The Myth of the Infallible Central Bank
Featuring David Levine
Published on: August 20th, 2019 • Duration: 18 minutesDavid Levine, founder of Odin River, returns to Real Vision to discuss the absurdity of negative interest rates and the way in which they’ve led to the mispricing of systemic risk across the world. In this interview with Alex Rosenberg, Levine highlights the recent spike in equity and treasury market volatility, argues that central banks are reaching their limitations, and suggests ways for investors to position themselves for the months ahead. Filmed on August 19, 2019.
ALEX ROSENBERG: Welcome to Trade Ideas. I'm Alex Rosenberg, here with David Levine, founder of Odin River. And also some will know you as the Paranoid Bull. Thank you for joining us here at Real Vision.
DAVID LEVINE: Great to be back.
ALEX ROSENBERG: Help us make sense of these markets here. Because with so many- as we are talking on Monday morning, the S&P is up 1%. A lot of up 1%, down 1%, seems to be the norm these days, and people are really trying to figure out what's driving the market now and what will drive us in the weeks, months, and perhaps a year or two years ahead? So if you were to tell us what the stakes are, what the market is trying to figure out now, what would that be?
DAVID LEVINE: Well, it's good to put this in context. So what's really interesting, if you look at the S&P 500 today, it's around 2900. Last January, the end of January 2018, the S&P 500 was higher than it is today. Last August, it was higher than it is today. And what's really interesting is that there's been a variety of different narratives that have taken over in the first half of this year because we bottomed in 2018, the end of December has been "bullish". There's been a lot of confidence, volatility settled down.
What's really funny, though, is that confidence was based on tweets, was based on a back and forth trade policy, was based on the idea that Donald J. Trump will control the markets up and down ahead of the election and get reelected. The narrative didn't really make sense if you think about it. If I look at the last two weeks, where the markets are up and down, where equity market volatility is up, where Treasury market volatility is up, where the bond yield curve has been inverting, that's a little bit more normal, in my opinion, given how volatile the real world actually has been since last January.
Remember last January was the beginning of the end of the top of a bull market. We had 90% of asset classes globally down in 2018. And so what happened the first half of this year, in my opinion, is a bear market bounce. We had volatility settle. We had correlations go back up, and so a lot of confidence in the narrative that maybe in my opinion, was it really justified. So what we're seeing now is more uncertainty. We're seeing that across various different markets. And in my opinion, that's more reflective of the fundamentals.
So I think what's happening is markets are becoming more normal. What we were seeing the first half of the year wasn't very normal. And so what I expect is more of the same, more volatility, more uncertainty, and markets beginning to reflect the fundamentals that we know are very volatile in the real world. Now, which fundamentals will matter most? We'll see. Trade war is very important. Global slowing in China, very important. Yield curve inverting, important. $16 trillion dollars of negatively yielding sovereign credit, important. US economy, are we in recession? Important.
So there's many different questions primarily macro-related that needed to be answered in the coming weeks. Those will probably determine the fate of things. But I would expect more volatility like this and more uncertainty, and maybe even narratives taking hold again, like everything's going to be fine or maybe not. We'll see what happens in Hong Kong. So a lot of uncertainty, but in my opinion, a little bit more of a normal market, and last couple weeks than what we saw before.
ALEX ROSENBERG: So, I'll let you play a little dealer's choice here. And of those questions, which one do you think that most investors are getting the most wrong? Where's the biggest problem in investors' thinking when it comes to this market?
DAVID LEVINE: This one thesis that I've been talking about for the last period of years, and I call it The Myth of the Infallible Central Banks, meaning in order for systemic risk to exist, there has to be an assumption that everyone's making that later turns out to be wrong. And it's got to be very, very big, and most people have to believe it to be true. Right now, that assumption, in my opinion, is called The Myth of the Infallible Central Banks. So embedded in a variety of these different assumptions that people are making about the markets is the idea, don't fight the Fed, don't fight the BOJ, don't fight the ECB.
In my opinion, that's just not a good assumption to make, meaning central banks have limits, those limits are political, those limits are legal. And in the United States right now, we had all the former Fed chairs write an article in the Wall Street Journal just in the last few weeks, questioning the Fed's very independence right now in the United States. So confidence is also very important for central banks.
So what I would say is, what level of confidence is the right level of confidence in central banks, is a very important question. And how this myth of the infallible central banks becomes unwound in the coming weeks and months, is very important. And that could happen in a variety of different ways. Two most obvious ways where we see that happening today, in the banking system. European financial system, European banks, we know they're under pressure, near all-time lows. Japanese banks, under pressure near decade lows.
And the fundamentals of those banks have been challenged very much by Central Bank policy in Europe and Japan. The second most obvious places is showing up. $16 trillion of negatively yielding debt primarily, the majority of which is sovereign credit. 16 trillion in negatively yielding debt should never exist, that was created by central banks. So we have these very big market signals that are already occurring, which are showing us they're reaching the limits of central bank power and central bank credibility and central bank effectiveness. So as those unfold in the coming weeks, I think those will be very important, weeks and months actually, those would be very important themes to watch unfold.
