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Capital Markets Will Break Loose of Central Bank Objectives... Eventually


Central banks can only suppress volatility and create "stability" for so long.

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One volatility-selling-strategy expression is that you make money 364 days, and on the next day, you go broke.

The central bank's "stability mandate" is starting to give people the willies. PIMCO Managing Director Bill Gross extols the virtues of picking up nickles in front of steamrollers at the Morningstar Conference. The Bank of International Settlements (BIS) responds with a warning today. Basic market disfunction is apparent with the recent spate of five-year US Treasury note specials and creeping increase in repo "fails."

Jim Grant wrote a book on the subject in 1996 called The Trouble with Prosperity. On December 5 of that year, Greenspan gave the infamous "irrational exuberance" speech:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
Mr. Bubble himself was worried about a bubble.

I feel the problem is seeded in the false goal of "stability." There is a critical difference between low volatility resulting from well-calibrated policy, and policies designed to suppress volatility, compress credit spreads, and guide the duration of those activities. Someday, the capital markets will break loose of these central bank objectives. There will be a plethora of pundocats "nailing it." The reality will be that significant players will be caught out by the adjustment. I am not convinced "Day 365″ is upon investors, but we are certainly long in the count.
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