Buttonwood

Cut off by their sugar daddy

Investors fear the loss of central-bank support

Jun 29th 2013

THE pattern is wearily familiar. In every year since 2010 global markets have started the year in optimistic mood only to run into trouble in the late spring and early summer. This time there is little doubt about the cause. The Federal Reserve has suggested that, unless the American economy deteriorates, it may start to slow the pace of its asset purchasescurrently running at $85 billion a monthlater this year. The purchases may stop altogether sometime in 2014.


Ever since the Fed began its latest round of quantitative easing (QE) last year, investors have felt they had a one-way bet. As David Simmonds of Royal Bank of Scotland remarked: “In this period the imperative was to venture forth with liquidity and to find some risk-seeking home for it, some extra yield, some enhanced return. This was a great rotation out of any remaining cash and into anything and everything else.”
.


Investors reacted to the potential loss of this support like trust-fund kids warned that Daddy is about to cut off their allowance. They panicked. What is striking is the breadth of assets that have fallen in price in recent weeks (see chart). Equities have dropped around the globe, with some markets (including China’s) now 20% below their recent peaks.

Government bonds have suffered: yields have risen sharply in safe, liquid markets like America and Germany, in troubled euro-zone members such as Italy and Spain, and in developing countries. And there has been a rout in the gold and silver markets, as well as a sell-off in economically sensitive raw materials such as copper.

Why would a reduction in the pace of QE by the Fed be a global problem? Other central banks may compensate, after all. The Bank of Japan has started a programme of rapid monetary expansion. There are hopes that Mark Carney, the new Bank of England governor, will ease policy. Some believe that even the European Central Bank will eventually be forced into QE.

One issue is the dominance of American investors on the global stage. As Jim Reid, a strategist at Deutsche Bank, comments: “The problem we face is that the US tends to set the price of debt everywhere.” With the yield on ten-year Treasury bonds rising by a percentage point since early May, other yields have been forced up in tandem. The effect is a global tightening in monetary policy. A spike in Chinese money-market rates has not helped, especially as investors were already concerned about a slowdown in Chinese growth.

What makes the markets harder to read is that bond yields are rising even though global growth forecasts have been revised lower and inflation is generally falling. This may reflect the determination of investors to stay one step ahead of the authorities. Rationally, if the end of QE is bound to result in a huge rise in yields, it makes sense to sell now rather than later.

But if yields rise far enough to dent the economy, or if stockmarkets collapse and undermine consumer confidence, the Fed may be forced to keep QE going. (That explains why shares rose on June 26th after a downward revision to America’s first-quarter GDP.) “Markets tend to test things,” Richard Fisher of the Dallas Federal Reserve told the Financial Times this week, comparing investors to “feral hogsIf they detect a weakness or a bad scent, they’ll go after it.”

The potential withdrawal of QE support also forces equity investors to focus on the fundamentals, which are not that supportive. According to Citigroup, downgrades of earnings forecasts are outpacing upgrades by a ratio of three to two. Equities look cheap relative to government bonds but not in their own right: the cyclically adjusted price-earnings ratio on the American market is 23.6, well above the historical average.

It is possible to put a positive spin on all this. The Fed’s hints of a “tapering” of QE, and the subsequent rise in bond yields, may simply signal a return to normal. Although growth in developing countries seems to have slowed, there have been better signs in the rich world: a good first quarter in Japan, falling unemployment in America and even glimmers that the worst may be over in Europe.

The more bearish possibility is that the developed economies will struggle to maintain momentum if emerging markets are slowing; that the rich world has still not managed to reduce its high debt levels; and that the sell-off represents a recognition by investors that they are in deep trouble without the crutch of central-bank support. It is a nice irony that the titans of fund management, who consider themselves robust champions of the free-market system, are so dependent on handouts from the monetary authorities.


De-Risking Revisited

Nouriel Roubini

27 June 2013

 This illustration is by Dean Rohrer and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.



NEW YORKUntil the recent bout of financial-market turbulence, a variety of risky assets (including equities, government bonds, and commodities) had been rallying since last summer. But, while risk aversion and volatility were falling and asset prices were rising, economic growth remained sluggish throughout the world. Now the global economy’s chickens may be coming home to roost.
 
