FINANCIAL CONDITIONS / PRUDENTBEAR.COM

Financial Conditions

by Doug Noland

September 20, 2013


The Fed really pushed the envelope too far this time. The Federal Reserve shocked the markets Wednesday with its decision to furlough QE “tapering.” The Bernanke Fed, having for years prioritized a clear communications strategy, threw unsettled global markets for a loop.

Much has been written the past few days addressing the Fed’s change of heart. I’ll provide my own take, noting first and foremost my belief that Wednesday’s decision likely marks a critical inflection point. A marketplace that had been willing to ignore shortcomings and give the Federal Reserve the benefit of the doubt must now reevaluate. After all the fun and games, the markets will have to come to terms with a divided and confused Fed that has lost its bearings. As much as the Bernanke Fed was committed to the notion of market-pleasing transparency, it had kind of come to the end of the rope and was forced to just throw up its hands.

I’ll make an attempt to place the Fed and markets’ predicament in some context – at least in the context of my analytical framework. This requires some background rehash.

Credit is inherently unstable. When Credit is expanding briskly, the underlying expansion of Credit works to validate the optimistic view (spurring borrowing, spending, investing, speculating and rising asset prices) – which tends to stimulate added self-reinforcing Credit expansion. When Credit contracts, asset prices and economic output tend to retreat, which works against confidence in system Credit and the financial institutions exposed to deteriorating Credit, asset prices and economic conditions. One can say Credit is “recursive.” And with Credit and asset markets feeding upon each another, I’ll paraphrase George Soros’ Theory of Reflexivity: Perceptions tend to create their own reality. Credit cycles have been around for a very, very long time. We’re in the midst of a historic one.

Credit fundamentally changed in the nineties, with the proliferation of market-based Credit (securitizations, the GSEs, derivatives, “repos”, hedge funds and “Wall Street finance”). Unbeknownst at the time – perhaps to this day - marketable securities-based Credit created additional layers of instability compared to traditional (bank loan-centric) Credit.

These new instabilities and attendant fragilities should have been recognized with the bursting of a speculative Bubble in bonds/MBS/derivatives (along with the Mexican collapse) back in 1994/5. Fatefully, policy measures moved in the direction of bailouts, market interventions and backstops. Credit and speculative excesses were accommodated, ensuring a protracted period of serial booms, busts and policy reflations.

Monetary policy fundamentally changed to meet the demands of this New Age marketable securities-based, highly-leveraged and speculation-rife Credit apparatus. The Greenspan Fed adopted its “asymmetric” policy approach, ensuring the most timid “tightening” measures in the face of excess and the most aggressive market interventions when speculative Bubbles inevitably faltered. Greenspan adopted a strategy of “pegging” short-term rates and telegraphing the future course of policymaking. This was apparently to help stabilize the markets. In reality, these measures were instrumental in a historic expansion of Credit, financial leveraging and speculation. The Fed has been fighting ever bigger battles – with increasingly experimental measures - to sustain this inflating monster ever since.

I am a strong proponent of “free market Capitalism.” I just don’t believe financial market pricing mechanisms function effectively within a backdrop of unconstrained Credit, unlimited liquidity and government backstops. I believe this ongoing period of unconstrained global Credit is unique in history. Indeed, this is an open-ended experiment in electronic/digitalized “money” and Credit. This experiment has necessitated an experiment in “activist” monetary management and inflationism. At the same time, these experiments have accommodated an experimental global economic structure. The U.S. economy is an experiment in a services and consumption-based structure with perpetual trade and Current Account Deficits. The global economy is an experiment in unmatched – and persistent - financial and economic imbalances.

U.S. and global economies are at this point dependent upon ongoing rampant Credit expansion. Highly interrelated global financial markets have grown dependent upon the rapid expansion of Credit and marketplace liquidity. The Fed and global central banks have for some time now been desperately trying about everything to spur ongoing Credit expansion (to inflate Credit). Curiously, they avoid discussing the topic and frame the issues much differently.

The Fed pushed short-term rates down to 3% to spur Credit inflation during the early-nineties. Rates were forced all the way down to 1% - and the Fed resorted to talk of the “government printing press” and “helicopter money” in desperate measures to spur sufficient reflationary Credit growth after the bursting of the “technology” Bubble. Even zero rates were insufficient to incite private Credit expansion after the collapse of the mortgage finance Bubble.

