Financial Market Quote of the 21st Century

If you’ll take the time to carefully read (not just my bolded lines) the excerpt below, think about it, digest it — ask me questions about it to gain clarity if you like — you’ll begin to grasp what truly underpins the market action that seems so nonsensical to so many tutored, experienced investors. 

This, sadly (I fear), will be lost on those who only see ever-rising asset prices and believe them to be either normal, or a new normal, for reasons they themselves can’t quite articulate (or have no interest in articulating), but simply receive as gospel Wall Street’s perpetual bull market narratives.

For context, where you see “carry”, think leverage:   emphasis mine…

“…in a carry regime, in which the volatility of asset prices is suppressed and eventually becomes very low, a greater range of financial assets will begin to appear more money-like; they will come to seem as good as money.

As the carry regime broadens, encompassing more financial assets—bringing down their yields and reducing their price volatility—then the effective supply of money, in terms of what the holders of the assets perceive to be money, will be growing.

One way to describe this is to say that “moneyness” is growing, even though the supply of money under the traditional measures of money may not be. In turn this would say that the central bank is losing direct control over the effective supply of money—the amount of moneyness.

The central bank has influence only over the traditional money supply because it only has direct control over the traditional banking system.

The types of financial assets that may seem to become more money-like as the carry regime broadens will normally be assets that are liabilities not of banks but of nonbank institutions, such as other financial corporations or even other nonfinancial businesses. In other words, a carry regime makes nonmonetary assets come to seem less risky, reducing yields (interest rates) on those assets and making them appear more money-like.

The effective supply of money therefore seems to grow. Whether this occurs directly as the result of perceptions that the central bank is guaranteeing the nominal values of non-monetary assets, or whether it is more a process that is driven by the markets that the central bank is dragged into, forcing it to seem to guarantee asset values to avoid the risk of crisis, it must be the case that the central bank is the vehicle through which this process occurs.

Ultimately, it has to be the case that the degree of moneyness of an asset will be crucially dependent on the degree to which the central bank—or possibly the government—supports, or underwrites, the asset. Without that implicit, or even explicit, support, it would be difficult for investors, or the public as a whole, to accept that various formerly nonmonetary assets were now as good as money.

In 2008, at the height of the financial crisis, the US government introduced a temporary guarantee for money market funds. In Europe, at the height of the euro area crisis, the European Central Bank announced its “whatever it takes” approach, interpreted as a statement of preparedness to guarantee the values of peripheral European government debt.

These and all the other post–crisis and “experimental” monetary policy measures could be argued to have increased the moneyness of a whole range of financial assets.

A central bank’s implicit guarantee for an asset arguably both increases the liquidity of the asset—because of the central bank’s supposed willingness to buy it—and reduces the risk of capital loss for the holder, thereby bringing the asset closer to being a form of money.

The central bank’s implicit guarantee essentially makes the asset a contingent liability of the central bank, and this is ultimately what gives the asset its moneyness.

The paradox is that the central bank is only able to do this because its power to create money is a great power, but the use of this power in this way actually serves to undermine its power. Its control over the total extent of moneyness is weakened.

This becomes most evident in the carry crash—when moneyness evaporates and what had seemed to be financial assets as good as money suddenly revert to being risky nonmonetary assets again.”

 Lee, Tim; Lee, Jamie; Coldiron, Kevin. The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (pp. 112-113). McGraw-Hill Education. Kindle Edition. 

P.s. The above doesn’t imply that there aren’t select, legitimate, long-term opportunities to be carefully exploited in today’s historically-precarious setup, in fact it exposes several…

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