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Could Markets Fall By 50% By 2019?

Years of central bank money printing has kept interest rates artificially low and made asset prices artificially high.

These asset bubbles are primarily found in the world’s property and stock markets. But this money has seeped into everything.

The Leonardo da Vinci painting that sold for a record $591 million late last year illustrates this well.

You’re witnessing an ‘everything bubble’.

So, how has this happened?

It all started in 2008/09 as a response to the global financial crisis.

Coordinated central bank action kept pumping money into the system to try and kick-start economic growth. The fear of a repeat of the 1930s depression era was palpable at the time.

The way they did this was by buying loans, or more accurately, assets. Remember: to a bank, a loan is an asset and a deposit is a liability. They’re on the other side of the fence from you and me.

The value of central bank assets expanded to a record $2 trillion in 2017.

In other words, central banks have pumped $2 trillion into the world economy by buying all sorts of bonds (loans).

The effect was two-fold:

By increasing demand for loans, the price, in this case the interest rate, falls too. And in a world of lower interest rates, banks and other financial institutions can in turn borrow and lend out more money at a cheaper price.

This process is at the centre of the debt-fuelled economy we live in.

Central banks are the powerful beating heart of this system. They’re both the market makers and price setters when they want to be.

It’s a case of ‘free market, what free market?’

Make no mistake, this is big government with big influence.

But it can’t go on indefinitely.

Even the central banks know this.

So now they are trying to carefully unwind this process.

But the consequences could be devastating…

Check out this chart:

Short Interest Ratio of LQD

Source: Datalend; JPMorgan
[Click to enlarge]

No, it’s not the price action of the latest hot cryptocurrency.

It’s actually the level of investors going short on US corporate loans. The percentage of investors betting against corporate borrowers making repayments in the US increased dramatically this month, from 1% to 5% of the shares issued.

That’s a steep rise.

Worth paying attention to

This is the professional end of the market — not the retail end.

This is Wall Street.

I bring this chart up because the move is happening at the same time central banks are unwinding their asset purchases.

As they do this, interest rates on bonds go up — the price companies have to pay to borrow money.

Citibank analysts observed a strong correlation between these two trends. Check out this chart here:

Central Bank Purchases and Interest Rate Spread

Source: Bloomberg and Citi Research
[Click to enlarge]

The left-hand side shows the level of central bank purchases (black line), and the right-hand side shows the interest rate spread (with the spread widening as the blue line moves down).

You can see the matching moves.

The dotted black line is the Citi projection to 2019.

You can see that Citi expects the trend to continue.

So let’s put all this together…

Since 2009 we’ve had a long-term process of money printing that has driven up asset prices and kept interest rates at record lows.

In turn, this has created record setting stock markets and property price bubbles.

At the same time, the US and a number of Western countries have never had more debt.

So now the central banks need to unwind this process. This would lift interest rates and make corporate lending more expensive (thus reducing profits and therefore share prices), and cause property prices and mortgages to go higher.

This could spook investors and result in sharp drops.

But the recent tax cuts and potential government infrastructure spending may stall any big crash in the short term. Though if markets don’t slow down or correct by the end of 2018, the 2019 crash could be far worse.

If the Citi correlation extrapolation is accurate — and historically it has been — it would imply that by mid-2019, equities are facing a nearly 50% drop to keep up with central bank asset shrinkage.

Of course, predicting what central banks will do isn’t easy. They may turn the taps back on at any moment if need be.

But you’ve got to ask yourself: How much longer can we put this day of reckoning off? The debt-fuelled central bank action can’t last forever.

And the longer it goes on, the worse the hangover will be.

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The Daily Reckoning's mission is to look at the investment world and the financial world in a sceptical and contrarian way. To do that day in and day out and tell you honestly what we see, even if it isn't always popular. If you'd like to subscribe to an alternative look at the mainstream interpretation of events, join for free here.



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