FINANCIAL MARKETS REACHED A “SINGULARITY” NO ONE WANTS TO DEAL WITH

Last week I wrote the provocative, but substantiated, “THIS IS NOT 1987, 2000, 2008 OR 2020, BUT A WHOLE NEW MARKET MONSTER” with the main goal of bringing to everyone’s attention how the current financial market is presented with many “unknown unknowns.” Today it’s worth looking a little deeper in the best effort to understand what lies ahead of us.

First and foremost, what is a “singularity”? Strictly speaking, “A singularity refers to a place in the universe where our laws of physics simply break down.” Transposing this into a financial perspective, we can then say “a singularity refers to a stage in financial markets where the laws used to describe and understand them simply do not apply anymore.”

🚩 This time the #FED CANNOT cut rates to save #stocks

A few days ago, it didn’t take long for Wall Street to scream for a FED emergency rate cut on the false premise that it would address the panic in financial markets that began on Monday with Japan’s stocks crash. This was simply the result of falling back onto something that, in many people’s perception, worked in the past and would work again. However, all these cry babies failed to recognize something immediately very obvious: in the current situation, a FED rate cut will make the situation worse, not better. Why? Putting it in simple terms, in weakening the USD this move will automatically strengthen the JPY, paradoxically forcing an even greater volume of JPY carry trade unwinding. What all those cry babies still fail to recognize is that, contrary to what’s written in their books full of assumptions, what troubleshooted the market free fall this week was an INCREASE in US Treasury yields, not the opposite. The move effectively strengthened the USD, stopping the hemorrhage triggered by an uncontrolled JPY carry trade unwind. Furthermore, even stones know that what enabled this current market bubble to keep growing despite the fastest FED rate hike cycle ever is the fact that the yield curve in US Treasuries remained inverted for the longest period of time ever. Let’s take the “Discounted Cash Flow” model as an example; what does an inverted yield curve do to it? It allows it to factor a discount rate for future cash flows that is much lower than one applied to present cash flows. If you combine this with overblown “expectations,” many of which are totally nonsense, the result is an expansion in valuations justified by models (created decades ago in a totally different environment) that are applied to a reality completely disjointed from them. We can make the equation even more complex by throwing in levels of corporate buybacks never seen before, but I believe we all got the point. After considering all of this, it should come as no surprise anymore that the REAL goal of central banks at the moment is to maintain the status quo of an inverted yield curve, as I highlighted in “FED AND BOJ WILL DO EVERYTHING THEY CAN THIS WEEK TO SAVE THE STOCKS BUBBLE ONCE AGAIN” even if this goal clearly breaks the rules upon which all stakeholders in financial markets rely.

🚩 GDP growth isn’t anymore the result of growing economic prosperity but growth in public debt

The mental association between “GDP growth” and “the economy is strong” is another rule blatantly being broken nowadays. It’s great for politicians seeking re-election, makes great MSM headlines, but is the economy truly strong? Obviously not to those who leave their apartments to stroll in their neighborhoods, go to work, buy groceries, and so on. As I highlighted many times, the last one in this post here, the misunderstanding is the result of a formula engineered many decades ago and now greatly exploited by governments.

GDP = C + I + G + NX where

C = Consumption

I = Investments

G = Government Expenditures

NX = Exports – Imports

What this formula didn’t account for properly when it was created was the fact that EVERYTHING could become a factor of Government Expenditures.

• Consumption since 2020 is being boosted by government stimmies in every shape and form
• Private Investments are nowadays driven by government subsidies since corporates aren’t keen to spend on CAPEX when stock buybacks provide greater shareholder value
• Import and Exports are also a factor of Government Expenditures that provide capital to private corporations to produce goods and services to then be sold abroad, particularly when local demand is close to a saturation point.

As a consequence, we should rewrite the GDP formula as:

GDP = G x (C + PI + I + NX) where PI is “Private CAPEX”

In this way, it should be easier to understand how G is effectively a multiplier of all other factors.

If this by itself wasn’t enough of a singularity already, today G is being financed outright with Public Debt that grows (because of chronic deficits), and will continue to grow, inexorably 🤷🏻‍♂️

Beware that Central Banks have great power to control the short end of the yield curve, not so the longer part of it. Furthermore, even if they will ultimately be successful in bringing the COST OF DEBT down, that won’t erase the total amount of debt. Look no further than Japan, where for decades the cost of debt has been almost meaningless, but still, the country kept piling up on debt to get going.

Central Banks and the fiat monetary system have been great enablers of this monstrosity, and yet people still don’t understand why inflation is still so entrenched in the economy (the real inflation, not the fake one not measured by government agencies like the BLS as I already explained in “THE PROOF THAT THE US BLS IS MAKING UP NUMBERS OUT OF THIN AIR”).

When the total stack of goods and services produced in an economy remains stable or grows just a little (the denominator) and the total amount of money in circulation keeps increasing as a factor of all I just described (the numerator), it only takes elementary school algebra to figure out that price inflation will keep increasing.

What would it take to break this vicious circle and put the economy back on track? Again, contrary to what many crybabies are advocating, the FED should let rates go up, not the opposite. Fighting this is similar to fighting the tides of the ocean, a battle that simply cannot be won like Japan is learning dearly at the present time.