Japan, struggling against two decades of stagnation and deflation, had to resort to Abenomics to avoid a quintuple-dip recession. In the United Kingdom, the debate since last summer has focused on the prospect of a triple-dip recession. Most of the eurozone remains mired in a severe recessionnow spreading from the periphery to parts of the core. Even in the United States, economic performance has remained mediocre, with growth hovering around 1.5% for the last few quarters.
 
And now the darlings of the world economy, emerging markets, have proved unable to reverse their own slowdowns. According to the IMF, China’s annual GDP growth has slowed to 8%, from 10% in 2010; over the same period, India’s growth rate slowed from 11.2% to 5.7%. Russia, Brazil, and South Africa are growing at around 3%, and other emerging markets are slowing as well.
 
This gap between Wall Street and Main Street (rising asset prices, despite worse-than-expected economic performance) can be explained by three factors. First, the tail risks (low-probability, high-impact events) in the global economy – a eurozone breakup, the US going over its fiscal cliff, a hard economic landing for China, a war between Israel and Iran over nuclear proliferation – are lower now than they were a year ago.
 
Second, while growth has been disappointing in both developed and emerging markets, financial markets remain hopeful that better economic data will emerge in the second half of 2013 and 2014, especially in the US and Japan, with the UK and the eurozone bottoming out and most emerging markets returning to form. Optimists repeat the refrain that “this year is different”: after a prolonged period of painful deleveraging, the global economy supposedly is on the cusp of stronger growth.
 
Third, in response to slower growth and lower inflation (owing partly to lower commodity prices), the world’s major central banks pursued another round of unconventional monetary easing: lower policy rates, forward guidance, quantitative easing (QE), and credit easing. Likewise, many emerging-market central banks reacted to slower growth and lower inflation by cutting policy rates as well.
 
This massive wave of liquidity searching for yield fueled temporary asset-price reflation around the world. But there were two risks to liquidity-driven asset reflation. First, if growth did not recover and surprise on the upside (in which case high asset prices would be justified), eventually slow growth would dominate the levitational effects of liquidity and force asset prices lower, in line with weaker economic fundamentals. Second, it was possible that some central banksnamely the Fed – could pull the plug (or hose) by exiting from QE and zero policy rates.
 
This brings us to the recent financial-market turbulence. It was already evident in the first and second quarters of this year that growth in China and other emerging markets was slowing. This explains the underperformance of commodities and emerging-market equities even before the recent turmoil. But the Fed’s recent signals of an early exit from QEtogether with stronger evidence of China’s slowdown and Chinese, Japanese, and European central bankers’ failure to provide the additional monetary easing that investors expected – dealt emerging markets an additional blow.
 
These countries have found themselves on the receiving end not only of a correction in commodity prices and equities, but also of a brutal re-pricing of currencies and both local- and foreign-currency fixed-income assets. Brazil and other countries that complained about “hot moneyinflows and “currency wars,” have now suddenly gotten what they wished for: a likely early end of the Fed’s QE. The consequences sharp capital-flow reversals that are now hitting all risky emerging-market assets – have not been pretty.
 
Whether the correction in risky assets is temporary or the start of a bear market will depend on several factors. One is whether the Fed will truly exit from QE as quickly as it signaled. There is a strong likelihood that weaker US growth and lower inflation will force it to slow the pace of its withdrawal of liquidity support.
 
Another variable is how much easier monetary policies in other developed countries will become. The Bank of Japan, the European Central Bank, the Bank of England, and the Swiss National Bank are already easing policy as their economies’ growth lags that of the US. How much further they go may well be influenced in part by domestic conditions and in part by the extent to which weaker growth in China exacerbates downside risks in Asian economies, commodity exporters, and the US and the eurozone. A further slowdown in China and other emerging economies is another risk to financial markets.
 
Then there is the question of how emerging-market policymakers respond to the turbulence: Will they raise rates to stem inflationary depreciation and capital outflows, or will they cut rates to boost flagging GDP growth, thus increasing the risk of inflation and of a sudden capital-flow reversal?
 
Two final factors include how soon the eurozone economy bottoms out (there have been some recent signs of stabilization, but the monetary union’s chronic problems remain unresolved), and whether Middle East tensions and the threat of nuclear proliferation in the region – and responses to that threat by the US and Israelescalate or are successfully contained.
 
