Nature is chock full of inherently non-linear systems that do not follow predictable or proportional paths, yet human nature seems unable to escape a linear mindset. Nowhere is this more evident than in the financial markets. Every time a policy action is followed by a “favorable” response in the markets, the mainstream chorus sets in to sing the praises of said policy. Many of the politicians, pundits and academics assume that the policies have induced a sustainable turning point simply because the markets are all moving in one direction for the time being.
On the other hand, you have sites like TAE and others who constantly remind that the pressure will not slowly and uniformly build up throughout the system, because we understand its non-linear progression. The ECB’s LTRO took the pressure off of the Euro peripheral bond markets (mostly Italy’s), as well as bank funding markets, and the Greek PSI relieved the possibility of an imminent “disorderly default” in the region, but they did not resolve any of the underlying issues in Europe. The pressures were merely masked and re-distributed to other parts of the system.
Within months of LTRO and weeks of the PSI, the spectre of financial contagion is once again haunting the Euro area – this time with all eyes trained on Spain. Today’s Spanish auction of 3-8 year bonds, just outside of the LTRO’s 3-year cheap liquidity range, was a major disappointment for the pundits, since it only placed a little over 70% over the amount targeted and at significantly elevated rates of interest from previous auctions. Is anyone other than the pundits surprised that this has happened? One day they are all yammering on about Greece, and the next day about Italy, and the next about Greece again, and then about Portugal and Spain. That’s just non-linearity for you.
Another thing weighing on the markets is the fact that it is near impossible for the Eurozone to avoid a deep recession this year, as reflected in the graph of PMI and GDP data above, and therefore Europe’s structural solvency issues are not going to simply disappear. Of course, we didn’t need to see this correlation graph to know that the sharp moves upward in 2009-10 data were entirely unsustainable. Finally, the liquidity addicts are disappointed that the Fed has refused to promise them another round of QE, despite constant rumors to the contrary over the past few weeks ahead of every Fed meeting and release of minutes.
They are realizing that with every passing day that the cheap liquidity does not arrive in the post-Greek default environment, the effects of such liquidity on the global financial system as a whole are severely diminished (or Why Liquidity is No Longer Enough). Today is just one of those days in which it dawns on big money investors, if only for a few moments, that all of those previous market rallies were merely a symptom of a non-linear system that is haphazardly marching through the stages of its collapse.