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The Fed and the May 6th crash: more monkeys & darts?

Mark Spitznagel in today's WSJ piece, excerpted below, has got it exactly right.  We encourage all to read it in full and also in conjunction with our posting, No Better than Monkeys Throwing Darts, in which Larry Swedroe recounts William Sheridan's research on 'expert' economic forecasting.

Whenever markets are manipulated by regulatory fiat there are unanticipated consequences, systemic or otherwise. The wealth transfer, perhaps one of the largest of all time, from investors to borrowers effected by the artificial manipulation of low to negative real rates is having untoward consequences on market function and risk allocations.  One suspects there are many more unanticipated consequences yet to come.


"The profitability of an investment is simply its return on capital beyond the cost of that capital. It is against this spread that investors must assess risk. So when the Fed distorted the cost of capital following the 2008 collapse by lowering it for many by roughly 2% (to about 0% for banks), it had the same effect as the 2% higher aggregate dividend yield for stocks or higher credit spreads for investment grade bonds. Suddenly what was toxic looked cheap.

The Fed lured everyone to buy everything and anything that was risky—and did so itself with outright purchases of risky assets like mortgage-backed bonds. Anyone eager for easy profits fell right in line, bidding up dangerous assets like clockwork. Sensing safety in numbers, the herd quickly followed, and in no time the market had consumed the Fed's gifted 2% profit spread and then some.

The Fed has managed to align every little market fault right with each other such that they all succumb to the very same stresses at the very same time. Meanwhile—no surprise—the world remains a very seismically active place. What's extraordinary is that the Fed continues this intentional deception about the real cost of credit, even as we've repeatedly witnessed the consequences of this policy.

Left alone, the market works naturally, with waves of buy-order ruptures and waves of sell-order ruptures. Sometimes mini-ruptures coincide to form much larger ones, such as on May 6. But searching for a discrete trigger for such events is futile. To find the real source of the system's excessive fragility, the regulators will need to look much closer to home."

Do we want thin markets or thick markets? It's not a tough call.

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