ALEX ROSENBERG: Let's just drill down a bit on the negative yielding bonds, something that has crept into the conversation is the Overton window is being opened about something that could happen in the US as well. I guess I'm trying to understand, because to me, it seems like a success of central banks that they were able to make people buy negative yielding bonds by setting rates negative and seeing that translate throughout the curve of the risk spectrum as well. People are talking about negative yielding mortgages now. What's your thesis about why that's so problematic, and what it means for the future central banking?
DAVID LEVINE: Oh, sure. It's just really, really basic. So if I lend you money, I need to be compensated for that risk. We know for a fact, not hypothesis fact, systemic risk exists. In 2008, it was proven beyond a doubt that if you have a credit bubble, you can have systemic risk. And that can show up immediately across the entire world, we almost had a global financial system collapse beyond repair in 2008. Thankfully, we were able to repair it.
Therefore, the risk of lending, the risk of participating in the financial market is positive. That is why the risk free rate is always positive. Whenever you study finance, there is a compensation for systemic risk that is embedded in every discount rate. And whenever we teach finance, it's one of the basic fundamental building blocks. Now, what central banks decided was, let's ignore that. What we care most about is stimulating the economy by inflating asset prices. And we will ignore systemic risk, because we believe, don't worry, central banks will be infallible, don't worry, governments will be able to pay their debts.
They overlooked this very basic fact, which is that systemic risk is positive, therefore, interest rates actually have to be positive, in my opinion, because of the very nature of risk itself, systemic risk. And so by making the mistake of lowering rates to zero and below, the central banks forced the system to underprice systemic risk throughout every single asset class that exists. Now, the concept of negative yields ignore a systemic risk. It also suggests that you and I are entering a contract where I'm guaranteed to lose money by lending you money, that is just not something that people should do in finance.
So this goes very deep, it goes very deep. And so I don't believe it is a success to have 16 trillion of negative yielding debt, I'd actually think it's a sign the system's actually in a a lot of trouble. You had the Austrian bond up 50% in a month, you had German government debt up 20% in a couple months, for what reason? In my opinion, no other reason than a blow-off top, quite similar to dot-com, only way bigger, way more important because this is government debt. Government debt is way more central to the financial system than subprime CTOs or any other credit instrument that's ever been an issue in the past.
So I actually don't think it's a success to see negative yields. I think it's actually really troubling. And it's a sign of how far the system has gone.
ALEX ROSENBERG: So going along with that thesis, how do you see it playing out from here? If this is a blow-off top, if this is a moment of capitulation, what does that mean for the months ahead?
DAVID LEVINE: Well, two of the most important places to look are the banking system, and then the credit markets. And those two things are both in trouble. Meaning, if you're a bank, you have to be able to make money by lending. And what negative rates do is it forces interest rates negative, and it also forces the yield curve to be flat. Those two factors make it very, very hard for banks to make money. So when we look at the equity market prices of European and Japanese banks, not surprisingly, they're near all-time lows in Europe and near decade lows in Japan.
So my opinion, the banking systems of both Europe and Japan are really important, because central banks now, especially in Japan, are at the limits of what they can actually do to help the situation. If the BOJ were to increase their interference or their influence on the interest rate markets in Japan, it would actually make things worse. So there's a really difficult situation in Japan, if the fundamentals continue to remain as bad as they are. In Europe, similarly, we saw Deutsche Bank already announcing restructuring. So we're in the middle of the European financial system unwinding.
Now, there is a German court case outstanding that is this is a little obscure, but it's important thing. The German Federal Constitutional Court, which is the equivalent of the Supreme Court, right now is reviewing the legality of QE. They have never ruled that the QE that was done in 2015 and beyond, is legal. Everyone assumes that the German Constitutional Court is going to come back in a few months and say, don't worry, QE is okay, the 33% rule that Draghi has been following if they want to increase it to 50%, that's going to be okay. But it might not be the case. We actually don't know it today. Nobody in the world, maybe the judges know, but I don't even know if they've decided, know whether QE is legal in Germany, which is just wild to think about if they were to come back and say it's illegal.
The point is that there's a lot of uncertainty in these markets, especially in the financial system. So I'd start with coming back to your question, what's most important, the financial system itself, especially in Europe and Japan. And the second point, which is credit market volatility, I mentioned a little bit about this court case, that would be something that's quite volatile across credit markets if it were to come back in a negative way.
But credit market volatility more generally, is also very important to watch. If you look at the last couple weeks, credit market volatility has picked up, Treasury market volatility has picked up even more than equity market volatility. Now, if we start to see that volatility increase, that could be quite dangerous, because it would also be a sign that we're likely starting to see defaults. Spreads can begin to widen and we can begin a credit cycle.
Now, everything I've said so far has ignored that fundamentals remained weak, fundamentals remained very weak. China just had one of the worst quarters in 20-plus years. Industries like automotive and semiconductors and others are weakening. And so, and not to mention oil and gas, like there's a bunch of industries where fundamentals are weak. So if we get credit market volatility picking up while fundamentals remain weak, ignoring whether or not the US is in recession, we can start to have a default wave, we can start to have credit volatility in those two things- banking system vulnerability in Europe, credit market volatility throughout the system, those would be things that could be quite dangerous in this environment.