A new period of uncertainty and volatility has begun, and it seems likely to lead to choppy economies and choppy markets. Indeed, a broader de-risking cycle for financial markets could be at hand.
 
 
 
Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.


The protests around the world

The march of protest

A wave of anger is sweeping the cities of the world. Politicians beware

Jun 29th 2013
.   



A FAMILIAR face appeared in many of the protests taking place in scores of cities on three continents this week: a Guy Fawkes mask with a roguish smile and a pencil-thin moustache. The mask belongs to “V”, a character in a graphic novel from the 1980s who became the symbol for a group of computer hackers called Anonymous. His contempt for government resonates with people all over the world.

The protests have many different origins. In Brazil people rose up against bus fares, in Turkey against a building project. Indonesians have rejected higher fuel prices, Bulgarians the government’s cronyism. In the euro zone they march against austerity, and the Arab spring has become a perma-protest against pretty much everything. Each angry demonstration is angry in its own way.

Yet just as in 1848, 1968 and 1989, when people also found a collective voice, the demonstrators have much in common. Over the past few weeks, in one country after another, protesters have risen up with bewildering speed. They have been more active in democracies than dictatorships. They tend to be ordinary, middle-class people, not lobbies with lists of demands. Their mix of revelry and rage condemns the corruption, inefficiency and arrogance of the folk in charge.

Nobody can know how 2013 will change the worldif at all. In 1989 the Soviet empire teetered and fell. But Marx’s belief that 1848 was the first wave of a proletarian revolution was confounded by decades of flourishing capitalism and 1968, which felt so pleasurably radical at the time, did more to change sex than politics. Even now, though, the inchoate significance of 2013 is discernible. And for politicians who want to peddle the same old stuff, the news is not good.


Online and into the streets
 
 
The rhythm of protests has been accelerated by technology. V’s face turns up in both São Paulo and Istanbul because protest is organised through social networks, which spread information, encourage imitation and make causes fashionable. Everyone with a smartphone spreads stories, though not always reliable ones.

When the police set fire to the encampment in Gezi Park in Istanbul on May 31st, the event appeared instantly on Twitter. After Turks took to the streets to express their outrage, the flames were fanned by stories that protesters had died because of the police’s brutal treatment. Even though those first stories turned out to be wrong, it had already become the popular thing to demonstrate.

Protests are no longer organised by unions or other lobbies, as they once were. Some are initiated by small groups of purposeful peoplelike those who stood against the fare increases in São Paulo—but news gets about so fast that the organising core tends to get swamped. Spontaneity gives the protests an intoxicating sense of possibility. But, inevitably, the absence of organisation also blurs the agenda.

Brazil’s fare protest became a condemnation of everything from corruption to public services. In Bulgaria the government gave in to the crowd’s demand to ditch the newly appointed head of state security. But by then the crowd had stopped listening.

This ready supply of broad, fair-weather activism may vanish as fast as it appeared. That was the fate of the Occupy protesters, who pitched camp in Western cities in 2011. This time, however, the protests are fed by deep discontent. Egypt is suffering from the disastrous failure of government at every level. Protest there has become a substitute for opposition. In Europe the fight is over how to shrink the state. Each time the cuts reach a new targetmost recently, Greece’s national broadcaster—they trigger another protest. Sometimes, as in the riots of young immigrants in Sweden’s suburbs in May and of British youths in 2011, entire groups feel excluded from the prosperity around them. Sweden has the highest ratio of youth unemployment to general unemployment in the OECD. Too many young Britons suffer from poor education and have prospects to match. In the emerging economies rapid real growth has led people to expect continuing improvements in their standard of living. This prosperity has paid for services and, in an unequal society like Brazil, narrowed the gap between rich and poor. But it is under threat. In Brazil GDP growth slowed from 7.5% in 2010 to only 0.9% last year. In Indonesia, where GDP is still below $5,000 a head, ordinary families will keenly feel the loss of fuel subsidies.

More potent still in the emerging world are the political expectations of a rapidly growing middle class. At the end of last year young educated Indians took to the streets of several cities after the gang rape of a 23-year-old medical student, to protest at the lack of protection that the state affords women.

