The conventional view holds that inflation poses the predominant risk emanating from loose monetary policy. Yet with Chinese and Asian mega-factories seemingly capable of forever saturating the world with inexpensive goods, central bankers and analysts these days easily dismiss inflationary risks. Essentially free money is, basically, costless, or so the thinking goes. And if it all seems too good to be true, it’s because no one wants to delve into the true costs associated with monetary policy incentives having so maligned global financial markets.
Previous CBBs have focused on the dysfunctional nature of the “risk on, risk off” – Roro – market trading dynamic. Instead of a fleeting fad, Roro has become only more deeply entrenched – seemingly becoming a permanent fixture. Arguably, the market backdrop has regressed only further into a casino of wagers either on or against the capacity of policy responses to incite market rallies. Risk markets have become only more highly correlated – and the bets only more fixated on red or black (or, more accurately, the flashing red or green from the Bloomberg screen). And the two biggest outgrowths from years of monetary policy incentives - the mammoth leveraged speculating community and global derivatives markets - are struggling to perform as expected. This comes as no surprise.
An era of “incentive distortions” - years of loose money and decades now of “activist” central bank market intervention – has severely distorted the underlying structure of Credit, financial market, and economic systems. Beginning back in the early 1990s, the Greenspan Fed actively “reallocated” financial returns to the impaired banking system by slashing short-term borrowing costs and orchestrating a steep yield curve (“free money” from borrowing short and holding longer-term debt instruments). Intervening in the markets to boost depleted bank capital was seen as providing extraordinary system benefits. Little attention was thus paid to the fact that this also incentivized leveraged speculation. And the hedge fund industry hasn’t looked back since, with assets exploding from about $50bn to surpass $2.1 TN. And with the Fed and the cadre of global central banks guaranteeing “liquid and continuous” markets, the derivatives and risk insurance marketplaces exploded to unfathomable hundreds and hundreds of Trillions. And the larger these Bubbles and associated risks inflated, the more confident the speculator community became that more aggressive policy measures and market interventions would be forthcoming.
I would today argue there is a momentous unappreciated cost to central bankers’ “reallocations” and “incentive distortions:” they’ve nurtured one massive, and now hopelessly unwieldy, “crowded trade” throughout global risk markets. And, as seasoned traders appreciate, once a trade becomes “crowded” the nature of how a trade – how a market – performs tends to turn highly unpredictable, erratic and, in the end, unsatisfying. Over time, fundamental developments are overshadowed by the brute force of market technicals. For example, “crowded” short positions will tend to “melt-up” into dramatic short squeezes before eventually collapsing. And crowded longs tend to turn highly speculative, yet inevitably susceptible to air-pockets and abrupt downdrafts. Locate a “crowded trade” and you’ve found a captivating place where it’s easy to lose money. In general, crowded trades fuel speculation, unpredictability, and Bubble Dynamics – along with a lot of frustration and eventual disenchantment.
Global central bankers have ensured that way too much money now chases limited global risk asset market returns (contemporary prevailing inflation). With global short-term rates pushed near zero, hundreds of billions have flooded into more speculative instruments and ventures, certainly including the global hedge fund community. Not surprisingly, funds have struggled with performance. After a poor 2011, scores of funds have crowded into similar trading strategies and are these days under intense pressure to make money. Many are desperate not to miss a tradable market trend, while at the same time suffering from an unusually low tolerance for losses. Funds, careers, businesses and dreams are at stake – and the “tape” shows it.
It’s all created an extraordinarily mercurial backdrop. The game of seeking to extract speculative trading profits from “crowded trades,” trend-following derivative trading strategies, and generally weak-handed participants has, itself, become one massive and dysfunctional crowded trade. “Crowded Trade Squared,” a creature of prolonged policy interventions and incentive distortions, is a perilous predicament posing as a functioning marketplace. Meanwhile, the backdrop seems to ensure the type of “Roro” volatility that wears down managers, performance and investor confidence. This is the case for markets across the globe, in an era where market-based finance has never been as critical to global financial, economic and social stability. And that amounts to an incredible accumulating cost the “inflationists” will continue to disregard.