Irrational Exuberance Comes With Payback Phase Baked In

Years of undisciplined monetary and fiscal policy have enabled the worst financial habits and highest debt abuse the world has ever known, and the payback period is now weighing on the world economy and asset prices.

International Monetary Fund executives are warning that the world is unprepared for the slowdown, and yet it’s here all the same–because reckless behaviors have earned it.

The US central bank has tightened its policy rate 900% in the last three years, but at just 2.5% today it meets this cyclical downturn with less than half its historical rate-cutting room on hand. Also, central bank balance sheets globally have already swapped cash reserves for trillions in assets purchased to prop up prices over the past eight years.

While the US Fed, ECB and Bank of Japan were collectively buying well over $100 billion in assets a month a year ago, now they withdrawing about $50 billion from global markets monthly as shown below. See: Stock market investors, it’s time to hear the ugly truth.

For those those who believe that central banks remain all-powerful and that a switch back to looser policies in the months ahead will be enough to stop asset prices from deflating, my partner Cory Venable offers the below chart of the S&P 500 since 1999 (20 years of the most notorious ‘easy money’ in history). He notes that while rate cuts start when stock markets decline, they do not prevent the losses.

Even when the US Fed slashed more than 5% off policy rates in the last two declines (compared with the minuscule room they have today), stocks lost 50%+. Bear markets typically bottom months after rate-cutting cycles have been in process for several quarters, and so far, this cycle, central banks are still in a self-proclaimed hiking mode.

It is important not to lose the plot here: economic downturns start because demand cycles are driven by credit and credit expansions cannot continue indefinitely any more than trees can grow into outer space. Market bottoms come not because rates are suddenly lower, but because sentiment that was far too optimistic at the top becomes far too pessimistic near the bottom and asset prices finally fall to levels that attract prudent cash investors once more.

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