January was an awful month for risk assets (stocks, DOW -5.5% and was much worse before the month-end rally) and February is, at best, a volatile month so far.
What drove January's weakness and February's volatility? Well, probably a combination of many things: valuations are stretched, the FOMC going the other way and tightening monetary policy, commodities in free-fall, and...other central banks around the world easing monetary policy. That's right, easing monetary policy has had the opposite effect of what we have seen the past 7 yrs.
Seems counter-intuitive that easy monetary policy actually brings about risk asset market weakness because over the past 7 yrs, investors have been trained that easy monetary policy helps inflate risk assets. No more.
Why? Because we have now entered into The Negative Feedback Loop or The Doom Loop. The Doom Loop is best-defined as a Vicious Circle or, more specifically to this situation, the more central bankers attempt to fix the situation, the worse they make it. This is the reason why the market will no longer trade up on bad economic news, which used to bring in the central bankers to cut rates even more...because lower and negative rates are making the situation worse.
This is best shown in three charts:
Chart 1 - Since 2008's financial collapse, central banks the world over have been pumping the global economy with monetary stimulus. To be sure, this was the right thing to do as it: 1) put the banks on a better footing and 2) forced them in to lending to consumers and corporate clients, which are both engines of the economy. This easy money also helped inflate asset prices, as we have seen in stocks, bonds, corporate bonds, commodities etc. So as you can see from the chart below, they dealt with a weak economy by lowering interest rates. But lower rates actually hurt the banks in that their Net Interest Margin (NIM) gets compressed so they become slightly earnings-challenged.
So as asset prices inflated, a funny thing happened...the goods and services part of the economy didn't take all that monetary policy and turn it into robust economic growth. Sure stocks hit all-time highs (you would have thought we had 6% US GDP growth with stocks at all-time highs??) but the real economy didn't show the strength the central bankers hoped for.
So what do these foreign central bankers do...they see the US economy as the one with the best-of-the-bunch growth potential so they ease rates (to spur economic growth and also to devalue their home currency to spur export activity to the USA, along with the home country's deflation (another story altogether)). Now, not only do some of these central banks cut rates further, they (Japan and ECB) cut rates to negative! Yes, that's right, you pay them to lend them money. Again some of this is due to deflation or diminished inflation expectations, but regardless, the outcome is the same...it hurts the banks even more. Banks are now getting Zero on their balances but still need to pay depositors a positive rate...that is Negative Net Interest Margin. It ain't good for banks. The one thing we know about all financial institutions is they need access to financing or funding to operate. Do you want to lend to any bank if it costs you money?? I think not.
So how are these banks left? Well, one part of their business, traditional deposit taking and lending gets turned upside-down and really hurts profitability.
See the Doom Loop below. And if you look at the riskiest of risk assets (stocks) the past few months, you will see this story is playing out.
Chart 2 - Now if we look at just how negative interest rates in the banking lending/borrowing sector have become, we can see Japan and the Euro area are solidly negative. Canada, the UK and the USA are all still positive, for now, although the talk of a Negative Interest Rate Policy (NIRP) has risen in all three of those countries.
Chart 3 - And Chart 3 is an example of what has happened to one particular European behemoth bank, Deutsche Bank (DB), but it has happened to many others in Europe and even in Canada too.. In early February, DB's credit default swap spreads (CDS) began to blow out (higher is a sign of worry over DB's credit worthiness). As you can see below, it got hit pretty hard. I think there are a few reasons for this like: what is their energy/commodity exposure (undisclosed), exposure to the weakening Chinese economy, legal issues and capital markets revenue declining, etc. But another reason is as explained above...how the heck does a bank make money when interest rates go negative? Their G+A cost structure is not set up for that but more importantly, regular depositors don't deposit cash in the banks but rather keep it at "home in a mattress". Or better yet, why do you think Gold has risen so robustly the past month? Some nations are contemplating taxing cash balances. They know not what they do as this just compounds the problem as banks are starving for cash balances to continue to operate. Never mind the leverage they need to continue to finance.
And so the Negative Feedback Loop or the Doom Loop kicks in and...makes things worse. Just check out how hard these financial stocks have been hit over the last while. What is the definition of insanity?...Doing the same thing over and over, getting a negative result, but continuing to do that same thing.