerned about this?

What is to come after this period of extreme deficit spending? This view alone shows that it is a one-way street, since there is no way out of this number. The only thing left to do is to print more and more and get it among the people and the companies. One could also use the phrase “Road To Perdition”.

At the same time, the national debt in the United States has climbed to its highest level since 1946. This development can be seen in the chart below.

If the Federal Reserve soon has to create even more electronic money to cover unpaid bills, towering budget deficits and expenditures that the country can no longer afford, confidence in the institutions, especially the federal government in Washington, will continue to plummet.

The Federal Reserve and its head, Jerome Powell, have repeatedly said that they have suitable instruments at their disposal to fight inflation, if necessary. What these instruments are, however, is not disclosed.

If confidence in the Fed and other institutions continues to decline, the Fed will eventually find itself in a situation where it has no control over anything at all and is left standing there as a naked emperor with no clothes.

Just as such things have been seen in numerous emerging and developing countries, this can and will happen in the U.S., the nation that (still) provides the world’s reserve currency.

DepthTrade Outlook

In concrete terms, it means being as prepared as possible for Day X, the day when residual confidence in the existing system collapses. Food access, energy access and investments in physical and real assets should prove helpful in making ends meet in the event of a collapse.

Hayato Ishikawa Send an email

Mr. Ishikawa has more than 25 years of experience in the financial markets, focusing on stocks, real estate, cross-asset risk hedging, and business founding. He is co-founder of a private investment group - specializing in the western pacific region and an independent analyst as well as business advisor. Mr. Ishikawa is known for bringing technical and fundamental analysis as well as sentiment into a coherent overall assessment - unbiased financial and political journalism made in Japan.
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