Is the 2021 Market Bust Imminent?

We take a look at the current state of affairs in historical context


Image: Alphahistory & TradingView


Introduction

In an article written a fortnight ago, we noted that institutional interventions in markets had created a dangerous level of systemic risk and we explored the possibility of a broad market crash and depression similar to the 1929 crash and Great Depression.

Today we discuss some more systemic risks and posit a scenario for the coming weeks.

This systemic risk begins with Alan Greenspan as U.S. Federal Reserve chairman in 1995 during the 'Tequila Crisis' that we have discussed elsewhere (From 1995 we see a pivotal change in global financial markets).

Here we will show that this technocratic experiment has failed in another set of charts to add to the earlier paper.

We will show that extraordinary actions of successive Fed chairmen created the perception of GDP growth, but instead created excess systemic risk and real GDP growth below trend.

We show that these interventions turned event risk into systemic risk throughout the U.S. dollar financial system before an imminent and potentially dangerous setup seen in markets today.

The Charts

First of all, if we take a look at U.S. GDP growth we see that the long-term growth rate deviates in 1995 — the year that Alan Greenspan began mispricing systemic risk in markets by interfering in the event-risk of the Tequila crisis.

The long-term result of this transfer of risk from singular events to systemic is seen in the difference in growth between b and the new tangent of growth at a.


Image: St Louis Fed


So why is this a problem?

Not only did Greenspan intervene in markets through transferring event-risk to systemic risk, but he also artificially reduced the price of money in lower-than-market interest rates, both causing the 2000 NASDAQ bubble and crash and the housing bubble that gave us the 2007/2008 Global Financial Crisis.

It had taken time for systemic risk to emerge in GDP data, but as this was a manipulation of monetary phenomenon we can take a look at real GDP to see the effect.

The linear line here (a) is the equivalent line (from Greenspan's intervention in 1995 onwards).

The trend does not survive the Global Financial Crisis (2007–2009).

Image: Statista


As we can see, they got away with it for a bit.

It was after the Global Financial Crisis (a systemic risk event) that systemic risk was repriced into GDP growth, weighing on GDP through the mechanism of monetary expansion (inflation) — as was the cause — and solution — to that crisis. Momentum has carried us through so far.

But intervening in systems in this way is not only a matter of growth — there are qualitative aspects to financial systems we can also measure.

If this intervention in 1995 is truly the maladaptive practice that we claim, we should also see it elsewhere — in the mechanics of the market.

And we do — this chart shows the velocity of money changing — in a clear down-trend from that date forward — a direct impact of interfering with systemic risk — of artificially intervening in systemic risk to pursue a delusion of control.

Image: St Louis Fed.


In this chart of declining velocity of money, we note the failed attempt to taper QE and normalise interest rate policy in 2016–2019. This is a failed attempt to re-introduce a price of money into the financial system.

It was in this event that the failure of the experiment was categorical.

Whether it began with one man's ego, with institutional or socio-cultural paradigmatic delusion is beside the point here. In late 2019, after $500 billion U.S. dollars were required in normal operating conditions in repo markets, it was clear that monetary policy could not — would not — ever normalise.

The history can also be seen in interest rates. Part of this increase in systemic risk was manipulating the price of money — of removing it completely!

This timeline shows how event risk was turned into systemic risk, setting up new and increasingly dangerous event risk with a compounding double-down to increasing systemic risk.

The failed taper is the final event here — the COVID-related interventions merely delaying the inevitable recognition that the U.S. dollar financial system has failed.


Image: St Louis Fed.


Assets held at the Federal Reserve are also worth tracking.

It must be remembered that the QE interventions as a response to the Global Financial Crisis were extraordinary at the time — and then compare them to more recent interventions.

Because boosting growth through the price of money using interest rates failed, this new strategy became necessary (which has now also failed in the inability to normalise monetary policy).

Image: St Louis Fed.


So, where are we today?

The Covid interventions have, at the end of an enormous market bubble, given us a super-bubble — and it may break naturally later in the year (as hypothesised in the previous article), or through deliberate institutional manipulation.


Are Banks Setting Up a Risk-Off Event through Liquidity?

It appears that banks may be hoarding cash, with the lending rate well below trend (and a reversal during potential reflation in Q1 2021)


Image: ZeroHedge


Perhaps as a result and in addition, Reverse Repo’s (banks hoarding cash) is incredibly high. Jamie Dimon was on record speaking about hoarding cash only this week.


Image: St Louis Fed.


The decision was made around late April (as per reverse repo data) as the trajectory of margin data (high leverage in the stock market — presumably from retail traders) was established and emerged, in all-time records.


Image: St Louis Fed.


Does this suggest that banks will crash the market after withholding liquidity and that they have cash reserves to reinvest at better prices, conveniently before the U.S. government is planning on a $5–6 trillion dollar attempt at reflation through infrastructure stimulus?

If this is the case, what if markets do not recover?

Should we entertain the scenario that markets crash here and cannot recover? Or perhaps that market risk is sold, retail margin is annihilated, banks re-enter and the U.S. government reflate through infrastructure stimulus?

Although there are some interesting developments here, it is not completely clear whether the risk is imminent (in the next month) or in Q3 or Q4. One concern in a major change in markets is in the U.S. dollar move we saw last week - is it the end of the short dollar trade finding a new equilibrium, or a full market reversal?


By Thomas Kuhn, CFA

Thomas is the author of ‘Bitcoin: A Revolutionary Investment’ and has previously written for the Asia-Pacific Research Institute of the Chartered Financial Analyst Institute, Hackernoon and Medium.

Get my book here: Bitcoin: A Revolutionary Investment