July 28, 2015
Aritzo, Sardinia, Italy
High up in the mountains of central Sardinia, it’s hard to even think about finance.
The weather is perfect. Sunshine abounds. The vistas are absolutely incredible. The food is amazing. This is definitely one of the nicest places I’ve ever been.
And yet it’s almost impossible to ignore the constant gyrations in global finance.
What’s happening in China is nothing short of astounding, seeing the depths to which a desperate government is willing to go to bail out a broken system and maintain the status quo.
You have to hand it to the Chinese– the clearly don’t give a damn about subtlety.
In the US, market manipulation has taken on a much more sophisticated approach.
It caught my attention last week that the Federal Reserve’s balance sheet is still within 0.3% of its all-time high.
All the fanfare about Quantitative Easing coming to an end, and the Fed cleaning up its balance sheet, turned out to be a load of bull.
When the Fed entered the financial crisis in 2008, its balance sheet was roughly $900 billion.
At its peak, its balance sheet totaled $4.5 trillion. Today, it’s still at $4.5 trillion.
So much for a new era of responsibility.
But to give you a sense of how closely tied the Federal Reserve is to financial markets in the US, this morning I pulled the data and plotted the two together.
This chart shows the relationship between the size of the Federal Reserve’s balance sheet and the Dow Jones Industrial Average since the start of the crisis in late 2008:
You can see that the market stays within a tight range, and as Quantitative Easing played out over the years, that range became even tighter.
Even now that Quantitative Easing has supposedly ended, the ratio between the Fed’s balance sheet and the Dow Jones Industrial Average remains nearly constant at 253x, with a standard deviation of just 1.5%.
That’s a fancy way of saying that, whether intentional or not, the Fed is completely dominating the US stock market.
It’s the same story with mortgages. Treasury bonds. And just about every other major asset class in the US.
Which means that any shrinkage of the Fed’s balance sheet will drag down markets with it.
The Fed may not be as brash as China, but their unsustainable support for financial markets is just as precarious.
This is a time for extreme caution; there’s simply been too much pressure built up in the system, and there’s no way of knowing when or where it’s going to be released.
Over a century ago in the early 1900s, the world was in an equally dire predicament.
Germany was the brand new kid on the block (having been officially formed in 1871), but was already among the greatest powers in Europe.
Russia, France, and Britain were all still dominant powers. Austria-Hungary and the Ottoman Empire were in serious decline, but were still forces to be reckoned with.
History tells us that any time there’s a clear shift between major powers, tension and conflict arise. And 100 years ago was no different.
By 1914 everyone in Europe was preparing for war. But nobody knew exactly what the cause would be.
Out of all possible scenarios that came across military planners’ desks, it ended up being a 19-year old Serbian named Gavrilo Princep who kicked the whole thing off.
He was just a kid—an obscure, unknown kid—who pulled the trigger that killed the Archduke, lighting the match that blew up the powder keg.
People certainly sensed that war was in the air. But no one would have ever predicted that it would start with Gavrilo Princep.
Similarly, we can look around the world and feel like crisis is in the air. But will it come from China? Greece? Puerto Rico?
Likely none of the above.
Any match that lights the system ablaze will probably come from some obscure corner of the Matrix, at a time and place that no one can possibly divine.