“Harrowing Reality” – Central Bankers Clueless About Implications Of World Financial System Interlinkages

Authored by Richard Breslow via Bloomberg,

It’s Friday before a long weekend in the U.S. I expect that, barring any unexpected news, shortly after the University of Michigan data is out, many traders will be thinking about their Valentine’s Day plans rather than the next move in the FRA/OIS spread. Still, how risk goes out will be an important indicator of sentiment. Even if the price action of any individual asset should be taken with a grain of salt.

It was another day and another German data miss. This time it was a flat Q4 GDP print. To be fair, it wasn’t a large shortfall, but their data, relative to both expectations and on an absolute basis, remain worryingly consistent. The currency didn’t take any particular notice. But people already have the position. The options market is skewing more and more to euro downside. And it doesn’t seem like there is much appetite, at this point, to add. Yesterday, ECB Chief Economist Philip Lane said the “low-interest-phase is temporary.” Traders are skeptical and EGBs have stayed bid.

The Swiss franc versus the euro has been a more interesting trade. Today’s low matched that of yesterday and we have since had a reasonable bounce. It’s beginning to look like getting through the buy zone that surrounds 1.06 may be a bigger task than current sentiment would suggest. Stay tuned.

U.S. equity futures are bid. Which is an odd fact to feel compelled to point out as they keep making new all-time highs. Treasuries are a snore. They are dancing to the global economic outlook drumbeat. And can’t be judged on strictly domestic circumstances. The only drama there is whether the 30-year can break back below 2%.

And copper is now pausing between two technical levels. It’s ready to roll with any news, but, on its own, is probably here for the day.

A benign beginning for financial markets. Traders can be as engaged, or not, as they like. And, so far at least, they’ve shown a distinct desire for a relaxed day. But it’s very difficult to forget the amount of discussion we’ve had recently about potentially severe stresses to the global economy, downside risks and the resultant implications for investors and monetary policy. And while traders may opt to lay low, this is just the time that the central bankers should be burning the midnight oil. Not to concoct a scheme for the next round of quantitative easing if needed. We all know what that entails. But to address the harrowing reality that the entire world financial system is is even more inextricably intertwined than 10 years ago. And we still have no idea about the true implications of those linkages.

It shouldn’t be accepted as mission accomplished for financial stability when people claim that the U.S. banks are now adequately capitalized and more properly regulated. The financial system is made up of way more systemically important classes of investors than just banks. Many of which hold massive quantities of related instruments. And subject to different standards of regulation, by different regulators. You can’t look at any one set of entities in isolation. They all go hand in glove. Add in other countries, some with huge dollar liabilities relative to their ability to service them in a financial crisis, dollar shortage environment, and a great deal of the risks we thought had been left behind with the financial crisis are as real as ever. Remember all the talk about forced liquidations if a bunch of BBBs suddenly found themselves fallen angels?

The Fed and ECB are in the midst of major policy reviews. They are committed to studying how they think about inflation. That’s all well and good. A far better use of their time and the resources they are employing in these endeavors would be to try to get a better understanding of who owns what and the implications for other investing sectors. Without doing so, they risk once again being blindsided by events. This current episode should be taken as a stark warning and a wake-up call. Not a signal of the all-clear just because stocks are bid.