In what can only be deemed biblical irony, uncontrolled poverty is the final arbiter for the fate of global capitalism. In what can only be deemed supreme irony, today's investors by and large don't see it coming. Why? Because they are too busy monetizing poverty.
Way back in the 1930s, economists coined this definition of a liquidity trap:
"A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest"
Not lending money because interest rates are too low, would make far too much sense to today's Idiocracy. Therefore in today's multi-trillion dollar global capital markets the standard definition of liquidity trap no longer applies. Money managers managing other people's money no longer have the option of sitting on a zero yield. Which is why they invest in imagined realities instead:
"There are times when an investor has no choice but to behave as though he believes in things that don't necessarily exist. For us, that means being willing to be long risk assets in the full knowledge of two things: that those assets may have no qualitative support; and second, that this is all going to end painfully. The good news is that mankind clearly has the ability to suspend rational judgment long and often"
Hence, a new definition is required for liquidity trap: One in which investors onboard excessive risk in order to realize hypothetical return. Which is where it gets interesting because even as default risk increases, the hypothetical return - according to the discount cash flow model (DCF) - increases commensurately. According to the well known DCF, Present value = the discounted value of all future payments and bond maturity value. As global interest rates fall due to rising recession expectations, the discount rate falls and the hypothetical present value increases.
The failure of the model and the way it is typically implemented is that it makes no adjustment or assumptions around the maturity value aka. Future value. If we take frackers as an example, as long as they can keep rolling over their debt with new debt, bondholders can keep pretending that the maturity value is 100% on the dollar. When the rollover window slams shut, the charade collapses, like a cheap tent:
“I feel that the United States has tremendous wealth. The wealth is under its feet. I’ve made that wealth come alive. ... We are now the No. 1 energy producer in the world...I’m not going to lose that wealth, I’m not going to lose it on dreams, on windmills, which frankly aren’t working too well”
"I'm not going to lose our wealth on hollow dreams"
“I feel that the United States has tremendous wealth. The wealth is under its feet. I’ve made that wealth come alive. ... We are now the No. 1 energy producer in the world...I’m not going to lose that wealth, I’m not going to lose it on dreams, on windmills, which frankly aren’t working too well”
"I'm not going to lose our wealth on hollow dreams"
We are witnessing this rush into risk across every risk asset market, as imaginary returns rise in lockstep with default risk.
Risk is binary:
Risk is binary:
Sadly as was not learned in 2008, the current global hunt for yield gives a false sense of low systemic risk. Which is why the Fed is in no way panicking. Their moves to ratchet down rates has artificially suppressed risk.
We saw the same thing with subprime during the last bubble - The Fed Stress Index bottomed out at the peak of the subprime bubble. This is the part of "The Big Short" when Christian Bale was playing drums a lot:
Despite all of the accumulated risk and last year's two substantial crashes, somehow the burden of proof is still on the bears. Which speaks to the conflict of interest generated by imagined realities. False hopes extrapolated into the indefinite future. The bullish argument at this late juncture is that because markets haven't collapsed to zero as bears expect, then risk must be low.
Put it all together and what do you get?
You get a "liquidity trap" occurring at peak denial.
"A year ago, Francesco Filia of Fasanara Capital told The Wall Street Journal that, “If my analysis is right, we’re past the point of no return...Turns out that was just one of many doom-and-gloom misfires that have been popping up across financial media during this long bull run"
In its most recent report, Fasanara likened negative rates to “the magic and poisonous blood-red wishing apple, sending Snow White into deep sleep.”
“Unlocked hot money, retail driven, passively managed: the daily liquidity risk is highly underestimated today,” the hedge fund wrote. “With it, the so-called ‘gap risk’, especially overnight gap risk."
The much ignored "Average true range" indicator takes into account gap risk, because it calculates volatility using daily closing prices instead of intraday price range:
"Wilder designed ATR with commodities and daily prices in mind. Commodities are frequently more volatile than stocks. They were are often subject to gaps and limit moves, which occur when a commodity opens up or down its maximum allowed move for the session. A volatility formula based only on the high-low range would fail to capture volatility from gap or limit moves. Wilder created Average True Range to capture this “missing” volatility"
