Earlier this month, along with our usual dire observations about an economy that has come unhinged, I noted that the world was not coming to an end. On closer inspection, I may have been wrong on that one.
One sign that all is not right in the world of investing is the increasing volatility. Volatility is not a good thing for investors seeking to limit their risk and markets recently have been as spiked as Jonestown Kool-Aid. The results could be nearly as disastrous. 
As the chart shows, currency, oil and interest rates have been up, down and all around. Bonds, too, have been volatile, and price shifts have been taking place with increasing frequency.
It makes me uncomfortable when I see government bonds flash crashing along with currencies of developed markets with enormous debt levels. The Swiss National Bank’s unpegged its currency and, if Japan keeps burning yens, China is likely to unpeg its currency. When that happens, it isn’t going to be fun.
Why is this happening? Because central bankers have become the masters of the universe. Make that Masters of the Universe.
As Zerohedge notes, “For the last few years, valuations in more and more markets seem to have stopped following traditional relationships and instead followed global QE. Likewise in meetings with investors, we have been struck by how little time anyone spends discussing fundamentals these days, and how much revolves around central banks. Record-high proportions of investors think fixed income is expensive and think equities are expensive. A growing number of property market participants seem to think real estate is expensive. And yet almost all have had to remain long, as each of these markets has rallied. Could it be that central bank liquidity has forced investors to be the same way round more so than previously, and that this is making markets prone to sudden corrections?”
Abnormal Is the New Normal
Putting central bankers in charge of the world’s financial systems might have seemed like a good idea back in 2008, when the world needed to be saved and there were few options for saving it. But in the seventh year of ruling the world, the most significant result is that markets have become distorted. The new normal is abnormal.
Zerohedge further noted that “it is expectations of central bank liquidity, not economic or corporate fundamentals, which have become the main driver of everything from €/$ to credit spreads to BTP yields.
“While central banks have always been significant market participants, their role has obviously grown since 2008. Most obviously, their global asset purchases have drastically reduced the net supply of securities available to be bought by investors. At the same time, we have seen a breakdown in a number of fundamental relationships which had previously correlated well with markets – and their replacement with metrics directly linked to central bank QE.”
One problem with the New Order is that it’s unlikely that central bankers can make a smooth transition back to the good, old-fashioned markets that react to financial performance and economic reality, rather than today’s Fed-induced fantasyland.
The Federal Reserve Board was able to end its quantitative easing program without the world coming to an end, but what happens when the Fed raises interest rates, as it eventually must? The stock market could go into cardiac arrest – and, having used all of its tools in an attempt to revive the economy, the toolbox is empty. Even Fed Chair Janet Yellen is no longer talking about “macroprudential supervision” as a Fed tool. So what’s left?
But someone will have to do something, as, “Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously.”
When investors are all rushing into the same markets at the same time, prices increase. When they all rush for the exits at the same time, prices decrease. In the bond market, the result is an illiquid market. Today, “investors now increasingly find themselves focused on the same thing: central bank liquidity. Every so often, when they start to doubt their convictions, they find that the clearing price for risk as they try to reverse positions is nowhere near where they’d expected.”
Because of this “herding” of investors, ironically, the more central banks seek to add liquidity to markets, the more illiquid they become. Herding “creates markets which trend strongly, but are then prone to sudden corrections. It also leaves investors more focused on central banks than ever before – and is liable to make it impossible for the central banks to make a smooth exit.”
Unfortunately, Zerohedge concludes, “The bouts of illiquidity will continue until central banks stop distorting markets. If anything, they seem likely to intensify: unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.”
Add today’s regulatory environment and high-frequency trading into the mix and there’s plenty to worry about. Even the Masters of the Universe may not be able to save us.