ALEX ROSENBERG: So when it comes to all these particular issues, and I'm glad we talked about central banks already, because the answer really comes back to central banks. I mean central banks could save Deutsche Bank and other European banks, central banks can continue to do things too.
DAVID LEVINE: Can I just interrupt?
ALEX ROSENBERG: Yeah, please. This is what I'm getting to.
DAVID LEVINE: This is the key point, which is the myth of the infallible central bank. And the reason it's a myth-- remember, 2008, this is really important to remember. In 2008, the actions that the Fed took were not in their authority. They were granted to them by Congress. They were granted to them by unified front of Democrats, Republicans and the White House coming together, locking arms and saying, we need to bail out AIG, we need to bail out Goldman Sachs, we need to bail out the financial system because it's important because we don't want the economy to go into a tailspin, even in the United States.
Could you imagine today, Nancy Pelosi walking into the White House with President Donald Trump and saying, hey, let's bail out AIG and Goldman Sachs. I don't know how well that would go over. Perhaps in an election year, the Democrats might say, oh, why don't we make this a tougher negotiation than the President would like? They may be incented to make things even more difficult than they otherwise might, given the context of the politics here.
To Europe, where you were going before, they actually tried to create a merger between Deutsche Bank and another bank in Germany and they failed. The reason is that it's not that straightforward. You have union workers on the board of Deutsche Bank and union workers said no merger, we don't want to get fired. And when you start to think about bailing out banks in Europe, that's where the laws become really important. So one of the key issues in this German case that I mentioned is that the German Constitution and the German laws want to make sure that Germany is not financing the deficits of other countries, specifically, countries like Italy.
So if you got into a situation where you needed a bank bailout, you'd actually need to have the different countries cooperate. At the end of the day, might that happen? I think probably, but most likely, that would take time, and therefore you'd have significant volatility in the near term. In other words, one of the best things that could happen for a bailout of the financial system in Europe might be significant volatility. If markets are down 30%, or 40%, and you have a lot of volatility, and there's " blood on the streets", that's when maybe that is a political will to come together and give the central bank the authority it needs to act in the time of crisis, which is what happened in a way. But the point is that there are limits to what the central banks can do at any point in time, and I think we're nearing those limits.
ALEX ROSENBERG: And at the very least, to paraphrase, if there is a central bank put the strike price is much lower than people might currently think it is.
DAVID LEVINE: That's a great way of putting it. I think that's right.
ALEX ROSENBERG: So given this view of the world that you articulated, what does it mean for you when it comes to asset allocation?
DAVID LEVINE: And so I think what it means, coming back to the very beginning of our conversation, what are equity markets doing today? They're much more volatile. We saw VIX as one measure of volatility, but realized volatility has really picked up in the last couple weeks. Valuations on any cyclical adjusted basis are very high. The same is true for credit markets, bond yields very low meaning bond prices are very high.
The asymmetry associated with any of the things that I'm talking about, meaning the risk to the downside, if any of the things I'm talking about materialize, are quite significant, both in equity markets and credit markets. For me, that means being net short. No, I don't advise that for nonprofessional investors. It's really, they shorting is quite dangerous. And it can be various symmetric to the downside, it takes lot of both patience and having a good sense of position sizing, risk management, stuff like that. In my opinion, derisking is probably the most prudent thing to do.
FDIC insured savings accounts, or you have 2% interest, and you have a guarantee at least from the government. I don't believe they will let FDIC insurance go even in a systemic type crisis. It's pretty attractive, you have 2% guaranteed in this market, or you have 16 trillion in negative yielding credit, including the US 10-Year below that. 2%, it's pretty attractive, in my opinion.
ALEX ROSENBERG: Maybe not the sexiest trade idea we have ever had.
DAVID LEVINE: Yeah, I think this is not a time to try to be sexy. Now, for me, being short is something that does make a lot of sense.
ALEX ROSENBERG: And when you say net short- stocks, bonds?
DAVID LEVINE: Yeah. So the way that I construct my portfolio is to be long progress. I'm long this conversation like, I'm long transparency. And there's a reason why #ParanoidBull, my Twitter account, is somewhere where I share my ideas. I believe very much in the mission of Real Vision, and very much in the modernization of finance. And so, being invested in themes like increased transparency in finance, themes like increased transparency in media and companies that are benefiting from that, both public and private. Holding that forever, to me, is a great thing to do.
Now, being short broader equity markets, being short companies that are being disrupted. Yes, being short credit, which is again, something that I wouldn't advise to your average investor. But doing these things in the context of portfolio, to me, makes a lot of sense, especially if one constructs it with not a lot of leveraging and some prudence with position sizing. I think it's the right way to go.
ALEX ROSENBERG: Well, David, I'm loving this conversation too. And thank you so much for joining us here in Real Vision.
DAVID LEVINE: Thank you for having me. It's great to be back.