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The Draghi Effect and the Overleveraged Funds

I have lost count of how many times Mr. Draghi has promised sovereign bond buying. But for now, all the ECB does is accepting sovereign bonds as collateral and has not printed money in exchange for paper. The reason is that the ECB cannot print money and all the talk amounts to interventions to prevent stock markets from falling.

Mr. Draghi has been threatened by German courts with an avalanche of lawsuits if he proceeds with outright quantitative easing because that would be essentially a tax on German taxpayers. However, stock markets rally each time Mr. Draghi makes promises of free money. Everyone knows that the EU problems are structural and cannot be solved with quantitative easing. EU members must reduce their public sector, stop acting as employers of last resort and attract foreign investments. Quantitative easing will make things worse as it will further increase moral hazard.

I have no idea how many potential LTCMs are out there now due to the (false) perception that this is an invincible stock market and that stocks and bonds will both keep going up because the financial media says that the economy is strong but at the same time there is deflation threat, i.e. conditions that support both stocks and bonds, as shown on the chart below:

SPX_TNX_CORR_20150108

It may be seen from the above chart that since June of last year the 250-day correlation between S&P 500 and TNX (10-Year Note yield) has been steadily rising but the former has increased more than 7% and the latter has decreased 25%, i.e. despite the rising correlation, both stocks and bonds have been rising and both equity and bond funds have been showing profits. This is the best of all possible worlds for equity and bond funds due to alleged deflationary pressures and talk of quantitative easing in Europe after the program in US was terminated.

The problem is how many funds are overleveraged and the risks of a large scale collapse in asset prices with a simultaneous rise in yields in case something goes wrong. The risks of moral hazard in the fund management business are increasing due to the constant talk about more free money. These risks take the form of increased leverage to take advantage of rising asset and debt prices due to the commitments made to keep interest rates low and print money. Anyone who believes that this is a sustainable scheme is not in touch with reality. The forexization of the stock markets by central banks by striking an elusive balance between deflation and inflation is a tricky and also dangerous path.

SPX_20150108

Fund managers now hope for another V-bottom after the ECB announcement yesterday of pending purchases of sovereign bonds.  The announcement came at the exact point that a test of the 200-day moving average for the S&P 500 was pending. Coincidence? I do not think so. There is crucial resistance in the S&P 500 near 2,079. Let us wait and see what commitments will be made to facilitate the break of the resistance and the new V-bottom.

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Disclosure: no relevant positions.
Charting program: Amibroker
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