CREDIT IS GOLD # 1 AND ICEBERGS / PRUDENTBEAR.COM

Credit is Gold #1 and Icebergs

January 24, 2014

by Doug Noland


The evolving EM crisis took a turn for the worse.

Backdrops conductive to crises can drag on for so long – sometimes seemingly forever - as if they’re moving in ultra-slow motion. Invariably, they lull most to sleep. Better yet, such environments even work to embolden the optimists. This is especially the case when policy measures are aggressively employed along the way, repeatedly holding the forces of crisis at bay. In the face of mounting risk, heightened risk-taking and leveraging often work only to exacerbate underlying fragilities. But eventually a critical juncture arrives where newfound momentum has things unwinding at a more frenetic pace. It is the nature of such things that most everyone gets caught totally unprepared.

EM currencies came under intense selling pressure this week. Most dramatically, the Argentine peso sank 15.1%. The Turkish lira fell 4.4%, the Brazilian real 2.3%, the Russian ruble 2.9%, the South African rand 2.0%, the Chilean peso 2.0%, the Colombian peso 1.5%, the South Korean won 1.9%, the Indian rupee 1.8%, and the Mexican peso 1.6%.

Notable market yield increases included the 59 bps surge in Turkish 10-year (lira) yields to 10.58%; the 113 bps increase in Venezuela 10-year (dollar) yields to 16.26%; the 122 bps jump in Ukraine 10-year (dollar) yields to 9.54%; the 19 bps increase in Russian 10-year (ruble) yields to 8.13%; the 19 bps jump in Mexico 10-year (peso) yields to 6.58%; the 25 bps increase in Brazil’s 10-year (real) yields to 13.14%; the 30 bps jump in Hungary’s 10-year (forint) yields to 5.71%; and the 30 bps jump in Indonesian (rupiah) yields to 8.78%.

The apt Bloomberg currency market headline read: “Contagion Spreads in Emerging Markets as Crises Grow.” Note plural “crises” as opposed to a singular EM crisis. This is a pertinent issue. A popular CNBC contributor posited Friday that EM-related market stress was not as troubling because it was related to individual country issues as opposed to what would be more challenging “macro” forces. I would counter that the unfolding global crisis will be particularly problematic because of what has been a dangerous interplay between global “macro” and individual country “micro” Bubble dynamics.

Virtually the entire EM “complex” has been enveloped in protracted destabilizing financial and economic Bubbles. In particular, for five years now unprecedented “developed” world central bank-induced liquidity has spurred unsound economic and financial booms. The massive investment and “hot money” flows are illustrated by the multi-trillion growth of EM central bank international reserve holdings. There have of course been disparate resulting impacts on EM financial and economic systems. But I believe in all cases this tsunami of liquidity and speculation has had deleterious consequences, certainly including fomenting systemic dependencies to foreign-sourced flows. In seemingly all cases, protracted Bubbles have inflated societal expectations.

Thursday saw the Argentine central bank step away from what had been ongoing currency support operations. The Argentine peso quickly devalued 15%, before ending the session down about 12% (biggest fall in 12 years). The central bank’s decision to preserve its dwindling reserve position is reminiscent of South East Asian central bank actions back during the 1997 crisis. The dramatic market response was similarly reminiscent – ominously so.

For a while, central bank willingness to use reserves to support individual currencies bolsters market confidence in a country’s currency, bonds and financial system more generally. But at some point a central bank begins losing the battle to accelerating outflows. A tough decision is made to back away from market intervention to safeguard increasingly precious reserve holdings. Immediately, the marketplace must then contend with a faltering currency, surging yields, unstable financial markets and rapidly waning liquidity generally. Things unravel quickly.

