Pater Tenebrarum

About the Author Pater Tenebrarum

I'm an independent analyst and have been involved with financial markets for 31 years. I write economic and market analyses for independent research organizations and a European hedge fund consultancy. I'm the main author of the blog 'Acting Man', which presents articles on the markets and the economy, a mixture of commentary on current events as well as economic theory and history from an Austrian school of economics viewpoint.

The Asset Bubble on Thin Ice


An Inexperienced Herd

A recent Bloomberg article discusses the fact that most traders active today have never known anything but the era of easy money, and wonders how they will handle the potential end of that era. To this it should be mentioned that the widely expected rate hike cycle may well never begin. The economies of industrialized nations have been severely undermined by loose monetary policy for many years. In concert with over-regulation and over-taxation, this has encouraged ever more capital consumption. Continued economic weakness may encourage the Federal Reserve to simply continue with the ZIRP policy, although it appears to be eager to end it.


herd-3Once the herd stampedes, nothing can stop it

Photo via


We have last discussed these problems in “The Sick US Economy” and “The Goldilocks Illusion”. As we have pointed out in the latter article, weak economic growth is not necessarily a guarantee that there won’t be any “price inflation”. A scenario in which the Fed will be forced to hike rates in spite of weak economic growth is not unthinkable. If so, then all these inexperienced traders could be in for the shock of a lifetime.


FF rateEffective federal funds rate, log scale: many traders have known nothing but the “quasi ZIRP” era and its seemingly forever rising risk asset prices – click to enlarge.


For every individual, price changes of a different “basket” of goods and services are important. A rich “one percenter” won’t even notice if his grocery, utility and health care bills are going up. By contrast, people whose incomes are in the lower quintile will be especially hard hit by rising prices of such necessities. Lately a number of city councils in the US have adopted a $15 minimum wage, following the example set by Seattle (the most recent example is Los Angeles). Many unskilled workers will lose their jobs as a result and will no longer be free to negotiate a lower wage with potential employers. They will become dependents of the State. However, the point we wish to make here is actually this: The fact that there is a nationwide push for such wage increases shows indirectly that the vast inflation of the money supply in recent years has likely already affected the prices of goods and services that are relevant for people with relatively low incomes.

Many companies in the service sector will be faced with choice of either closing up shop or raising their prices. Most will at first try the second option and wait and see if it works (i.e., if their customers are prepared to pay higher prices). As the huge pile of money created by the central bank continues to ripple through the economy, more and more final goods prices are likely to rise, especially in light of the shift in investment in the economy’s capital structure which artificially suppressed interest rates have engendered.

According to the above mentioned Bloomberg article:


“Today, El Mihdawy is part of a Wall Street demographic whose own trial by fire awaits: traders who’ve never known anything but a post-crisis world of rock-bottom interest rates and ever-rising markets.

This youth brigade — call it Wall Street’s class of 2009 – – is about to learn what higher rates from the Federal Reserve look like firsthand. Their inexperience has left older, more experienced colleagues wondering how these relative youngsters will fare.

“What we’ve been through the past four years has been ‘what is the fastest, easiest money to find?’” said El Mihdawy, who studied economics at Columbia University. “If one day that narrative changes and investors no longer believe in the omnipotence of central banks, then it will bring back what was old school — fundamental analysis and really caring about what’s going on.”

No one is suggesting that Wall Street traders are any less capable than they were in the past. But what’s remarkable is the sheer number of those who started their careers after the Fed dropped rates close to zero in 2008.

While the average Wall Street trader is 30 years old, about 30 percent started within the past five years, according to, a salary comparison website, which compiles data from its 50,000 financial services users. And two-thirds of traders have never seen a full Fed tightening cycle.


(emphasis added)

It seems to us Mr. El Midhawi has correctly recognized another major problem: namely the currently widespread confidence in the omnipotence of central banks. A tightening cycle is not the only event that could potentially shatter the complacency of market participants and introduce inexperienced traders to the concept of downside volatility.


Multiple Dangers

There are numerous threats for overpriced “risk assets” these days. The irrational faith in central banks could e.g. easily be upset if industrialized economies were to fall back into recession in spite of their ministrations. Economic performance in the major currency areas is in any case nothing to write home about. A large part of the economic activity monetary pumping has generated is moreover highly likely to consist of malinvestment.

In a “normal” cycle it usually takes rising interest rates to unmask these malinvestments, but the current cycle is slightly different from previous ones in a number of respects, and it cannot be ruled out that recessions will strike before rate hikes are implemented, or that a single rate hike suffices to tip the scales. This has e.g. happened several times in post-bubble Japan, so there exist precedents. If one widely held view is unexpectedly challenged, other perceptions may change as well. One of them is the idea that as long as “QE” is practiced somewhere in the world, asset prices can only rise. This is less and less likely to be true the higher asset prices go and the more divorced from underlying economic reality they become.