Even bigger protests had swept the country in 2011, as the middle class rose up against the corruption that infests almost every encounter with government officials. In Turkey the number of students graduating from university has increased by 8% a year since 1995. The young middle class this has created chafes against the religious conservatism of the prime minister, Recep Tayyip Erdogan, who wants large families and controls on alcohol.

The 40m Brazilians who clambered out of poverty in the past eight years are able for the first time to scrutinise the society that their taxes finance. They want decent public services, and get overpriced sports stadiums instead.


Trouble in Brussels and Beijing.
 
 
How will this year of protest unfold? One dark conclusion is that democracy has become harder: allocating resources between competing interest groups is tougher if millions can turn out on the streets in days. That implies that the euro zone’s summer will surely get hotter. The continent’s politicians have got off lightly so far (the biggest demonstrations in Paris, for instance, were whenFrigide Barjotled French Catholics in a bid to stop gay marriage). Yet social instability is twice as common when public spending falls by at least 5% of GDP as when it is growing. At some point European leaders must curb the chronic overspending on social welfare and grapple with the euro’s institutional weakness—and unrest will follow.

Happily, democracies are good at adapting. When politicians accept that the people expect better—and that votes lie in satisfying themthings can change. India’s anti-corruption protests did not lead to immediate change, but they raised graft up the national agenda, with the promise of gradual reform. To her credit, Brazil’s president, Dilma Rousseff, wants a national debate on renewing politics. This will be neither easy nor quick. But protest could yet improve democracy in emerging countries—and even eventually the EU.

Democrats may envy the ability of dictators to shut down demonstrations. China has succeeded in preventing its many local protests from cohering into a national movement. Saudi Arabia has bribed its dissidents to be quiet; Russia has bullied them with the threats of fines and prison. But in the long run, the autocrats may pay a higher price.

Using forcé to drive people off the streets can weaken governments fatally, as Sultan Erdogan may yet find; and as the Arab governments discovered two years ago, dictatorships lack the institutions through which to channel protesters’ anger. As they watch democracies struggle in 2013, the leaders in Beijing, Moscow and Riyadh should be feeling uncomfortable.


Uninsurable Risks
 
June 28, 2013

by Doug Noland



An extraordinarily unsettled quarter ends on a tenuous up note.

June 24 – Financial Times (Alistair Gray and Pilita Clark): Insurers have issued a rare warning that the speed at which the oceans are warming is threatening their ability to sell affordable policies in a growing number of places around the world. Parts of the UK and the US state of Florida were already facing ‘a risk environment that is uninsurable’, said the global insurance industry trade body, the Geneva Association. They were unlikely to be the last areas with such problems, said John Fitzpatrick, the association’s secretary-general… ‘Governments may have fiscal austerity issues in the short run. But in the long run they’re going to have big exposures – to repair damaged infrastructure from storms.’ …In spite of the losses from Sandy and a spate of natural catastrophes the previous year, overall global property insurance premiums have remained broadly stable outside loss-hit areas. However, insurers warn premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates.”

I found multiple reasons this week to think back to a March 2000 CBB, “A Derivative Story.” It was my fictional account of how cheap flood insurance spurred a spectacular boom and bust cycle on “a little town along the river”.

Basically, writing flood insurance during a drought provided extraordinaryreturnopportunities. A speculative Bubble developed in the marketplace, whereby thinly capitalized speculators came to dominate the market for cheap insurance. The easy availability of inexpensive protection was instrumental in fueling a self-reinforcing economic Bubble along the waterfront. Between the building boom and inflating real estate prices, the amount of outstanding flood insurance ballooned (exponentially). As speculation in this marketplace turned manic, the entire insuranceindustry” became precariously undercapitalized, especially in the context of rapidly inflating latent risks. Losses had been avoided for years – and many just presumed drought was the new normal. And in the unexpected event of torrential rainfall, most anticipatedhedgingpotential flood loss exposures in the liquid marketplace for cheap reinsurance. Well, the insurance market collapsed in illiquidity with the inevitable arrival of a major flood. Financial and economic losses proved catastrophic in my sad little tale.