Bloomberg headline: “Turkey’s ‘Embarrassing’ Intervention Fails to Curb Lira Selloff.” Thursday saw Turkey’s central bank aggressively intervene (first time in two years) to support its flagging currency. Estimates had the central bank buying $3.5 to $4.0 billion of lira in the marketplace, in what was called a “shock and awe” approach. The market was neither shocked, awed nor even mildly impressed, as the lira traded down 1.7% to yet another record low. As always, a key risk of aggressive market intervention is that a conspicuous lack of effectiveness will incite “hot money” outflows as well as aggressive bets against policy measures. Global policymakers take note.

After peaking at $115 billion in mid-December, Turkey’s international reserve holdings this week fell to $107 billion. Reminiscent of 1997, there reaches a point when shrinking reserves becomes a signal for a “hot money” rush for the exits. Central banks attempt to keep currency markets orderly, but such efforts risk a rapid drawdown of reserve holdings. A precipitous currency drop then opens cans of worms of difficult to control risks. A Friday Bloomberg headline: “Lira Intervention Seen Futile as Basci Lacks Ammo: Turkey Credit.”

Also Friday from Bloomberg (Taylan Bilgic): “Turkey Companies See Lira Ruin After Basci Miss: ‘The lira’s plunge has left Turkish companies struggling to service their foreign-currency debts as banks refuse to rollover loans, according to Suleyman Onatca, chairman of the Turkish Enterprise and Business Confederation. ‘Companies indebted in foreign currency are ruined,’ Onatca said… ‘This is an approaching disaster for small companies.’”

January 24 - Bloomberg (Anurag Joshi): "Indian companies facing some $300 billion-equivalent of debt maturing in two years are poised to extend the biggest dollar loan spree since 2010 to lock in rates as the Federal Reserve tapers stimulus. ONGC Videsh Ltd. leads companies seeking at least $5 billion in offshore bank debt this quarter after $10.5 billion was raised in the three months to Dec. 31, the most since the first quarter of 2010..."

The issue of EM sovereign and corporate borrowings in dollar (and euro and yen) denominated debt has speedily become a critical “macro” issue. More than five years of unprecedented global dollar liquidity excess spurred a historic boom in dollar-denominated borrowings. The marketplace assumed ongoing dollar devaluation/EM currency appreciation. There became essentially insatiable market demand for higher-yielding EM debt, replete with all the distortions in risk perceptions, market mispricing and associated maladjustment one should expect from years of unlimited cheap finance. As was the case with U.S. subprime, it’s always the riskiest borrowers that most intensively feast at the trough of easy “money.”

So, too many high-risk borrowers – from vulnerable economies and Credit systems - accumulated debt denominated in U.S. and other foreign currencies – for too long. Now, currencies are faltering, “hot money” is exiting, Credit conditions are tightening and economic conditions are rapidly deteriorating. It’s a problematic confluence that will find scores of borrowers challenged to service untenable debt loads, especially for borrowings denominated in appreciating non-domestic currencies. This tightening of finance then becomes a pressing economic issue, further pressuring EM currencies and financial systems – the brutal downside of a protracted globalized Credit and speculative cycle.

In many cases, this was all part of a colossal “global reflation trade.” Today, many EM economies confront the exact opposite: mounting disinflationary forces for things sold into global markets. Falling prices, especially throughout the commodities complex, have pressured domestic currencies. This became a major systemic risk after huge speculative flows arrived in anticipation of buoyant currencies, attractive securities markets, and enticing business opportunities. The commodities boom was to fuel general and sustained economic booms. EM was to finally play catchup to “developed.”

Now, Bubbles are faltering right and left - and fearful “money” is heading for the (closing?) exits. And, as the global pool of speculative finance reverses course, the scale of economic maladjustment and financial system impairment begins to come into clearer focus. It’s time for the marketplace to remove the beer goggles.

No less important is the historic – and ongoing - boom in manufacturing capacity in China and throughout Asia. This has created excess capacity and increasing pricing pressure for too many manufactured things, a situation only worsened by Japan’s aggressive currency devaluation. This dilemma, with parallels to the commodity economies, becomes especially problematic because of the enormous debt buildup over recent years. While this is a serious issue for the entire region, it has become a major pressing problem in China.