If perceptions change – for whatever reason – a number of market-immanent technical weaknesses could finally come to the forefront. There are underlying problems in the markets in connection with liquidity. One of these problems is the fact that banks have largely ceased to act as market makers in corporate bonds, as new regulations have hampered their proprietary trading activities. It has become more expensive for them to carry an inventory of non-government bonds, as they are required to set relatively large amounts of capital aside when holding such bonds. By contrast, government bonds have been assigned a risk-weighting of zero by regulators, as absurd as that is in the wake of the euro area debt crisis (this by the way exposes banks to an even greater extent to sovereign risk than before, which could come back to haunt them as well).

When selling in junk bond starts in earnest, it will therefore likely occur in a vacuum. ETFs holding corporate bonds are a potential source of great trouble in this respect, as they will become forced sellers in this vacuum if redemption requests come flooding in. Meanwhile, the currently extremely low default rates in junk bonds and leveraged loans are not due to the great economic environment or the profitability of the issuing companies: Instead they are mainly a result of loose monetary policy and the yield chasing it has induced. As long as this environment persists, companies can easily refinance their debt, almost regardless of the fundamental backdrop.

This has recently become evident in the oil sector, as the collapse in oil prices has barely dented the ability of companies in the sector to issue new bonds. In other words, the junk bond market has all the characteristics of a Ponzi scheme these days. Meanwhile, looking at a chart of the BofA/Merrill Lynch High Yield Master 2 effective yield, it appears as though this market has actually become a lot more risky, but in a “quiet manner”, under the radar of most observers. We are merely referring to the technical picture here, but as a rule of thumb, when potentially dangerous technical developments are widely ignored, they often turn out to be meaningful in retrospect:


Merrill High Yield IndexMerrill High Yield Master 3, effective yield: after putting in a double bottom between 2013 and 2014, junk bond yields have climbed off the secondary low in five waves, and have corrected since then. The correction has put everybody to sleep again, but it may actually turn out to be the calm before the storm – click to enlarge.


Another liquidity related problem is the fact that more than 70% of all trading activity in stocks is executed by machines these days. Whether it is HFT or systemic black box trading, many programs are executing trades based on similar inputs. It could easily happen one day that no-one will be there to take the other side of trades if a wave of selling is triggered (and the trigger could be a superficially innocuous event, such as the breaking a moving average). The infamous “flash crash” of 2010 has already provided a preview of such an event (see “Dress Rehearsal for the Fully Automated Crash” for a discussion of this particular event and its implications).

As Zerohedge recently pointed out, one side-effect of the increase in automation has been that the bulk of trading activity on the stock market has been shifted into the final half hour, as that is when open-ended ETFs are executing most of their trades (on account of inflows/outflows). HFT programs have been “trained” to make use of this effect, as their market-neutral strategies are easier to implement in time periods when market liquidity is high. As a result liquidity is scarce during the better part of a typical trading day.


nanexHigh frequency trading visualized by Nanex – it reminds us of TRON


ETFs are themselves a source of an array of potential problems. One is the asset/liability liquidity mismatch mentioned above, which is especially pronounced in ETFs holding bonds. This is not the only problem ETFs have created though. Since many ETFs that are holding stocks are mimicking capitalization weighted indexes, they are contributing to the mispricing of stocks, as they are mindlessly adding to their inventory based on these weightings. This has contributed to the market’s upward bias, while “price” and “value” have at the same time drifted ever further apart. The longer this continues, the more vulnerable the market will become.



The current asset bubble depends on a number of perceptions that could easily be put to the test by unexpected developments. There is a widespread consensus on a number of issues. This includes the belief that the economy will strengthen, that the emergence of “price inflation” is practically impossible, that “QE” will always guarantee rising asset prices, and that central banks have everything under control. Now we learn that in addition to this, a surprisingly large number of traders has no experience beyond the ZIRP & QE era of recent years. Meanwhile, the market’s underpinnings in terms of liquidity exhibit numerous weaknesses. These are unimportant as long as the current consensus isn’t challenged, but that could easily change.

We still remember “portfolio insurance”, a hedging strategy practiced in the 1980s. At the time, fund managers put dynamic hedging programs into place in the belief that they could avoid being caught in a market downturn by selling short S&P futures contracts once a serious decline started. At the same time, no program trading restrictions had been put into place yet. This proved to be a toxic combination when seemingly out of the blue, the crash of 1987 struck (the idea that “portfolio insurance” would be an effective hedge against losses turned out to be misguided – S&P futures traded at a large discount to the cash markets during the crash, and selling them was a great way to lock in huge losses). We see the weaknesses identified above in a similar light: They won’t matter until they do, but then they will suddenly matter a great deal.