With this New Age (experimental) marketable Credit infrastructure crumbling, the Bernanke Fed resorted to a massive inflation of the Fed’s balance sheet – an unprecedented monetization of government debt and mortgage-backed securities. What unfolded was a historic reflation of global securities prices, along with further massive issuance of marketable debt securities. In spite of all the “deleveraging” talk, the growth of outstanding global debt securities went parabolic. Central bank holdings of these securities grew exponentially. Instrumental to the Credit boom, Fed policy spurred Trillions to leave the safety of “money” for long-term U.S. fixed income, international securities and the emerging markets (EM). It is unknown how many Trillions of leveraged speculative positions were incentivized by global central bankers. The combination of an unprecedented policy-induced inflation of prices across securities markets and a low tolerance for investor/speculator losses creates a very serious and ongoing dilemma for the Fed and its global central bank cohorts.

Over the years, I’ve chronicled monetary management descending down the proverbial “slippery slope.” Actually, monetary history is rather clear on the matter: Loose money and monetary inflations just don’t bring out the best in people, policymakers or markets. I definitely don’t believe a massive Bubble in marketable debt and equity securities is conducive to policymaker veracity. I don’t believe a multi-Trillion dollar pool of leveraged speculative finance – that can position bullishly leveraged long or abruptly sell and go short - promotes policy candor. Actually, let me suggest that a global Credit and speculative Bubble naturally promotes obfuscation and malfeasance. Invariably, it regresses into a grand confidence game with all the inherent compromises such an endeavor implies.

I titled a February 2011 CBB “No Exit.” This was in response to the details of the Fed’s plan for normalizing its balance sheet after it had bloated to $2.4 TN (from $875bn in June of ’08). There was simply no way the Fed was going to be able to sell hundreds of billions of securities into the marketplace without inciting risk aversion and de-leveraging. I assumed the Fed’s balance sheet would continue to inflate, though never did I contemplate the Fed resorting to $85bn monthly QE in a non-crisis environment.

I speculated a year ago that the Fed had told “a little white lie.” The Fed was responding to rapidly escalating global risks – right along with the Draghi ECB, the Bank of Japan, the Chinese and others. Open-ended QE was, I believe, wrapped in a veil of an American unemployment problem for political expediency. Meanwhile, the Fed has pushed forward with “transparency” believing it gave them only more control over market prices. And, at the end of the day, the $85bn monthly QE, the unemployment rate target, and long-term (zero rate) “forward guidance” provided a securities market pricing transmission mechanism that must have made Alan Greenspan envious.

The bottom line is that the $160bn (Fed and Bank of Japan) experiment in ongoing monthly QE (along with Draghi’s backstop) only worked to exacerbate global fragilities that were surfacing last summer. I believe increasingly conspicuous signs of excess had the Fed wanting to begin pulling back. Yet just the mention of a most timid reduction of QE had global markets in a tizzy. After backing away from an exit strategy, the Fed has for now backtracked on tapering. It seems I am on an almost weekly basis now restating how once aggressive monetary inflation is commenced it becomes almost imposible to stop.

In my July 12, 2013 CBB, “Bernanke’s Comment,” I highlighted what I thought at the time was a comment for the history books: “If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.”

As someone who places “Financial Conditions” at the heart of market and economic analysis, I felt Bernanke had opened a real can of worms on the policy and communications front.

From Wednesday’s FOMC statement: “The committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The committee recognizes that inflation persistently below its 2% objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.”

Have Financial Conditions really tightened in recent months? Stock prices have surged to all-time record highs. The S&P500 has gained 7.7% in three months, with Nasdaq up 12.4%. The small cap Russell 2000 has surged 11.3% in three months. The Nasdaq Biotech index has jumped 24.8%, increasing its 2013 gain to 53.3% (2-yr gain of 116%). Internet stocks enjoy a three-month gain of 12.6%. The average stock (Value Line Arithmetic) is up 11.2% in three months. Stock prices indicate the opposite of tightening.

Last week set an all-time weekly record for corporate debt issuance. The year is on track for record junk bond issuance and on near-record pace for overall corporate debt issuance. At 350 bps, junk bond spreads are near 5-year lows (5-yr avg. 655bps). At about 70 bps, investment grade Credit spreads closed Thursday at the lowest level since 2007 (5-yr avg. 114bps). It's a huge year for M&A. And with the return of “cov-lite” and abundant cheap finance for leveraged lending generally, U.S. corporate debt markets are screaming the opposite of tightening.

August existing home sales were the strongest since February 2007. National home prices are now rising at double-digit rates. An increasing number of local markets –certainly including many in California – are showing signs of overheating. Prices at the upper-end in many markets are back to all-time highs. And despite a backup in mortgage borrowing costs from record lows, housing markets have yet to indicate a tightening of Financial Conditions. Clearly benefiting from loose lending conditions, August auto sales were the strongest since 2006.

