Earlier today we showed an amazing schematic courtesy of Citi’s Matt King: if one includes the reserve liquidation by various EMs and SWF, and nets it against liquidity injections by DM central banks (and the PBOC), one gets a perfect quantitative, not just qualitative, walk-thru on how to trade markets: in other words one can measure, using high frequency data in real-time, just where markets should trade based on liquidity flows, and promptly profit from any arbitrage opportunities.
But aside from the potential for substantial profits, there are more profound implications. Matt King lays them out as follows:
If this relationship were to continue to drive markets, it would point to three conclusions.
First, if outflows from EM continue to be “worse than previously thought”, as the IIF put it this week, that may continue to weigh also on developed markets. We recommend the IIF’s monthly ‘portfolio flows tracker’ as the best high-frequency indicator as to how those flows are developing; we also use data from those EM central banks that promptly publish reserves information as a guide to the broader universe.
Second, the relationship suggests individual central banks are considerably less in control of their own destinies than they might have hoped. Our rates strategists have already pointed out that long-term inflation expectations in Europe and the US have more in common with a global – Chinese – factor than with domestic wage and price developments. With the current magnitude of EM outflows seemingly entirely offsetting ongoing ECB and BoJ QE, it seems fair to wonder whether the sorts of increases likely from the BoJ next week and the ECB in March will have as great an effect as investors seem to be hoping.
Third, the fact that just one variable, with nothing in common with credit or equity fundamentals at all, does such a good job of explaining changes in market prices is in itself disturbing. It points to just the sort of herding effects we have argued were in play all along, and suggests that recent complaints of illiquidity, and sudden bouts of volatility, are being driven by more than just regulatory constraints on dealer balance sheets. Such a relationship leaves little room for heterogeneous market views.
King’s summary:
To sum up, it does not follow that everything need evolve in a bearish direction; what strikes us mostly is how interlinked, even circular, the outlook remains.
While we are suspicious of the reasoning behind the last day or so’s rally – Aramco may find oil prices “irrational”, but if neither it nor anyone else is prepared to cut production, our commodities strategists see little reason for near-term optimism – that does not mean it cannot continue. As in August and September last year, there is a great deal of bearishness in market pricing already. If investors are bracing themselves for outflows which fail to materialize, the resultant short squeeze can be vicious. The more bearish the pricing, the greater the risk that reasonably stable economic data (as recent Chinese and European numbers have been) produce just such a squeeze. If that in turn helps to reverse the recent trend towards mutual fund outflows, as is suggested by our latest investor survey, the chance grows that this will come to be seen as just another example of the market predicting a recession that never happened, as in 2011. It is just such a view that underpins our house forecasts, and continues – just – to seem the most likely overall scenario.
But this will not address the underlying issue for economists and investors alike. Weak multipliers in the economy away from EM and commodities have left us overly dependent on monetary policy. When monetary stimulus’ effect on markets fails to be matched by a corresponding improvement in the real economy, we are inevitably vulnerable to a correction.
Perhaps if this sell-off fizzles out by itself, as it did last October, central banks will again be spared the need to face up to the distortive effect they have had upon markets, and can continue the pretence that markets are still following fundamentals. After all, for many of them, this has been the sell-off which ‘isn’t supposed to be happening’.
As in many a nursery game of ring-a-ring-a-roses, the problem is not just that, once we have all linked hands, we really do all end up either standing up or falling down together. It is also that, in the giddy excitement induced by running round in circles, sometimes you end up falling down even when you didn’t intend to.
What is the implication of all of the above?
The reality is that the vast majority of market participants are not only idiots, they are also very lazy: they have no desire to read any of the above, and certainly no interest in understanding what it means, or what truly makes the market tick. Back in 2007 this meant blaming the rating agencies for everyone’s blow up. This time the scapegoat will likely be HFTs.
However, a small handful of people will read the full Matt King note – which is a must read – and understand just how close we are to the event horizon in which central banks lose not credibility but control over risk assets. This also means an end to the fiat system: a truly epochal outcome and the biggest phase shift in modern economics and financial markets.
But the real rub is the following: most market participants already have had a suspicion of what Matt King has so eloquently explained. They likewise had a sense days before Lehman collapsed that something historic was brewing. Back then, it was Matt King’s note “Are the Brokers Broken” issued on September 5, 2008 that explained to everyone just how broken the system was, and allowed everyone to visualize the Lehman failure. Ten days later it was realized.
Now, Matt King has done one better, and has explained not only how central banks rigged everything, but how the loss of control could and will look like. Which makes us wonder: will it be sufficient to explain just how broken everything is – with the source being not some tinfoil fringe blog but the head credit strategist of Citi – for said breakage to migrate from the merely hypothetical to the realized?
We look forward to finding out very soon.
via Zero Hedge http://ift.tt/20nRvwO Tyler Durden