Smart Bird: Tearing Down the Free Markets

I don’t normally talk about single news articles, but this one has many implications.

What happens when central banks do whatever it takes to keep the stock market rally going even while the world economy is in a deep recession. Honest investors betting on realistic price discovery find the central bank steps in to destroy their trades. And those trades dry up and only the bullish speculative crowd remains.

Shorting stocks is not evil. It keeps the financial ecosystem healthy. Weak companies are culled out and lying CEOs are exposed. But when even zombie companies that face default continue to rise on a sea of liquidity, the shorts pull out of the markets.

A strange effect happens when those who bet on the market going down (shorting) pull out, the market becomes unbalanced to the upside. The bubble extends higher with less resistance. But something else happens.

When the market finally succumbs to reality, there is no one “shorting” the market who would at some point normally step in to cover their shorts – buy. Plunges can become deeper and faster.

Shorting is only one small part of the markets that have become distorted by the central banks interventions. There are many others. The risk is building.

Stock lenders wince as hedge funds lose their shorts 11 October 2020 Reuters

Short selling has declined this year as hedge funds ditch bets against a relentless, stimulus-driven stock market rally, prompting a drop in income for asset managers and brokers involved in such trades.

“It’s ‘whatever it takes,’ globally, and it is by far the most frustrating rally for all our client base,” said George Boubouras, head of research, at K2 Asset Management, a Melbourne based fund which invests worldwide.

“With so much liquidity from central banks it is a difficult macro environment to run sustained short positions.”

“For Blackrock and others, a hit to securities lending revenues is likely to be a pain point,” said Stephen Biggar, director of financial services research at Argus Research in New York.

“The revenues generated were a big rationale for how fund companies were able to lower their fees.”

A while back I wrote about how Charles Schwab bought USAA investment accounts and how today brokerage companies engineered their cash accounts to make money so they could offer free trades. This plan worked with interest rates climbing to 2%. They earned 2% on your money while paying you a nominally low interest rates on your brokerage cash.

But now that the Fed has forced interest rates to near zero, the brokerage companies are not earning income on your cash. With free trades their profits are hurting in this new low interest rate, longer environment.

And in Europe, the central bank is telling banks to get ready for negative interest rates (on smaller accounts I assume).

I would say the central bank’s experiment has gone terribly wrong in so many ways.

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Categories: Perspectives