Provide the marketplace a policy target for the unemployment rate and let the economic analysis and forecasting begin. Ditto for CPI and GDP. But “Financial Conditions”? This is an altogether different animal, subjectively in the eye of the beholder - not easily quantified. In my analysis of Financial Conditions, I talk of a broad global “mosaic.” I closely examine scores of indicators, data and markets, doing my best to discern subtle changes in “Financial Conditions,” and speculative and market liquidity dynamics. And within this mosaic, the pertinent and key indicators are in a constant state of flux. I discuss such challenging analysis in terms of a science and an art. How does the Fed define Financial Conditions? Does this imply a market liquidity backstop? Which markets? Under what circumstances? How?

Within my Financial Conditions analytical framework, I view the “leveraged speculating community” as the marginal source of marketplace liquidity. When the hedge funds and others are embracing market risk and leverage, this ensures abundant liquidity and resulting loose Financial Conditions. A move to de-risking/de-leveraging implies a tightening of Financial Conditions. QE only complicates already challenging analysis. The initial QE chiefly involved accommodating speculative de-leveraging (a shifting of positions from the speculators to the Fed’s balance sheet). As such, it actually had a much more muted impact on market liquidity than most appreciated at the time.

Non-crisis QE, on the other hand, has had a profound impact. It has directly injected liquidity into the marketplace, while at the same time inciting additional risk-taking and speculative leveraging. Moreover, this added liquidity and heightened speculation hit already highly speculative/overheated global markets. In short, recent QE had a major inflationary impact on global speculative Bubbles. From this perspective, it’s not too difficult to appreciate why global markets convulsed on the mere talk of even timid Fed tapering. On the margin, today’s QE has unprecedented impact – and this market addiction will not be easily conquered.

So how is it possible that the Fed speaks of a tightening of Financial Conditions with stock prices at record highs, corporate debt yields near record lows and benchmark MBS yields at only 3.43% (10-yr avg. 4.60%)?

Here’s how I see it. For going on five years now, experimental Fed policy purposely inflated bond and stock prices. Bond prices/yields were pushed to unprecedented extremes, with artificially low market yields now suppressed only through ongoing aggressive Fed buying. Similarly, securities and asset price Bubbles have been inflated around the globe. Emerging markets and EM economies, in particular, have suffered from gross Bubble-related excess and maladjustment. Trillions have flowed into various (inflated) markets at home and abroad with little appreciation for the risks monetary policies have created. Just the prospect of a gradual reduction in QE was enough to instigate a destabilizing reversal of speculator and investor flows.

What the Fed likely views as a tightening of Financial Conditions, I see as initial – and inevitable - cracks in the "global government finance Bubble.” The Fed wants to “push back” against a rise in mortgage borrowing costs, while likely content to “push back” on EM fragility as well. A weaker dollar surely helps push back against the unwind of “carry trades” and other speculative de-leveraging. And the Fed surely would prefer to counter some of the tightening that has developed in municipal finance.

Bubble analysis plays prominently in my Financial Conditions analytical framework. Financial Conditions will typically tighten first at the “periphery” – as the weakest (“marginal”) borrower begins to lose access to cheap finance. This marks a key inflection point for Bubbles- and the Fed would clearly want to push back against any risk of a bursting Bubble. After all, faltering liquidity and heightened risk aversion at the fringes tend over time to have expanding contagion effects. May and June saw cracks, and Fed back-peddling continued through Wednesday’s meeting.

After trading as high as 6.37% in July 2007, benchmark MBS yields dropped all the way down to almost 5% by January 2008. The Fed’s response to initial cracks at the periphery of mortgage finance (subprime) actually only extended the problematic inflation at the Bubble’s core (almost $1.1 TN of risky mortgage Credit growth in ’07) – not to mention $145 crude and synchronized global risk market Bubbles. The initial European response to the Greek collapse extended the period of problematic excess and imbalances at Europe’s core. The Fed’s concern for the recent tightening of Financial Conditions at the “periphery” (EM, muni Credit and, perhaps, mortgages) ensures only more time for excess to build at the Bubble’s core (Treasuries, corporate debt, junk and leveraged lending, equities and, basically, anything with a yield).

My chronicling of the Greatest Bubble in History is going on five years now. This thesis is based upon the global nature of current Credit and speculative excess, along with attendant financial imbalances and economic maladjustment. My thesis is premised upon Bubble excess having, after decades, made it to the heart of government finance and contemporary “money.” This implies acute – and intransigent – fragilities, which ensure policymakers won’t have the grit to pull back. As was made even clearer Wednesday, the Fed is foremost determined to push back. And that’s precisely the mindset that has allowed the “granddaddy of all Bubbles” to get completely out of hand.

I believe the Bernanke Federal Reserve made yet another major blunder this week, and the likely price will be only greater market instability.