So have the Bernanke Federal Reserve and fellow global central banks been adeptly supporting the global economic recovery after 2008’shundred year flood” - as conventional thinking believes? Or have they instead been inflating history’s greatest Credit Bubble? Policy uncertainties and unstable global markets have again made this a pressing question.

The usual (“inflationist”) punditry has been in attack mode against Bernanke’s call to begin (most gingerly) the process of backing away from extraordinary crisis-period quantitative easing measures. They claim the recovery remains too weak and inflation too low to contemplate policytightening.” Some go so far as to claim the Fed is repeating its 1937 mistake, whereby tightening measures are said to have aborted a fledgling recovery and needlessly extended the Great Depression.

Every boom and bust cycle runs its own course. But I would strongly argue any comparison to 1937 is misguided. In no way do I believe the 2008 financial crisis was the current historic cycle’s 1929.

There was indeed significant financial and economic stress in 2008/09. But there was definitely no global collapse in Credit or economic activityno globalized economic depression. Actually, on a global basis debt growth has run unabated. And after a meaningful yet non-catastrophic setback in 2009, global GDP growth quickly recovered. With record outstanding debt, record GDP and near-record securities prices, it’s unreasonable to argue for unending depression-era fiscal and monetary stimulus.

More than a decade ago, Dr. Bernanke, with his “helicopter money” and “government printing press,” arrived on the scene with academic theories to fight the scourge of deflation. Well, the tech Bubble had burst - but I argued strongly at the time that THE greater Credit Bubble was very much alive and well. Extraordinary Fed stimulus was poised to inflate the fledgling mortgage finance Bubble. I argued in 2009 that THE Bubble hadn’t burst, instead unmatched global fiscal and monetary stimulus had unleashed the “granddaddy of them all” – the global government finance Bubble.

This is notintelligentsia” – and I would add that recent market developments have again made this a most pertinentdebate.” Has the Fed been successfully countering a post-Bubble landscape - or has it instead been further inflating a historic Bubble? Do Dr. Bernanke’s academic theories of how the Fed must ensure there is amplemoney” in the real economy to address insufficient demand really hold water? Or have zero rates and Trillions of QE simply flooded excess liquidity into already distorted global securities markets? Has Federal Reserve policy led to runaway Bubbles in dysfunctional risk marketsfueling an epic globalbuilding boom along the river”?

I have in past CBBs noted key differences between the traditional government currency printing press and today’s newfangled electronic version. Traditional monetary inflations created government currency - purchasing power that worked to bid up prices throughout the real economy. The contemporaryprinting presscreates electronic debit and credit entries that predominantly provide new purchasing power that bids up prices of financial assets. I have argued that this mechanism has been fueling dangerous securities markets and asset Bubbles around the globe. I have further argued that the Fed and central banks had unwittingly nurtured acute Bubble fragility to any potential reduction in central bank liquidity.

How does one reconcile massive ongoing money printing” with deflating commodities prices and generally contained consumer price inflation? Well, perhaps the commodities market is the proverbialcanary in the coalminewarning that QE has indeed fueled increasingly vulnerable Credit and asset Bubbles. The backdrop is increasingly reminiscent of the late-1920s, when many (including the Fed) believed weak commodity prices were a call for further monetary accommodation. I am today playing the role of the “old codgers” from the Roaring Twenties that warned of the dangers (and utter futility) of trying to sustain a deeply maladjusted system and historic financial Bubbles. While they were correct in their analysis, history has been unkind to these liquidationists” and Bernanke Bubble poppers.” Dr. Bernanke (and conventional thinking) is convinced the issue during the late-twenties and thirties was deflation and the Fed’s negligence in failing to print sufficient money supply. I am convinced that Bernanke’s analysis is flawed: the key issue was the Fed repeatedly placed coins in the fusebox” during the twenties – in the process accommodating precarious financial and economic Bubbles.

Quantifying current Bubble risk is an impossible task. Global debt and securities markets easily surpass a hundred Trillion. Gross derivative exposures are in the many hundreds of Trillions. The now enormous Chinese and EM financials systems, in particular, lack transparency. The amount of global speculative leverage is unknown. The degree of global financial distortion and economic maladjustment will not become apparent until the next major period of market risk aversion and resulting tightened global financial conditions. For now, recent market gyrations support my view of precarious Latent Market Bubble Risks.