🚩 Stock valuations aren’t anymore the result of strength in underlying economies and societies

After what we discussed in the previous two points, it is pretty straightforward to understand why stock valuations everywhere but in China are totally inflated.

Why not in China? As I described in “CHINA HAS BEEN THE FIRST ONE TO ABANDON THE QE ABERRATION, WHO IS GOING TO BE NEXT?” the government already realized long ago that if no forceful actions were taken to break the vicious circle QE > Government Spending > Inflated valuations, not only was the economy set on an unsustainable path, but the wealth inequality resulting from that would have eventually triggered social tensions that a country of 1.4 billion souls cannot afford to risk. The war against financial speculation and financial dealings without any economic purpose has now even reached an extreme where the government is publicly shaming its perpetrators (“China names and shames buyers of its government bonds”).

Clearly, continuing on the path of uncontrolled government deficits, debt monetization, and leaving financial markets free to behave as they please, which is not what “free markets” means, is the perfect recipe for economic and social disaster. The link between stock valuations and the economy must then be restored, and there is no painless way around it as China is showing to the world.

🚩 Debt isn’t any more a problem for the borrowers but for the lenders

As the old saying goes, “If you are a small borrower, debt is your problem, but if you are a big borrower, then it is the lender’s problem.” Currently, debt levels, both public and private, are beyond sustainable for any lender out there. Since banks reached capacity long ago due to capital constraints, this helped to create new categories of “shadow banks” such as Private Equity, Insurance, and, more scarily, Pension Funds. Let me be clear, “Shadow Banks” are incredibly poorly equipped in terms of capital to withstand a significant write-off in the value of their assets, and this is because they operate exactly like banks but outside any banking regulation. This resulted in incredibly dangerous behavior of not marking to market asset values properly. How can you blame them? The moment that is done, the vast majority of shadow banks will be insolvent in the blink of an eye. Are banks then “safe” as the regulator wants everyone to believe? The complete opposite, as we saw in “WHICH BANKS ARE AT RISK OF GOING BUST IN A LIQUIDITY CRISIS? – EPISODE 2” and mostly as a result of a “regulatory arbitrage” banks greatly took advantage of. What kind of “arbitrage”? Not properly marking to market the value of their books, shifting more assets into a “Hold to maturity” category where they don’t belong since a lot of the debt hidden there cannot mathematically be repaid.

It doesn’t take much imagination to picture this growing stack of global debt like a huge house of cards that keeps growing toward the sky. Sooner or later, the weight of this whole thing will simply be too much to sustain by a system that, in a myopic pursuit of ROE maximization, keeps paying dividends and/or performing stock buybacks that are effectively making its base more and more fragile in the same way termites eat furniture from the inside, leaving the outside intact, till at a certain point the furniture crumbles under its own weight.

This is another thing China understood very well as of late, and all its actions have been targeted towards strengthening the capital base of the financial system while shrinking shadow banking to a manageable size and bringing it under the umbrella of the banking regulator (all actions taken towards Ant Financials since 2022 are a great example of what I am talking about).

🚩 Derivatives aren’t any more a means to transfer risk, but a means to pursue it

This is a topic I touched upon so many times, but things keep evolving beyond any of my wildest imagination. Bloomberg’s article “Wall Street Engineers Invent a New Head-Spinning Options Trade” is yet another great example of how derivatives are in reality tools to gamble (with leverage) on certain market events rather than to manage risk and in aggregate make the system stronger.

We already saw what the launch of “everyday 0DTE options” did to financial markets in 2022 and how the launch of 0DTE options on the VIX effectively “broke” the barometer everyone used to gauge the level of risk in financial markets.

Once again, financial market stakeholders keep using outdated models like VAR or Backtesting to make decisions in a completely different environment than when the models were conceptualized. Isn’t this effectively like flying an airplane at full speed without an instrument that can tell the pilot the speed, the inclination, and another sort of metrics that can help him assess the risks of the flight properly? Add to this the inexperience of many in the market today, and you have the perfect recipe for disaster, exactly like it happened to Air France Flight 447 (“What Really Happened Aboard Air France 447”).

If you put all together what we discussed in today’s article, it is clear how financial markets are currently sitting in a singularity of such complexity that there are only two ways to deal with it:

• Reboot the system to put it back on the tracks it stood on for a very long time.
• Rethink the whole set of rules and regulations with the ultimate goal of pushing the system to create a new infrastructure that can handle the new environment, effectively putting it onto new tracks rather than continuing to run off-track as it is now.

Neither of the two is achievable without going through a great deal of pain that requires a rock-solid commitment to navigate, as China is showing to the world objectively speaking.

At this point, there is a fair question we can ask ourselves, dear readers: what kind of politician that faces re-election every handful of years will be willing to embark on such a task to tackle this big “singularity” and do what it takes to salvage future generations? This question eventually extends to government officials who depend on governments in charge for their jobs, and I hardly think anyone will ever be willing to go against it and sacrifice their personal well-being (they can easily lose their jobs) for the common good.

Personally speaking, I don’t think there is anyone in the current system willing to embark on such a herculean task. This is why the best anyone can do is to prepare themselves for the moment, not a matter of if, when the whole system won’t be sustainable any more and it will all implode. Only at that point, similar to 2008, there will be no escape from taking action. But beware, today the magnitude of damages, because of all I described above, will be much greater, and your future will depend on your ability to be one of those standing on top of the rubble and not underneath.