Negative Interest Rates Next Up - Will Pump Markets But Eventually Destroy The Global Financial System

Once again, in the September Federal Reserve (FED) policy meeting, the FED did not raise the fed fund rate, leaving it at 0% to 0.25%.

The stock market has had a huge run since the lows of 2009. At their recent all-time highs this year, gains of nearly 200% since 2009 were reached, yet the real economy has barely seen anything better than flat growth during this time. Simply stated, this is not a real bull market, but a distorted inflated market based on monetary policy that has been too easy, and for far too long.

So why doesn't the FED begin the normalization process and begin to raise the fund rate? Because if they do, it will cause an instant forced deleverage and instant insolvencies globally. Additionally, many institutions have had a false sense of security from buying and selling derivatives and "derivative insurance."

Derivatives are the one thing that has still not seen any regulation, and these were the primary reason the market crashed in 2008. Warren Buffet rightly calls the derivative market "weapons of mass financial destruction."

However, Warren specifically was referring to derivatives tied excessive leverage (risk taking) risk parity - derivative insurance.

What is, and are these specific and dangerous derivatives you might ask? Derivatives are financial contracts that are assigned a perceived value backed by underlying assets which are used as 'collateral' if you may -- what is commonly referred to as "creative financial engineering."

Now, if the FED were to raise the fund rate, the FED would want better collateral to ensure the short term loan can be paid back at the higher rate. By raising the rates now, the collateral requirements for short term overnight parking at the FED would rise considerably. The current collateral is basically monetized derivative junk debt.

Because the collateral currently is basically garbage junk that has been swapped back and forth for years now in the banking repo market. Institutions/banks could instantly lose access to park this money short term, of which has mainly been used to lever up the stock market by lending/leverage between 'banks' at the FED discount rate, which is currently around 0.75% -- a rate hike also hikes the discount rate, and underlying bonds that institutions rely on to borrow against lose value quickly as yields rise.

High frequency trading firms would instantly lose a lot of liquidity. If you remove massive amounts of liquidity from equity markets too quickly, you get a fast, sudden, and severe market sell off. When we saw the fast downturn in August, this was in part from a liquidity drop shock, also caused in part by China dumping US treasuries (that's another discussion).

More and more, we are also seeing a continuing decline in stock market futures liquidity.

As an example, companies like Valeant (NYSE:VRX) would be under severe pressure to service their ballooned debt, and could quickly go "belly up," due to their massive amount of levered acquisitions that used high yield grade junk bond induced debt verses real assets.

The above is the real reason for the fed not raising the Fed fund rate. It's not as simple as saying, " it's only a 0.25% hike, what can be so bad about that?" The stock market is disconnected from the real economy, rising to record levels primarily from quick and easy monetary policies and easily gained leverage. This is basically the same problem we saw in 2008, but on a much more massive scale as it's just not one market (housing), but the entire global equity market. The current financial condition out there is much more fragile than most realize, even by the most educated of men and women who are taught on a theoretical basis of how economies used to work, not as they currently work.

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James Hunter 4 years ago Member's comment

Great article and good discussion, thanks.

Gary Anderson 4 years ago Contributor's comment

Your two points for helping the economy, cut interest on excess reserves, and raise the funds rate to 2 percent are good, but I think you have to take long treasury bonds out of usage as collateral. Otherwise the long end will stay low yield, high priced.

Scott Matusow 4 years ago Author's comment

I agree, but these are things the current fed won't do. Personally, I don't buy they are increasing balance sheet. I think they have unwound a good deal of it. But how can we know, unless someone audits the fed now we aren't aware of!?

Gary Anderson 4 years ago Contributor's comment

Hi Scott, I don't see long bonds ever going up in yield that much and that won't give banks motive to lend unless they just throw that benchmark away. There is insatiable demand for the long bond. My article today explores that. I wish you would look at it.

Scott Matusow 4 years ago Author's comment

I'll look in a bit after I get back from working out, thanks!

Gary Anderson 4 years ago Contributor's comment

Great article, except that supply side is hardly Keynesian. Supply side is tax cuts and private hot money. Keynes would say fix the roads, fix the real economy. And we aren't doing it!

Scott Matusow 4 years ago Author's comment

Ok, let me correct that. " Supply side with today's MODERN keynesians".. Better?

Gary Anderson 4 years ago Contributor's comment

Lol, thanks.