I’ll attempt to use some data to illustrate how Fed policymaking has greatly exacerbated already outsized market risks. As a crude proxy for “market risk,” I’ll combine outstanding Treasury debt, Agency debt/MBS, Corporate bonds, municipal debt and the value of U.S. equitiessecurities that fluctuate in the marketplace based upon perceptions of value, liquidity and risk. It is worth noting that “market risk” had inflated to $33 TN during the booming nineties, after beginning the decade at $10 TN. Importantly, the nineties saw a fundamental shift to market-based Credit instruments, with the proliferation of ABS, MBS, the GSEs and “Wall Street Financemore generally.

I have over the years argued that Credit is inherently unstable. The move to market-based debt instruments created an acutely unstable Credit system, instability that provoked a change at the Federal Reserve to a policy regime committed to backstopping the securities markets. For more than twenty years now, this new policy regime has led to an unending series of Bubbles, booms and busts, even more aggressive policy responses and only bigger, more precarious Bubbles. This is critical analysis that remains completely outside of mainstream economic thinking.

When Dr. Bernanke began his crusade against deflation risk back in 2002, “market risk” was at $29.7 TN. Extraordinary monetary stimulus (and resulting mortgage finance Bubble excess) was instrumental in market risk surging to $53 TN by the end of 2007, before dropping abruptly to $44.8 TN in 2008. During the past four years, “market risk” has inflated $16.7 TN, or 37%, to a record $61.5 TN. Perhaps more illuminating, as a percentage of GDP, “market risk” began the 1990’s at 182% and closed the decade at 323%. Post tech-Bubble asset prices had the ratio back to 284% by the end of 2002. By 2007, however, it had inflated all the way to 378%. In 2009 it fell back to 314%. It then ended 2012 at a record 392%. From another angle, over the past 10 years GDP increased $5.2 TN, or 50%, while “market riskinflated $31.8 TN, or 107%. While conventional thinking subscribes to the post-2008 deleveraging viewpoint, I believe the data strongly support my re-leveraging and historic Bubble thesis.

Global insurance companies have come to believe that global climate change has made some locationsUninsurable.” Extraordinary changes in the weather landscape have made areas so prone to potential catastrophe that risks cannot be effectively priced in the insurance market and reserved for by those writing policies.

I will posit that years of central bank intrusion and market domination have made global risk marketsUninsurable.”Market risk” has ballooned precariously higher, with massive issuance of non-productive government debt and other late-cycle private-sector Credit excesses. Meanwhile, central bank liquidity injections have inflated global asset market prices, while inciting speculation along with a manic global search for yield. Distorted "Bubble" global economies are increasingly succumbing to the debt and maladjustment overhang, while Financial Euphoria has seen securities markets inflate into dangerous speculative Bubbles.

There is a great flaw in the Bernanke doctrine of inflating the Fed’s balance sheet to both accommodate massive fiscal deficits and inflate securities markets, while using zero rates to force savers into the risk markets. This has led to an unprecedented (and problematic) mispricing of debt and securities prices globally, while incentivizing leveraging and speculation. Trillions of risk-consciousmoney” has flowed into global markets (through ETFs, hedge funds, mutual funds, etc.) with little appreciation for the true risk-profile of global financial markets. One could say a Bubble in perceived low-riskinvestingevolved into a key facet of the overall global risk market Bubble.

There remains a perception that risks can be readily hedged and that central banks will ensure liquid markets even in the event that the marketplace moves to de-risk. But the marketplace cannot offload market risk. Risks can be shifted around the marketplace. Yet if the market en masse seeks to reduce risk there is no one with the wherewithal to take the other side of the trade. This issue becomes especially salient when market risks are exceptionally elevated; when risks are underappreciated and misunderstood; and when most (sophisticated speculators, investors and unsophisticated savers alike) are heavily committed to the risk markets. That’s where I believe we are today.

Importantly, at least segments of the “global leveraged speculating community” must by now be increasingly impaired. The gold, precious metals and commoditiesreflation trade” has been an unmitigated disaster. While not yet a full-fledged disaster, the popular emerging market (EM) trade is unraveling. The currencies and global leveragedcarry trades” have become perilous minefields. Global fixed income markets, more generally, are increasingly unstable and illiquid.

