Central Banks Still Behind the Curve

Today’s effort is going to be a bit of a thought piece. That’s a fancy way of saying that I’ll be making it up as I go along.

But I’ve been thinking about the whole ‘cash on the sidelines’ argument for pushing markets higher, versus the restraining influence of rising interest rates in the US and a halving of the European Central Banks’ monthly bond buying program.

Although you often hear the phrase ‘cash on the sidelines’, there is really no such thing. There are no ‘sidelines’ in financial markets. There is only the game. And you have to play it, in one way or another.

Let’s take a step back a bit. I want to explain the crucial role that cash in the system plays.

For example, a credit crunch occurs when the demand for cash intensifies to such an extent that participants sell off assets at any price to obtain that cash. The underlying reasons behind the crunch will vary. But it usually relates to a realisation that asset values are stretched and cashflows cannot service the debt that supported those valuations.

As this realisation spreads throughout the market, investor psychology changes and there is a rush for cash.

But at this point, there isn’t enough cash in the system. That’s because central banks have usually spent the preceding years raising interest rates, which effectively means removing cash from the system.

For example, the US Federal Reserve raised rates 17 times from the 2003 low into 2006.

The lack of cash in the system was the reason why stocks fell so much in 2008. All asset prices are relative. Relative to other assets at the time, cash was scare. Risk assets like stocks had to fall significantly to make them attractive relative to cash.

When central banks realised what was happening, they quickly cut interest rates. That is, they started pumping cash into the system. They were trying to satisfy the huge demand for cash by increasing its supply.

But they weren’t just trying to satisfy the short term demand for cash. Such was the damage done to asset values, central banks tried to create so much cash as to makes its relative value almost worthless.

That’s why they started the quantitative easing programs. This is how you put more cash into the system when official interest rates are already at 0%.

Eventually, there was so much cash relative to other, riskier financial assets that the value relationship changed. This took a long time. The psychological damage inflicted during the credit crisis was severe. 

But now here we are with abundant cash levels AND relatively high equity prices.

Because there is still so much ‘cash on the sidelines’, there is an argument that prices could continue to rise.

That’s true to an extent. But the point to note is this: Just because you might buy stocks with your cash holdings, it doesn’t mean that the cash disappears. It simply moves to someone else.

It’s only when that person quickly decides they don’t want to hold cash either, and they buy other assets with it, and so on and so on, that the cash movements start to have a noticeable impact on stock prices.

Plenty of cash to go around

My guess is that this has been happening around the world for some time now. The US may be slowly raising rates, and therefore removing cash from the system. But they’re not doing so at a pace fast enough to compensate for the falling demand for cash. (This is the opposite of what happens in a credit crunch.)

And Europe and Japan are still injecting cash into their economies, which then flows around the world in search of riskier assets.

The point is this: Cash is not on the sidelines, it is in the game. And as investors play a faster game of pass the (cash) parcel, asset price inflation will continue to rise.

This is why you shouldn’t be concerned about another 2008 style credit crisis. There is too much cash in the system to inflict that sort of damage anytime soon.

That’s not to say we won’t have a decent correction soon. In fact, I wouldn’t be surprised to see a 10–20% correction unfold this year. But it won’t be a credit crunch. For that to happen, global central banks need to be on a tightening path for some time.

Once they start tightening, you can almost guarantee they will tighten too much. That is, they will cross the line and remove too much cash from the system. That will lead to widespread debt servicing problems, a change in investor psychology, and a rush to cash.

Instead of passing the cash parcel, market players will hold onto it. This is the very definition of a liquidity freeze.

But as I said, we’re nowhere near that point. Right now, pass the cash parcel is in full swing, and central banks are only very timidly trying to reduce the size of the parcel.

That’s basically why you’ve seen the US stock market rise unimpeded for the past two years. Central banks are behind the curve. There is too much cash in the system given the positive investor psychology that is unfolding.

The real danger will be if central banks panic over any future stock market correction and implicitly promise to maintain abundant levels of cash to support higher prices.

That would surely set the wheels in motion for a major bubble…followed by a major bust.

Is there anything our central bankers cannot do?

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

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