Is Guy Debelle right?

The warnings from the Reserve Bank's assistant governor may have spooked some investors, but are they justified?

Guy Debelle’s speech yesterday was a glass of water in the face, a bell sounding down a quiet street, a brimstone sermon to scare the crap out of a happy clapping congregation.

Debelle is assistant governor (financial markets) of the Reserve Bank of Australia – a central banker no less – but gosh it was an unusual speech for a central banker. For that reason it can’t be ignored.

His point was that when the sell-off comes, it could be violent, mainly because liquidity is less than people think.

That’s because market-making capacity has been reduced due to regulatory changes. And even when there used to be more market-makers, sell-offs were “quite violent” because they “have just as much reluctance to catch a falling knife” as anyone else.

In any case, he said, a number of investors are buying assets “on the presumption of a level of liquidity which is not there” – that is, they think they can get out in time.

“History tells us that this is generally not a successful strategy. The exits tend to get jammed unexpectedly and rapidly.

“On top of that, my time in financial markets has taught me that one should never under-estimate the role of mechanical rules or mandates in driving market behaviour more than rational pricing.” So there is a fair chance that volatility will feed on itself.

He rattled a couple of other chains as well, such as the fact that interest rates are low and will go up.

It was one of the clearest and scariest speeches by a central banker I have ever read. Actually make that THE clearest and scariest.

Central bankers are supposed to have an inbuilt clarity limitation device that can’t be over-ridden, like the speed governor on a B-double.

A few questions spring to mind.

First, did he run it past the Governor? And if so, does Glenn Stevens agree that we could be in for a violent sell-off?

Second, are we in the sell-off now? The Australian sharemarket has tumbled 9 per cent and before the rebound that was occurring as Debelle spoke yesterday, the resources sector was down 13 per cent in five weeks.

Perhaps not. It’s not very violent (yet) and yesterday’s action suggested that there is still plenty of latent buying, if not liquidity. So presumably the violent sell-off is still to come.

Third, what should we do? Is the assistant governor of the RBA telling us to get out now to beat the rush? To sell our shares? Really?

I did that a few years ago – I thought a violent sell-off was coming so I wrote a “glass of water in the face” sort of article and ended up looking silly because it didn’t happen.

Unfortunately, my warning came a week after the start of QE2, the Fed’s second programme of quantitive easing, in which it bought $US600 billion in long dated Treasuries. That was followed by Operation Twist ($US400 billion) a year later and QE3 ($US85 billion a month) a year after that. QE3 will finally finish this month, a total of $US3.5 trillion in purchases later.

In other words, I forgot one of the fundamental rules of investment – don’t fight the Fed.

Former Federal Reserve chairman Ben Bernanke once remarked: “The problem with QE is that it works in practice, but it doesn’t work in theory.”

The result is that the US economy is doing fine now with decent employment growth and low inflation, but it’s hard for anyone to believe that was actually achieved through money printing. There are many bears for whom the whole thing is a ticking bomb.

Europe, on the other hand, is not doing fine at all, and the European Central Bank seems unwilling or unable to do much about it; specifically EU rules and/or Germany’s obsession with fiscal and monetary rectitude are preventing it from engaging in unbridled Fed-style QE.

There’s nothing new in 2014 about that – for five years Europe has been lurching from crisis to despair, but markets have been untroubled beyond annual, short-lived corrections (apart from last year) because of what the Fed was doing. America’s vigour trumped Europe’s pathos.

But now Europe is slipping back into recession and investors are beginning to price in the prospect of long-term stagnation and deflation. That’s what last week’s action was about.

If the ECB doesn’t respond to this by launching QE, and Germany continues to force fiscal austerity on the rest of the Europe, markets will eventually tank and Guy Debelle will be proved right.

If the ECB does, finally, do “whatever it takes”, as the Fed has been doing for five years, then Debelle will be wrong.

It looks as simple as that.

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