Central Banks Prepare Another Bubble-and-Bust Cycle

When I began my career in money management 35 years ago, it was understood that the key to successful investing was properly weighing risk against reward. When my clients asked me to put their money to work for them, they were entrusting me with the responsibility of earning a solid return while avoiding unnecessary risk.

In fact, this same calculation — the pricing of risk — is the essence of capitalism.

But today, the discipline of investing, and with it our capitalist system, has been twisted beyond recognition. Virtually everyone, from retirees on fixed incomes, to day traders, to professionals at the world’s largest investment banks, has decided that one side of the risk-versus-reward equation is barely worth considering. They’re focused only on how much they could make, not on how much they could lose.

With massive QE, central banks have encouraged risky investing.

Why has the traditionally conservative business of investing been turned on its head? Why have short-sighted, excessively risky trades become de rigueur? The answer is no mystery. It’s the fault of the central banks.

As the world’s largest central bank, the Federal Reserve must bear the brunt of the blame. Since the depths of the global financial crisis, Chairman Ben Bernanke and company have kept interest rates pegged at historically low levels, making traditional safe-haven assets like U.S. Treasuries unattractive.

This ultra-low interest-rate environment forced investors to look elsewhere for yield. And as rates stayed persistently low, investors started looking further and further afield, to ever riskier, higher-yielding assets.

Still, low interest rates don’t fully explain why investors have become reckless. Why are they buying assets indiscriminately, rather than choosing relatively safe equities and corporate securities? Why have the most risky bonds outperformed other sectors of the market?

Again, I blame the central banks.

To go along with low interest rates, institutions from the Federal Reserve to the European Central Bank to the Bank of Japan have flooded the markets with liquidity, a policy collectively known as quantitative easing.

The Fed is now on its third round of QE, buying $85 billion a month in Treasuries and mortgage-backed securities. The ECB calls its programs “Long-Term Refinancing Operations,” but they’re simply quantitative easing by another name. These LTROs loosened the requirements on the types of assets European financial institutions could use as collateral in return for euros. And just three months ago, the BOJ expanded its Asset Purchase Program by the equivalent of $1.4 trillion over two years, effectively doubling the country’s money supply.

The ostensible purpose of quantitative easing is to boost the economy by encouraging investment. But as is often the case, the side effects are worse than the disease. QE hasn’t just encouraged investment; it’s encouraged risky investment. Investors have learned that even their most reckless, heavily leveraged bets will pay off, because of the liquidity being pumped at full blast into the financial system.

Just as a rising tide lifts all boats, this flood of money props up both good- and bad-quality assets. But the central banks have been short-sighted. Quantitative easing cannot go on forever, and investors are now finally thinking about what will happen when the tide inevitably goes out.

In fact, the mere suggestion that the Federal Reserve will begin to taper its monthly bond-and-mortgage-buying program has thrown the markets into upheaval. Massive positions built up by unwary investors over the past couple years are now being unwound en masse, setting up a rush of uninterrupted selling, driving equities and bond prices sharply lower.

The sell-off is in danger of becoming a vicious cycle, as the leverage that multiplied investors’ gains now works against them. Margin calls are proliferating and losses are compounding, as selling fuels more selling.

An artificial bull market, and a headlong plunge — that’s what we got. All because of irresponsible central bankers. Hubris led them to believe they could control the markets, but they only encouraged reckless investors to inflate another bubble.

You might have thought that the bursting of the tech bubble over a decade ago would have taught them a lesson. But humility seems to be in short supply at the Federal Reserve and other central banks.

Best wishes,

Douglas