Extremely low market yields and risk premiums/Credit spreads ensured the speculators ramped up leverage in order to achieve their bogey 8-9% (pension fund acceptable) annual returns. The exchange-traded fund (ETF) phenomenon ensured that a couple Trillion flowed easily into all types of mispriced asset classes.

The torrent of leveraged buying and ETF flows brought unprecedented liquidity to generally illiquid U.S. corporate and municipal bonds. A torrent of leveraged buying and ETF flows brought unprecedented liquidity to EM markets that over the years earned their “roach motelsmoniker. A torrent of flows ensured ultra-easy financial conditions that for four years have worked to validate the (mis)perception of minimal risk throughout U.S. and global markets.

Of course, New York President Dudley and other Fed officials have come out to comfort an unsettled marketplace. Dudley even suggested that the Fed could actually do QE bigger and longer if necessary. Such pandering is precisely why markets are these days so exposed to Bubble risks.

The Fed has made such an incredible mess of monetary policy. Fed policies have fomented a historic Bubble and there will no painless extrication. Various Fed officials have said the market has “misinterpreted,” “misunderstood,” and is “quite out of synch” with the Fed’s recent policy message. I don’t believe the market misunderstands the Fed as much as the Fed and market participants for years have misunderstood market risk dynamics.

Bubbles don’t inflate forever. I’ll assume that at least the sophisticated market operators now appreciate the rapidly escalating risk to EM markets and economies.

I’ll assume there is newfound appreciation for the serious liquidity issues overhanging various markets. I’ll assume the leveraged players are responding to the new backdrop with plans for reduced leverage and risk. The sophisticated market operators will now work to “distributerisk to the less sophisticated, a process they expect will be aided by ongoing Fed verbal and QE market support.

Prominent fund managers and bullish pundits have blanketed the airways the past few days with hopeful messages that the worst of the bond selling is over and that the great equities bull market remains intact. It’s just not going to be that easy. Outflows from bond, EM and stock funds have been enormous. Despite this week’s rally, the fear is that investors will be none too pleased when they see monthly/quarterly brokerage statements. The “sophisticatedsurely don’t want to be in a situation where they’re fighting the “unsophisticated” to the exits. They need to see that feel-good bull market feeling return to risk markets relatively quickly - or else.

Above I mentioned how Federal Reserve doctrine changed during the nineties to support the proliferation of market-based Credit. During the decade, the market for derivatives and myriad types of risk insurance ballooned right along with Credit and market risk. I’ve argued over the years that Credit and financial market risk are actually Uninsurable – in that they are neither random nor independent events such as car accidents and house fires.

Actually, it is the nature of market risk for losses to occur in particularly non-random and non-independent waves. Somehow the lessons of 2008 were quickly unlearned.

And while I’m on the subject of risk management, it’s worth noting that for years one could simply mitigate risk by holding Treasuries (and bunds, agency debt, etc.). In the event of market turbulence, rising Treasury prices would work to offset declining prices for stocks, junk bonds and such. Problematically, Treasury prices have of late been declining right along with risk assets, as “safe haven”, risk asset and commodity prices all turn atypically correlated.

There’s been a proliferation of “risk paritystrategies that are struggling under current market conditions. If things don’t normalize quickly, market participants will be forced to adjust their views of risk and liquidity management.

In a way, the Federal Reserve has for years circumventednature” by assuring market liquidity. It is this assurance that has empowered a booming derivativesinsurancemarketplace that operates on the specious assumption of “liquid and continuous markets.” The vast majority of derivative market insurance written requires some degree of “dynamichedgingi.e. selling of instruments to generate sufficient cash flow to pay on market insurance contracts sold/written. This is one of those key Latent Market Bubble Risks.

Global climate change is fundamentally altering the risk and the insurance marketplace, although “premiums have been kept artificially depressed in the short term because capital has flocked to the sector in the face of historic low interest rates.” Global central banks have unwittingly inflated risk and grossly distorted the risk insurancelandscape across global risk markets. We’ll see how longcapitalcontinues to flock to global securities markets. Early indications of how global risk markets will function in the face of a reversal of flows are anything but encouraging.