This week the markets seemed to begin taking the unfolding Chinese Credit crisis more seriously. There was talk early in the week of concerted efforts to save the troubled $496 million (“Credit Equals Gold No. 1”) trust product from a possible end-of-month default.

From Bloomberg: “Industrial & Commercial Bank of China Ltd. Chairman Jiang Jianqing said the lender won’t compensate investors for losses tied to a troubled trust product distributed by the bank, CNBC reported. The incident will be a lesson for investors on moral hazard and risks associated with such investments, Jiang told CNBC… The… lender won’t take ‘rigid responsibility’ for the losses and will review all its partnerships in entities with which it does business, Jiang said…”

Savers, investors and speculators will indeed learn painful lessons in China Credit – and it’s difficult for me to envisage this learning process going smoothly. “Credit Equals Gold No.1” is the proverbial tip of the Iceberg for a Credit system today suffering from a historic gulf between saver perceptions of “moneyness” and the poor and deteriorating quality of much of underlying system Credit. Incredible quantities of finance have flowed freely into risky Credit vehicles with the expectation that the banks and governments (local and central) will not allow losses nor ever tolerate a crisis. This is precisely the recipe for Credit accidents and even disaster.

And while there will certainly be ongoing measures taken by the People's Bank of China and Chinese officials, the bottom line is that Credit conditions have meaningfully tightened for China’s corporate and local government borrowers. The weak reading on manufacturing conditions (HSBC PMI) earlier this week was viewed as confirmation that "Credit transmission" issues have begun impeding growth.

At the same time, data this week provided added confirmation (see “China Bubble Watch”) that China’s spectacular apartment Bubble continues to run out of control. When Chinese officials quickly backed away from Credit tightening measures this past summer, already overheated housing markets turned even hotter. Now officials confront a dangerous situation: Acute fragility in segments of its “shadow” financing of corporate and local government debt festers concurrently with ongoing “terminal phase” excess throughout housing finance. China’s financial and economic systems have grown dependent upon massive ongoing Credit expansion, while the quality of new Credit is suspect at best. It’s that fateful “terminal phase” exponential growth in systemic risk playing out in historic proportions. Global markets have begun to take notice.

There are critical market issues with no clear answers. For one, how much speculative “hot money” has and continues to flood into China to play their elevated yields in a currency that is (at the least) expected to remain pegged to the U.S. dollar? If there is a significant “hot money” issue, any reversal of speculative flows would surely speed up this unfolding Credit crisis. And, of course, any significant tightening of Chinese Credit would reverberate around the globe, especially for already vulnerable EM economies and financial systems.

Yet another crisis market issue became more pressing this week. The Japanese yen gained 2.0% versus the dollar. Yen gains were even more noteworthy against other currencies. The yen rose 4.2% against the Brazilian real, 3.9% versus the Chilean peso, 3.5% against the Mexican peso, 3.9% versus the South African rand, 3.8% against the South Korean won, 3.0% versus the Canadian dollar and 3.0% versus the Australian dollar.

I have surmised that the so-called “yen carry trade” (borrow/short in yen and use proceeds to lever in higher-yielding instruments) could be the largest speculative trade in history. Market trading dynamics this week certainly did not dissuade. When the yen rises, negative market dynamics rather quickly gather momentum. From my perspective, all the major speculative trades come under pressure when the yen strengthens; from EM, to the European “periphery,” to U.S. equities and corporate debt.

It’s worth noting that the beloved European “periphery” trade reversed course this week. The spread between German and both Spain and Italy 10-year sovereign yields widened 19 bps this week. Even the France to Germany spread widened 6 bps this week to an almost 9-month high (72bps). Stocks were slammed for 5.7% and 3.1% in Spain and Italy, wiping out most what had been strong January gains.

