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Equity markets under pressure as Boom/Gloom Index signals Great Unwinding

Economic growth
By Paul Hodges on 02-Oct-2014

Index Oct14Whisper it quietly if you are walking past the imposing Federal Reserve building in Washington DC, so as not to disturb the occupants.  They believe that their efforts to boost financial markets have had their effect, and that the real economy, in which we all live and work, will now recover.

But what if the blog and many others are right, that the Fed’s money has simply enriched those who play in financial markets?  If this view is right, then financial markets are at severe risk as the supply of cheap money comes to an end.  As Larry Fink, CEO of Blackrock, the world’s largest asset manager has warned today:

What frightens me the most is the narrative that’s being discussed. You’re hearing from banking sources – whether it’s the BIS or the FSB or the Federal Reserve – a narrative that ‘there’s bubbles’, a narrative that ‘the private sector is guilty of investing in products that maybe lack long-term liquidity at interest rates that in the long run would probably represent some form of losses’. And the reality is, though, they’re to blame – and they’re not taking any of that responsibility.

“Actually, if you look at the behaviour of central banks, they have rewarded the debtors and crushed the savers . . . We’ve never debated that.”

This also seems to be the warning from October’s Boom/Gloom Index, which aims to measure financial market sentiment:

  • It peaked at 14 back in March, and its later rallies never came close to repeating this level (blue column)
  • But the S&P500 kept moving upwards in almost a straight line as the Fed’s money came flowing (red line)
  • Now we will start to see which view is right, as the Fed is due to start its very slow ‘taper’ of funding this month

Of course, the Fed will not be surprised if today’s market weakness takes the S&P500 down 10% or so.  After all, as the chart shows, the last proper ‘correction’ was back in the summer of 2011 when the Fed first tried to wean markets off their supply of cheap money with the ending of QE2.  So a 10% fall will probably not change their minds.

But, of course, if the blog’s view of the Great Unwinding is correct, then a major downturn is in prospect.

It will look at this risk in more detail later this month, as we approach the 2-month anniversary of the Great Unwinding’s start on 18 August.  Since then, Brent oil prices have fallen $10/bbl, and the US$ Index has risen an astonishing 5 points.  The US$ has also now broken out of the triangle shape created by the stimulus programme.

As the blog noted at the end of August, this downward move in the oil price is potentially very important as the triangle “has monitored the balance between:

  • The financial players, trading electronically on the futures markets second by second
  • The physical players, actually using the product for transport, heating and other ‘real’ purposes

The blog would really prefer to find that its analysis was wrong, and that the Fed’s policy has indeed proved successful in returning the economy to steady growth.  The alternative, as it first warned a year ago, is that the outcome of the Great Unwinding of global stimulus is “going to be scary“.