EC Financial Markets At Critical Juncture – Could A Crash Eventually Happen?

On The Nature of the Pullback

 

Why have stocks and high yield debt recently declined? The standard excuses trotted out by the financial press make very little sense. For instance, it is held that stocks have fallen due to rising geopolitical upheaval in Ukraine, Iraq and elsewhere (actually, the “elsewhere” situations, such as the falling apart of Libya are rarely mentioned, because they are overshadowed by the other two).

But this makes no sense when we consider that the market was perfectly happy to completely ignore both developments for months. Why should they matter now, if they haven’t previously? There is only a kernel of truth in these assertions insofar as “bad news” from these conflicts can serve as short term triggers for market weakness on a daily or even hourly basis. However, there is a difference between a trigger and a “reason”.

As Zerohedge has pointed out, outflows from high yield debt ETFs are causing some indigestion, because the ETFs themselves are highly liquid, while the underlying debt is anything but. We have also briefly discussed this problem of bond market illiquidity in our recent comprehensive update on the junk debt bubble (see: “A Dangerous Boom in Unsound Corporate Debt” for details), however, we haven’t brought it into context with ETFs.

Zerohedge is quite correct in pointing this relationship out – it is an added wrinkle complicating the situation. Why are corporate bonds illiquid? Because the biggest banks have withdrawn from proprietary trading and market making in these instruments due to various post-crisis regulations that have been imposed (such as the Dodd-Frank monstrosity).

It is important to understand in this context that these vast addition of regulations in what is already one of the most over-regulated sectors of the economy brings a raft of unintended negative consequences with it. The entire shebang fails to strike at the root, instead it is yet another attempt to make fractional reserve banking somehow “viable”.  The most important privilege banks enjoy, which is the basis of our entire debt money system, is to be preserved at all cost.

This system siphons wealth in insidious ways from actual wealth creators to the State and its favored  industries, among which the banking industry inhabits the top spot. Almost no regulations would be required in a true free market banking system that  scrupulously respects property rights. You may wonder why the big banks haven’t made more of an effort to roll these regulations back. The reason is simple: one of the main effects of imposing ever more bureaucratic oversight and decrees is to completely stamp out competition from smaller rivals and upstarts, who cannot afford paying the costs of compliance. Thus the business becomes ever more concentrated in the hands of fewer and fewer large banks.