Even U.S. equities succumbed to global pressures. Notably, the cyclicals and financials were hit hard. Both have been Wall Street darlings on the bullish premise of a strengthening U.S. (and global) recovery and waning Credit and financial risk. Yet both groups this week seemed to recognize the reality that what is unfolding in China and EM actually matter – and they’re not pro-global growth. With recent extreme bullish sentiment, U.S. equities would appear particularly vulnerable to a global “risk off” market dynamic.

U.S. speculators and investors have become accustomed to hasty comments or policy measures in response to the first sign of market weakness. Chairman Bernanke’s (past June) Comment that the Fed would “push back” against any “tightening of financial conditions” worked wonders on market sentiment and “animal spirits.” But I don’t expect the exiting Bernanke to ride to the markets’ rescue. I also don’t expect Bill Dudley and fellow FOMC doves to upstage the new chair Janet Yellen. And it would as well appear alarming to the marketplace if Yellen felt the need for public statements prior to the official start of her reign. With a Fed meeting scheduled for next week, an “emergency” meeting or other public statement over the weekend would also seem unlikely. This might actually be the beginning of a new environment where Fed officials are reluctant to jump to the markets’ defense at the first sign of nervousness.

Last year was extraordinary on so many levels. Too be sure, a “couple” Trillion of global QE made for some abnormal market dynamics. Typically, trouble at the “periphery” would lead to de-risking, de-leveraging and resulting contagion effects that begin their journey toward the “core.” But in 2013, with unprecedented global liquidity coupled with unprecedented speculation, initial cracks in “periphery” Bubbles spurred a speculative onslaught on “core” equities and corporate debt markets.

I would argue that 2013 dynamics significantly exacerbated global systemic fragilities. Over all, global financial systems and economies became only further dependent upon abundant cheap liquidity. The liquidity backdrop may have held EM crisis dynamics somewhat at bay, but it also prolonged a dangerous expansion of late-cycle debt. Meanwhile, “developed” market speculative Bubbles inflated precariously. “Money” flowed freely into all types of risky securities, instruments and products. Most importantly, inflated securities prices became only further detached from deteriorating fundamental prospects.

Last year’s “May/June Dynamic” provided some indication of transmission mechanisms from EM trouble to our markets and economy. There were liquidity issues related to an abrupt reversal of flows away from various ETF products. In particular, outflows impacted liquidity and risk perceptions in U.S. municipal finance. It is worth noting that Puerto Rico Credit default swap (CDS) prices jumped 21 bps this week to a record 778 bps. Puerto Rican officials were on CNBC Friday stating their intention to tap the markets for financing next month. Good luck with that. They may have missed their timing.

In striking contrast to “The May/June Dynamic,” Treasury yields have recently been declining as opposed to moving higher. Treasuries, bunds and other “developed” sovereign debt are enjoying a safe haven bid, likely bolstered by heightened global disinflationary forces. And while this makes life somewhat easier for those managing so-called “risk parity” strategies, this important change in market behavior surely complicates myriad other strategies. Those short Treasuries or bunds as hedges (or funding sources) for various leveraged “carry trade” strategies suddenly face an unfavorable dynamic.

It’s worth noting that most spreads reversed course and widened meaningfully this week. This comes after what appeared to be the whole world coming to realize the fun and easy profits of selling/writing CDS and other forms of Credit insurance (“writing flood insurance during a drought”). This backdrop would seem ripe for a bout of risk aversion, where abruptly shifting markets force players to pare back some exposure to “alternative” Credit strategies and myriad leveraged trades. This would provide a more traditional mechanism for transmitting market tumult at the “periphery” toward the “core.”

In a year that at this point seems poised to see a significant reduction in Federal Reserve liquidity creation, I would expect a return of a more “risk on, risk off” trading dynamic. This would seem to ensure that increasingly serious problems at the “periphery” have contagion effects that risk engulfing the “core.”