The central banks of the world are massively and insouciantly pursuing financial instability. That’s the inherent result of the 68 straight months of zero money market rates that have been forced into the global financial system by the Fed and its confederates at the BOJ, ECB and BOE. ZIRP fuels endless carry trades and the harvesting of every manner of profit spread between negligible “funding†costs and positive yields and returns on a wide spectrum of risk assets.
Moreover, this central bank sponsored regime of ZIRP and money market pegging contains a built-in accelerator. As carry trade speculators drive asset prices steadily higher and fixed income spreads steadily thinner—- fear and short interest is driven out of the casino, making buying on the dips ever more profitable and less risky. Indeed, the explicit promise by central banks that the money market rate will remain frozen for the duration and that ample warning of any change in rate policy will be “transparently†announced is the single worst policy imaginable from the point of view of financial stability. It means that the speculator’s worst nightmare—–suddenly going “upside down†due to a sharp spike in funding costs—-is eliminated by central bank writ.
Stated differently, ZIRP systematically dismantles the market’s natural stability mechanisms. One natural deterrent to excessive financial gambling, for example, is the cost of hedging a speculator’s portfolio of “risk assets†against a broad market plunge. In an honest market environment, hedging costs consume a high share of profits, thereby sharply limiting risk appetites and the amount of capital attracted to speculative trading.
By contrast, an extended regime of ZIRP, coupled with the central banks’ perceived “put†under risk assets, drives the cost of “downside insurance†to negligible levels because S&P 500 put writers are emboldened and subsidized to pick up nickels (i.e. options premium) in front of a benign central bank steamroller. This ultra-cheap downside insurance, in turn, attracts ever larger inflows of speculative capital to the casino.
This corrosive game has been underway ever since the Greenspan Fed panicked on Black Monday in October 1987 and flooded the stock market with liquidity. It is now such an endemic feature of Wall Street that it is falsely assumed to be the normal order of things. But, then, would anyone have been picking up nickels in front of the Volcker steamroller?
This dynamic is evident in the chart of the S&P 500 since the March 2009 bottom. The dips have gotten shallower and shallower as ZIRP and other pro-risk central bank policies have eroded the market’s natural defenses against excessive speculation. As of mid-2014, therefore, it can be fairly said that fear and short interest have been extinguished almost entirely. The Wall Street casino has thus become a one-way market that coils dangerously upward, divorced completely from the fundamentals of earnings and cash flow and real world economic conditions and prospects.
